Developed Countries

Highlights Duration: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Fed: Low inflation expectations mean that the Fed is unconstrained when it comes to easing policy. Rate cuts will continue until either the funds rate reaches zero, or financial markets signal that enough stimulus has been delivered. Spread Product: Investors with 12-month investment horizons should neutralize allocations to spread product versus Treasuries, including high-yield where the recent oil supply shock will weigh heavily on returns. Investors should also downgrade exposure to MBS with the goal of re-deploying into corporate credit once the current risk-off episode runs its course. Feature Risk off sentiment prevailed in financial markets again last week, as COVID-19 continues to spread throughout the world. Most recently, the city of Milan has been placed under quarantine and New York state has declared a state of emergency. It is difficult to have much certainty about the virus’ ultimate economic impact, but the prospect of US recession looms larger and larger. In bond markets, the 10-year Treasury yield has fallen to 0.54% and the yield curve is pricing-in 91 bps of Fed rate cuts over the next 12 months (Chart 1). If those expectations are met, it would bring the funds rate down to 0.18%, only slightly above the zero-lower-bound. Chart 1Market Priced For A Return To The Zero-Lower-Bound On the bright side, there is ample evidence that global economic growth was trending up before the virus struck in late January, and we remain confident that a large amount of pent-up demand will be unleashed once its impact fades. However, we have no clarity on how much longer COVID-19 might weigh on growth. For this reason, we recommend a much more defensive US bond portfolio allocation, even for investors with 12-month horizons. Specifically, investors should keep portfolio duration close to benchmark and reduce spread product allocations to neutral. The market is sending the message that more rate cuts are needed. We will be quick to re-initiate a below-benchmark duration recommendation when we think that bond yields are close to bottoming. In the below section titled “How To Call The Bottom In Yields”, we discuss the factors that will help us make that decision. A State Of Monetary Policy Emergency The Fed took quick action last week, delivering an inter-meeting 50 basis point rate cut as the stock market tumbled on Tuesday morning. Alas, the market is sending the message that those 50 bps won’t be enough. Fed funds futures are pricing-in another 82 bps of easing by the end of next week’s FOMC meeting, followed by further cuts in April (Table 1). Table 1Expectations Priced Into The Fed Funds Futures Curve Of course, easier monetary policy is not the solution to what ails the global economy. At his press conference last week, Fed Chair Powell justified the emergency cut by saying that it will help “avoid a tightening of financial conditions which can weigh on activity, and it will help boost household and business confidence.” This is a fair assessment of what monetary policy can hope to accomplish in the current environment. At most, monetary policy can limit the damage in financial markets, which is a worthwhile goal given the strong historical correlation between financial conditions and economic growth (Chart 2). Chart 2Fed Must Do Its Best To Support Financial Conditions What’s more, with inflation expectations at very low levels – as we go to press the 10-year TIPS breakeven inflation rate is a mere 1.03% – there is no reason for the Fed to resist easing policy, even if the expected benefits from easing are small. Chart 3Markets Demand More Easing From our perch, the only possible reason for the Fed to refrain from cutting rates quickly all the way back to zero would be to preserve some monetary policy ammunition for when it is needed most. The Fed probably doesn’t see things this way. In conventional economic models it is the level of interest rates that influences economic activity. Therefore, the way to get the most bang for your stimulus buck is to cut rates to zero as quickly as possible. However, if monetary policy is primarily influencing the economy via its impact on financial conditions and investor sentiment, as Chair Powell claimed, then it would be advisable to only deliver rate cuts when financial conditions are tightening rapidly. That is, don’t cut rates if the stock market is rebounding, save your ammo for when equities are in free fall and panic is widespread. We can’t know for certain what the Fed will do between now and the next FOMC meeting. But we can say that, with inflation pressures low, there are no constraints against cutting rates back to the zero bound. The safest takeaway for bond investors is to assume that rate cuts will continue until either (i) the fed funds rate hits zero or (ii) we see signs that the markets and economy are no longer calling for further stimulus. Those signs would be (Chart 3): Yield curve steepening, particularly at the short end. Stocks outperforming bonds. A rising gold price. A falling US dollar. Bottom Line: More rate cuts are coming, and they won’t stop until either the fed funds rate hits zero or financial markets signal that sufficient stimulus has been delivered. We can’t be certain whether that will occur with more or less than the 91 bps of rate cuts that are currently priced for the next 12 months. As such, we recommend keeping portfolio duration close to benchmark. How To Call The Bottom In Yields The US economy is on the cusp of entering a downturn of uncertain duration that will likely be followed by a rapid recovery. Given that outlook, the next big call to make is: When will bond yields put in a bottom? We identify four catalysts that we will monitor to make that call. 1. Virus Panic Abates This is the most important catalyst that could lead us to re-initiate a below-benchmark duration recommendation. The pattern of past viral outbreaks is that bond yields tend to fall until the number of daily new cases reaches zero. This is precisely what happened during the 2003 SARS epidemic (Chart 4A). As for COVID-19, the number of daily new cases looked like it was approaching zero a few weeks ago, but then reversed course as the virus moved on from China to the rest of the world (Chart 4B). One ray of hope is that the number of new cases in China is approaching zero. This suggests that it will also be possible for other countries to contain the virus, but right now it is unclear how long that will take. Chart 4AYields Will Bottom When New Cases Reach Zero Chart 4BNew COVID-19 Cases Still ##br##Rising   In sum, we will keep tracking the global daily number of new cases and will shift to a below-benchmark duration recommendation as it approaches zero. 2. Global Economic Data Improve (Especially China) Chart 5Waiting For A Global Growth Rebound China is where the COVID-19 outbreak started and it is also where we are now seeing the impact in the economic data. The Global Manufacturing PMI dropped from 50.4 to 47.2 in February, due in large part to the plunge in China’s index from 51.1 to 40.3 (Chart 5). In order to call the bottom in US bond yields we will need to see evidence that China can come out the other side of the economic downturn. This means seeing an improvement in the Chinese and Global Manufacturing PMIs. We would also like to see improvement in other global growth indicators such as the CRB Raw Industrials index (Chart 5, panel 2) and the relative performance of cyclical versus defensive equity sectors (Chart 5, bottom panel). Aggressive Chinese stimulus (both monetary and fiscal) might help speed this process along. China’s credit impulse is on the rise (Chart 5, panel 2), and our China Investment Strategy service observed that recently announced policy initiatives related to infrastructure, housing and the automobile sector resemble those that led to a V-shaped Chinese economic recovery in 2016.1  We will be inclined to shift back to below-benchmark portfolio duration when the Global Manufacturing PMI, CRB Raw Industrials index and the relative performance of cyclical versus defensive equities move higher. 3. The US Economic Data Worsen Chart 6Waiting For Weaker US Data While the Global and Chinese economic data are currently in the doldrums, we still haven’t seen COVID’s impact on the US economy. The US ISM Manufacturing PMI is in expansionary territory and the Services PMI is at a healthy 57.3 (Chart 6). Meanwhile, US employment growth has averaged +200k during the past 12 months (Chart 6, panel 2) and the US Economic Surprise Index is above 60 (Chart 6, bottom panel)! Until the US economic data take a hit, another downleg in US bond yields is likely. Looking ahead, if the Global and Chinese economic data are improving as the US data are weakening, financial markets will extrapolate from the Chinese experience and start to price-in an eventual US recovery. Therefore, bond yields will probably start to move higher while the US economic data are still weak. For this reason, one catalyst for us to re-initiate below-benchmark portfolio duration will be when the US economic data weaken. 4. Technical Signals Table 2The 3-Month Golden Rule We don’t recommend relying on technical trading rules when forming a 12-month investment view, but technical signals can help add discipline to investment strategies, especially when calling tops and bottoms. One framework with a decent track record is our Golden Rule of Bond Investing applied to a shorter 3-month investment horizon.2 While this 3-month rule doesn’t work as well as when it is applied to a 12-month horizon, we still find that if you correctly predict whether the Fed will deliver a hawkish or dovish surprise relative to market expectations during the next three months, you will make the right duration call 63% of the time (Table 2). The 3-month Golden Rule worked better for dovish surprises than for hawkish surprises in our sample but delivered solid results in both cases. The median 3-month excess Treasury index return versus cash was -1.09% (annualized) when there was a hawkish Fed surprise, compared to +2.56% (annualized) when there was a dovish Fed surprise. For context, the median annualized 3-month excess Treasury index return versus cash during our sample period was +1.79%. Until the US economic data take a hit, another downleg in US bond yields is likely. The overnight index swap curve is currently priced for 94 bps of rate cuts during the next three months, which would essentially take the funds rate back to the zero bound. As of now, we cannot rule out this possibility and are therefore not inclined to look for higher yields during the next 3 months. Momentum, Positioning & Sentiment Other technical signals can also help call tops and bottoms in bond yields. One such signal comes from our Composite Technical Indicator, an indicator that is based on yield changes, investor sentiment surveys and positioning in bond futures markets. Right now, the indicator is sending a strong “overbought” signal with a reading below -1 (Chart 7). Chart 7Technical Treasury Signals In isolation, an overbought signal from our Composite Technical Indicator is not a strong reason to call for higher yields. We found that, historically, a reading below -1 from our indicator precedes a 3-month move higher in the 10-year Treasury yield only 53% of the time (Table 3). Table 3Technical Treasury Indicator Performance (1995 – Present) One reason for the Composite Technical Indicator’s mediocre performance is that, even at low levels, the market can always become more overbought. But we can partially control for this by combining the overbought signal from our indicator with simple momentum measures that might signal a trend reversal. For example, a reading below -1 from our Composite Technical Indicator combined with a 1-week increase in the 10-year yield precedes a higher 10-year yield during the next three months 58% of the time. If we wait for a 2-week increase in the 10-year yield the rule’s success rate rises to 60%, and it rises to 71% if we wait for the 10-year yield to break above its 4-week moving average. At present, our Composite Technical Indicator shows that Treasuries are extremely overbought, but momentum measures are sending no signals about an imminent trend change (Chart 7, bottom 3 panels). Bottom Line: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Some Quick Notes On TIPS, MBS And Spread Product Allocations Along with raising recommended portfolio duration to benchmark on a 12-month horizon, we also recommend neutralizing exposure to spread product in US bond portfolios. This includes reducing exposure to high-yield corporate bonds. High-yield remains attractively valued but will continue to sell off as long as risk-off market sentiment prevails. The looming oil price war will also weigh heavily on the sector, which is highly exposed to the US shale energy space. Once again using the SARS epidemic as a comparable, we see that – like Treasury yields – junk excess returns bottomed when the number of daily new cases approached zero (Chart 8). We could still be relatively far from this point, so taking risk off the table makes sense.  New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. We also recommend moving MBS allocations to underweight. New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. This spike is not yet fully reflected in MBS spreads, which remain relatively tight (Chart 9) Chart 8Too Soon To Call For Peak Junk Spreads Chart 9Downgrade MBS . Going forward, even after the economic fallout from COVID-19 has passed and it is time to increase exposure to spread product, we will likely continue to recommend an underweight allocation to MBS because better opportunities will be available in investment grade and high-yield corporate bonds where spreads will be much more attractive. On TIPS, last weekend’s oil supply shock – combined with the demand shock from COVID-19 – will conspire to keep long-maturity TIPS breakeven inflation rates well below their “fundamental fair value” for some time yet. But for investors with longer time horizons we see exceptional value in TIPS relative to nominal Treasuries. Even before yesterday’s big drop in oil, the 10-year TIPS breakeven inflation rate was 52 bps cheap relative to the fair value reading from our Adaptive Expectations Model (Chart 10).3 Chart 10TIPS Offer A Ton Of Long-Run Value Investors with 12-month investment horizons should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?”, dated February 26, 2020, available at cis.bcaresearch.com 2  For more details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 3 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Financial markets have experienced two weeks of wild swings: Following the negative 5-standard-deviation weekly move in the S&P 500 two weeks ago, the index moved at least 2.8% in each of last week’s first four sessions. 10- and 30-year Treasury yields made one all-time low after another. The coronavirus has arrived in the United States: It would appear inevitable that the coronavirus is going to spread across the US; the unknowns are how long it will spread, how deadly it will be, and how much it will impact the economy. Confronted with these unknowns, markets shot first and left asking questions for later. The selling may have gone a little far. The Fed and the Democratic candidates for president were in the news last week, … : The Fed made its first intra-meeting rate cut since the financial crisis was raging, cutting the fed funds rate by 50 basis points instead of waiting for its regularly scheduled March 17-18 gathering. Super Tuesday upended the chase for the Democratic presidential nomination, as our geopolitical strategists foresaw. … and we offer our quick read on their market impact: We expect that the Fed’s rate cut will be modestly positive for markets and the economy, while Joe Biden’s move to the head of the Democratic pack greatly diminished a risk that would otherwise have troubled investors all the way to November 3rd. Feature US equities have endured a rollercoaster ride over the last two-and-a-half weeks. From its all-time intraday high of 3,393.52 on February 19th, to the February 28th intraday low of 2,855.84, the S&P 500 corrected by 15.8% in just seven sessions. The brunt of the decline occurred two weeks ago, when the index lost 11.5% in its fourth worst week in the last six decades. The decline amounted to more than a negative 5-standard-deviation event, and took its place among what we now consider to be landmark episodes in US stock market history (Table 1). Table 1Socialism + Pandemic = History (But Not The Good Kind) The epic rout followed a weekend of distressing news. First, the coronavirus (COVID-19) slipped its Asian bonds, popping up fully formed in Italy and Iran in a sobering demonstration of its global reach. Second, Bernie Sanders had seemingly solidified his grip on the Democratic presidential nomination by trouncing the rest of the crowded field in the Nevada caucuses with nearly twice the share of the vote that he captured in his Iowa and New Hampshire wins. We therefore characterize the February 28th intraday low as the coronavirus/Sanders bottom. The former is still running around freely, but the latter has been largely contained. COVID-19 will surely be with us for a while longer, and may yet push the S&P 500 below its February 28th low, but it will have to do so without help from Bernie Sanders. Joe Biden reclaimed front-runner status following his tremendous Super Tuesday performance, and support for him coalesced with remarkable speed, relieving investors’ acute concern about a Sanders presidency. The primary campaign is still in its early stages, and the gaffe-prone Biden is capable of multiple stumbles between now and the nominating convention, but a general election without a self-declared socialist bent on ending health insurance as we know it will provoke considerably less market anxiety. The Rate Cut Equities had been pining for a rate cut, beginning last week’s surge upon the news that central bankers would be joining the G-7 Finance Ministers on their hastily arranged Tuesday morning conference call. After an immediate 2.5% pop upon the announcement of the intra-meeting cut, however, the S&P 500 sagged and wound up ending Tuesday’s session nearly 2% lower than its pre-cut level. The dismal market reception, and Powell’s own halting, tepid responses to questions at the press conference to discuss the rationale for the move left investors wondering if the Fed had made a mistake. We neither know nor care if it will turn out to be good policy, but we expect that the rate cut will lend support to risk assets over our 12-month investment horizon. Why would the Fed use monetary policy to try to combat a public health crisis, or any supply shock? Monetary policy tools were not made to fight public health crises. They will not speed the development of an antidote, make medical care more widely available, or make up for a lack of preparedness at the public health agencies leading the effort to blunt COVID-19’s spread. They also are not particularly well-suited to combat supply shocks. They cannot resolve global supply bottlenecks, put more people back to work in China, South Korea and Italy, or create and distribute all the test kits and protective clothing that medical professionals sorely need. It is within the Fed’s power, however, to try to keep COVID-19’s second-order economic consequences from taking root. Negative headlines, deserted shopping districts and runs on products like hand sanitizer and face masks can drag down business and consumer confidence. Falling confidence can weigh on consumption and investment, hobbling output, stifling employment growth, and raising the specter of a negatively self-reinforcing dynamic in which layoffs lead to less consumption, which feeds more layoffs, and less investment, etcetera. If the Fed can bolster the spirits of consumers and businesses, it can help to contain COVID-19’s adverse economic impact. Won’t this move leave the Fed with less ammunition down the road? Yes, it surely will, especially if the Fed would prefer to stick to conventional policy tools to combat the next recession. Last week’s cut may postpone the start date of that recession, however, affording the Fed a chance to execute a series of rate hikes before it arrives. For an investor with a timeframe that doesn’t exceed twelve months, it may not matter, provided the increased accommodation successfully reduces near-term recession risk. Do you think this move will be effective? At the margin, yes, we think it will. First of all, it will contribute to the mortgage-refinancing wave that has been building since the beginning of the year (Chart 1). With an average 3.45% 30-year fixed-rate mortgage rate, data provider Black Knight estimates 11 million borrowers could save at least 75 basis points by refinancing their existing loans.1 If the average rate were to fall to 3%, as it would if the spread between mortgage rates and Treasury yields simply eases back to the 2% neighborhood (Chart 2), the pool of potential refinancers would expand to 19 million. Reduced mortgage payments put more money in homeowners’ pockets and will help support consumption at the margin. Chart 1Mortgage Refis Were Already Ramping Up, ... Chart 2... And There Will Be Even More Activity Once Mortgage Spreads Normalize Lower rates will also increase demand for new-home purchases, which have positive multiplier effects, and other big-ticket consumer goods. They will also support investment at the margin, as hurdle rates fall, and more opportunities are projected to generate a positive net present value. Potential homebuyers may be less prone to attend open houses or conduct home searches if COVID-19 spreads, and skittish managers may be less prone to invest, but easier monetary conditions do promote economic activity. Finally, a Fed that is demonstrably committed to easing monetary conditions to mitigate COVID-19’s potential negative impacts may help shore up business and consumer confidence. It will take confidence to keep gloomy virus headlines from becoming a self-fulfilling recession prophecy. As Figure 1 illustrates, the Fed does have the means to boost demand in financial markets and the real economy. Figure 1Monetary Policy And The Economy What will it mean for markets? It may encourage investors to pay more for each dollar of a corporation’s earnings, helping to cushion equities from falling earnings projections (the Confidence/Risk Taking channel in Figure 1), though we think a surer outcome is that it will keep the search for yield at a fever pitch. Life insurers, pension funds and endowments can no longer rely on highly-rated sovereign bonds to deliver the income to meet their fixed obligations, but have very little leeway to allocate away from fixed income. They have therefore been forced to venture further and further out the risk curve (Figure 1’s Portfolio Balance Effect), which has had the effect of providing an ample supply of funds for less-than-pristine borrowers. Under zero- and negative-interest-rate policy (ZIRP and NIRP, respectively) just about any borrower aside from brick-and-mortar retailers and thinly capitalized oil drillers can attract a line of would-be lenders out the door and around the corner simply by offering an incremental 50-75 bps of yield. Since no borrower defaults, or goes bankrupt, as long as there is a lender willing to roll over its maturing obligations, extraordinarily accommodative monetary policy has had the effect of limiting default rates. We expect that the Fed’s move back in the direction of ZIRP will continue to squeeze spreads and ease financial conditions. That’s far from an ideal fundamental basis for owning spread product, and it won’t keep credit outperforming forever, but we expect it will allow spread product to continue to generate positive excess returns over Treasuries and cash over the next twelve months. Recession Prospects There is no doubt that the probability of a recession is rising. COVID-19 is already exerting intense pressure on the airline and hotel industries, and strapped small businesses will find themselves in its crosshairs soon. It is certainly possible that a recession could sneak up on us while we focus on our assessment of the monetary policy backdrop. But just as COVID-19 survival rates are heavily influenced by a patient’s intrinsic condition, the economy’s prognosis may be a function of its pre-outbreak status. To assess the economy’s vital signs, we begin with housing, the major economic segment with the greatest interest-rate sensitivity. If monetary policy is less accommodative than we’ve estimated, the housing market might be gasping for air, but it appears to be as fit as a fiddle. Permits and starts turned sharply higher in the middle of last year (Chart 3, top panel), following the sales component of the NAHB survey (Chart 3, bottom panel) and purchase mortgage applications (Chart 3, middle panel). Homes are already quite affordable, relative to history (Chart 4, top panel), and they’re bound to get even more affordable as mortgage rates fall. Chart 3Housing Charts Are Up And To The Right Across The Board Chart 4Homes Are Amply Affordable Nothing in the available data indicates that housing is running too hot. Residential investment’s contribution to GDP has flipped from barely negative to modestly positive (Chart 5), and there are no signs that its current course is unsustainable. Unsold inventories and the share of vacant homes are at 25-year lows (Chart 6), and starts and permits are only just catching up with the multi-year average of household formations, suggesting that the market has been undersupplied since the crisis excesses were worked off. The overall takeaway is that the housing market is in the early days of an overdue recovery that has plenty of room to run. Chart 5Residential Investment's Current Pace Is Easily Sustainable, ... Chart 6... And The Housing Market Still Looks Undersupplied Chart 7The Labor Market Is Strong Table 2No Sign Of Recession Here February’s employment situation report, ignored by markets in the throes of Friday's selloff, suggests that the labor market, and by extension the economy, was in fighting trim before COVID-19 took root in American soil (Chart 7). February’s net job additions far surpassed consensus estimates, and the figures for January and December were revised appreciably higher (Table 2). With the three-month moving average of net additions coming in one-third higher than expected, the report was nothing short of tremendous. The March release is sure to be worse, and the all-time record streak of expanding monthly payrolls may well come to an end, but the patient was in an awfully robust state before it encountered the virus, and that bodes well for its immediate future. The Democratic Primaries Super Tuesday turned out to be super for US financial markets. With all of the Democratic party’s machinery now at the service of Joe Biden, the probability that frightening left-tail outcomes might emerge from the general election has been dramatically reduced. Markets can live with a Biden-Trump contest no matter how it turns out. Although we thought that markets were exaggerating the potentially negative conditions that would ensue under President Sanders, they would have been subject to rolling bouts of angst every time his general election prospects rose. Though our geopolitical strategists unwaveringly saw the former vice president as the Democratic frontrunner, theirs was a decidedly minority view. Following the Nevada caucus, Sanders was viewed far and wide as the presumptive nominee. Although a Biden administration would presumably be less market-friendly than the current administration, he himself is a card-carrying member of the establishment and wouldn’t do anything that would upset the apple cart. From an investment perspective, Biden is the candidate that would Make America Predictable Again, and even if re-election is markets’ preferred outcome, the prospect of a Biden presidency is hardly frightening. Investment Implications Although our conviction level has fallen in the face of COVID-19 uncertainties, we hold to our view that a soft patch is more likely than a recession, and a correction is more likely than a bear market. 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. We think the most plausible worst-case scenario is a sharp but short recession, produced by a nasty supply shock that frightens households and businesses enough that they cease to consume or invest. The demand strike would imperil indebted businesses that suffered the biggest revenue declines: airlines, hotels, restaurants, retailers, thinly capitalized oil producers and a range of small businesses. They would shrink their workforces and many would default on their loans. That would be bad, as all recessions are bad, but it wouldn’t be a replay of the crisis. Credit extended to the sorts of borrowers listed above, ex-small businesses, is well-dispersed throughout the economy via corporate bonds and securitizations. The exposures the SIFI banks and their large- and mid-cap regional bank cousins have retained will be easily absorbed by the layers of additional capital mandated by Dodd-Frank and Basel 3. It seems to us that markets are pricing in a significant probability of something much worse than a run-of-the-mill recession, and we think that sets up an attractive risk-reward profile for investors in risk assets. We reiterate our risk-friendly recommendations, though we now recommend that fixed-income investors maintain benchmark duration positioning. We failed to appreciate the potential scope for a decline in long yields and are correcting course now.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Boston, Claire and Raimonde, Olivia, “A 30-Year Mortgage Below 3%? Treasury Rally Offers Bargain Loans,” Bloomberg, March 5, 2020.

Special Report

Highlights Joe Biden is the Democratic Party’s presumptive nominee following Super Tuesday. The onus is on Bernie Sanders to upset the race yet again. This is unlikely. Biden’s nomination is less market-negative than that of Sanders, but increases the risk of a Democratic Senate and hence tax hikes. The coronavirus threat to Trump’s reelection is two-pronged – and rising. Go long global equities ex-US on the basis that the virus fears will give way to public resilience and global stimulus. Feature A non-populist, non-protectionist candidate is emerging as the Democratic Party nominee for the US presidency – a positive development for global risk assets in 2020. Judging by preliminary results from the Democratic Party’s “Super Tuesday” primary elections, former Vice President Joe Biden has become the presumptive nominee, one of our key 2020 views. Our simple, back-of-the-envelope projection of delegates to the Democratic National Convention in Milwaukee, Wisconsin, July 13-16 shows that as long as Biden maintains his average vote share thus far, he is narrowly on track to win a majority of pledged delegates and thus clinch the nomination by June (Chart 1).  Chart 1Projection Of Democratic Delegates To National Convention, Milwaukee, July 2020 The chief risk to our view – that Vermont Senator Bernie Sanders, a left-wing populist, would run away with his momentum in February – has peaked. While Sanders won an average of 38% of the delegates on offer, he only won 28% of the popular vote, compared to Biden’s 44% of the delegates and 33% of the popular vote. The centrists as a bloc are outvoting the progressives and only two candidates are left. Ultimately Biden’s two-pronged path to victory in the Electoral College in November reinforces the Super Tuesday results, giving him greater electability and making him the likeliest victor of the Democratic Party primary. Super Tuesday Makes Biden Presumptive Nominee Biden racked up victories in key states including Texas, Massachusetts, Minnesota, and Virginia. He is now the leader in delegates to the party’s national convention (Chart 2), the popular vote, the number of states won, and the biggest states. The exception is California, one of the country’s most left-leaning states, where Sanders won, albeit with the combined progressive vote less than 50%. The voting pattern shows that Democrats still prefer centrist candidates to left-wing or “progressive” candidates by 50% to 40% on average (Chart 3). With two candidates left, this dynamic should favor Biden. Chart 2The Delegate Count Thus Far Chart 3Popular Vote: Biden/Centrists Versus Sanders/Progressives Chart 4Super Tuesday And Beyond By winning Texas and sweeping the South, Biden is heavily favored to win Florida on March 17 – always one of his strong suits vis-à-vis Sanders and a sign of electability in November. But his surprise victories over Sanders in Minnesota and Massachusetts show that he is competitive in the Midwest and Northeast, meaning that he is also likely favored to come out on top in Michigan and Ohio on March 10. The same goes for Illinois, the home state of his 2008-12 running mate Obama, on March 17 (Chart 4). True, in Minnesota and Massachusetts Biden benefited from Senator Elizabeth Warren’s clearing the 15% threshold, thus subtracting from Sanders’s vote share and delegate share. Warren may or may not drop out of the race. Sanders needs to arrest Biden’s Super Tuesday bounce and convince Democratic voters that he is more electable against Trump than Biden. This is a tall order for March 10-17, but Sanders has performed as well or better than Biden in the Northeast and Midwest as a whole, and these are the two regions that yield the most delegates in the rest of the primary (Chart 5).  Biden’s centrist rivals dropped out of the competition after his big win in South Carolina on February 29. His remaining centrist rival, Mayor Michael Bloomberg, suffered a humiliating defeat – pulling in Aspen, Colorado and Napa Valley California along with American Samoa despite spending over $400 million in advertisements (Chart 6). As we have argued, it takes votes, not just money, to win elections. Chart 5The Battle For The Northeast And Midwest Chart 6Bloomberg’s Folly It is a two-man race. If Biden can beat Sanders surrounded by competitors, then the onus is on Sanders to change the game from here. Otherwise Biden wins. Bottom Line: Biden is the likeliest winner. We will have to see another drastic change in momentum for this outcome to be overturned. Sanders’s underperformance on Super Tuesday suggests that his challenge to our base case (a centrist nomination) has peaked.    A Contested Convention? Still Unlikely Chart 7Biden’s Super Tuesday Bounce The coalescing of the centrist and progressive blocs, combined with a likely Super Tuesday bounce, will put Biden back in the lead in national polling (Chart 7). A contested Democratic convention remains unlikely, though it cannot be ruled out. Biden and Sanders are racing neck-and-neck for delegates and another twist in the race could deprive Biden of the simple majority of pledged delegates needed to clinch the nomination. The problem for Sanders is that in a close delegate matchup, a centrist candidate is favored to come out with the nomination. VIX futures suggest that this outlook is priced in, as they are falling for July (the month of the convention) relative to June (the conclusion of the primary election). Volatility induced by the primary election should gradually subside from now through July. Volatility will spike with the conventions in July mostly because of the uncertainty over the general election, and it should also pick up in September and October ahead of the November 3 vote. The spike in volatility that is always to be expected in the October ahead of a presidential election should continue increasing relative to July (Chart 8).   How can we be confident? The combination of the party establishment and the alternate or “reformist” centrist faction should be sufficient to overwhelm the combined “progressive” or anti-establishment bloc. Biden could fail to win the nomination on the first ballot, but the pro-establishment “super delegates” (party stalwarts who are not pledged to any particular candidate) would have the ability to swing subsequent ballots either in his favor or in favor of an alternate centrist (Chart 9). From a game-theoretical point of view, a sequential voting procedure is deadly to Sanders. His only hope was to rack up such a strong plurality in the primaries that he could take the convention by force. That is now unlikely. Chart 8VIX, Rightly, Not Pricing Contested Convention Chart 9Which Way Will The Super Delegates Swing? Even without a contested convention – and certainly with one – the Democratic Party could suffer from internal divisions that affect its challenge to the Republicans in November. The closer Sanders comes to Biden in delegate count, and especially if he should lead Biden yet still lose the nomination, the more his supporters will cry foul. In that case the party would send anywhere from 30%-40% of its voters away feeling disenfranchised. The worst-case scenario for the Democrats would be a convention troubled by open partisan rancor and social unrest, as occurred in the infamous 1968 convention in Chicago. Peace protesters against the Vietnam War and supporters of anti-war Senator Eugene McCarthy besieged the convention and were hounded and repressed by police forces under Chicago Mayor Richard Daley. Moderate Vice President Hubert Humphrey won the nomination despite the strong showing of anti-war sentiment in the primary election. The convention exposed the party’s rifts for all the nation to see. Humphrey went on to lose the election to Republican Richard Nixon. Chart 10Democrats Need To Avoid 1968 Replay Something akin to 1968 could occur this summer if Sanders’s supporters believe he has, for the second time, been deprived of the nomination unfairly in preference for a lackluster establishment candidate who will lose to Trump. But circumstances today are not (yet) so dire. The backdrop in 1968 was one of general upheaval, with opposition to the Vietnam War and the assassinations of Martin Luther King Jr and Robert F. Kennedy, the latter directly contributing to the dispute over delegates at the convention. The labor market was extremely tight (as today), but inflation was spiking (unlike today), fueling domestic unrest (Chart 10). The Democratic Party establishment is neither as disconnected from its base nor as draconian as in 1968. Biden or any other centrist nominee will seek to placate the left wing, likely through a leftward shift on some policies and a progressive vice-presidential pick. Opposition to Trump will act as a unifying force among Democrats. Bottom Line: A contested convention remains unlikely, but it cannot be ruled out. Biden is more likely to win the nomination due to his Super Tuesday bounce and the tailwind for centrists over progressives within the primary voting patterns thus far. If the convention is contested, it will likely result in a centrist candidate and the alienation of the progressive wing, and thus favor Trump’s reelection odds. Implications For The General Election Since November 2018 we have emphasized that US presidential elections are referendums on the incumbent party. Only rarely can the opposition defeat a sitting president amid an expanding economy, even if the ruling party lost the midterm election (as did the GOP in 2018). Major scandals reduce the historic reelection rate, but Trump has been acquitted so his biggest scandal is largely neutralized (Chart 11). The uptick in his approval rating after signing trade deals with China, Canada, and Mexico and getting acquitted by his fellow Republicans in the Senate confirms that he should be seen as favored for reelection. His approval is historically low but not prohibitive, as it tracks with Obama’s ahead of the 2012 election – low approval being in part a structural indicator of highly partisan times (Chart 12).  Chart 11Unseating An Incumbent Is Difficult Chart 12Trump’s Low Approval Not Prohibitive Yet Trump is only slightly favored. The coronavirus outbreak – and more importantly, the fear of it – threatens to damage Trump’s economy and highlight his fatal policy flaw: health care. Most of his first year in office consisted of a failed attempt to repeal and replace the Affordable Care Act (Obamacare), leaving 28 million Americans without health insurance (uninsured individuals increased by 2 million in 2018, the first increase since Obamacare was passed). The Democrats weaponized this gaping policy vulnerability in the vital Rust Belt swing states during the midterm election. Anything that shifts the focus of the election to health, as opposed to the growing economy, is positive for the Democrats on the margin (Chart 13). Granted, the narrative over Trump’s handling of the coronavirus crisis will become a non-diagnostic partisan battle. Neither Xi Jinping nor Donald Trump are responsible for the virus outbreak, but Trump is accountable for the popular perception of his handling of it whereas Xi is not. Ultimately the underlying material conditions of the economy will prove decisive. If the fear factor at home and abroad results in a sharper slowdown and higher unemployment by November, Trump is doomed. The swing states are already vulnerable because they took a heavy blow as a result of Trump’s trade war with China (Chart 14). Chart 13Is Health Care Trump’s Fatal Flaw? Chart 14Virus Fears Threaten Trump's Economy On the other hand, if the fear factor subsides due to the virus’s non-apocalyptic death rate, globally coordinated stimulus – starting with China but reinforced by the Federal Reserve’s surprise 50 basis point rate cut on March 3 – could generate a rebound by Q4 that redounds to Trump’s favor. Doesn’t America’s extreme political polarization create a kind of tribalism that overwhelms traditional “pocketbook” variables in forecasting an election (Chart 15)? Aren’t Democrats sufficiently fired up against President Trump to generate massive voter turnout that wipes out his thin margins of victory in the key swing states? After all, turnout in some of the primary elections is on par with the year the Great Recession began (Chart 16). Chart 15Does Reality Matter Amid Polarization? YES Chart 16Democrats Not Turning Out At 2008 Levels Most likely the economy will be decisive. Democratic fury against Trump will not translate as easily to the broader public if the economy is decent or rebounding in the second half of the year. Voter turnout tends to correlate with unemployment, including in the swing states (Chart 17). The coronavirus shock to the economy, not the blame game surrounding the virus or health care system, will be the determining factor. Chart 17Voter Turnout Responds To Economy … Including In Key Swing States This offers little consolation for Trump, since the brunt of the coronavirus impact on the economy is yet to be felt. While we still give Trump the benefit of the doubt for reelection, our quantitative election model says that the election is “too close to call,” primarily because of weak state-by-state leading economic indicators for Pennsylvania, Michigan, and Wisconsin (Chart 18). These indicators will tick down further due to the virus impact before they tick back up. Our base case is that the uptick will occur, but clearly the fear factor is the biggest risk to Trump’s reelection. Chart 18Quant Model Says US Election “Too Close To Call” The fact that Biden is a slightly more competitive candidate against Trump than Sanders will not help. Biden has a broader Electoral College pathway than Sanders. Both are competitive in the key Rust Belt swing states on which the 2016 election hinged – Michigan, Pennsylvania, Wisconsin. But Biden is also competitive in Florida, Arizona, and North Carolina, states largely closed to Sanders. Still, the difference between the Democratic challengers is marginal as neither is extremely charismatic and the election is a referendum on the ruling party and national direction as a whole. The Senate race is critical to the general election outcome (Chart 19). A Democratic president will be constrained if the Republicans maintain control – Sanders’s revolutionary agenda would be put on ice from the beginning, whereas Biden would have to focus on compromise (and would be prevented from repealing Trump’s tax cuts). Because Republicans saw a banner year in the Senate election in 2014 they must defend a larger number of competitive seats this year (10) than Democrats do (3) (Chart 20). If Democrats win the White House then they also need to win all three “toss up” races (Arizona, Colorado, Maine) – which is very doable – as well as keeping hold of their weakest seat (Alabama) or winning one additional seat (Kansas? North Carolina? Iowa?) in order to get an even balance in the Senate. This would give them the minimum necessary for majority voting since the vice president casts the decisive vote in a tie. Chart 19Democrats Lead Generic Ballot Chart 20Balance Of Power In The US Senate, 2020   Winning this many seats seems extremely difficult, based on the voting patterns in 2016 and 2018 (Table 1, Appendix), unless one considers the type of national environment that would see the incumbent Trump removed from office: it is an environment in which either voter turnout or support rates have shifted, in which case voters who view the Republicans as discredited are less likely to retain Republican senators who carried Trump’s water in the impeachment trial. Note that Biden is an asset in every key Senate race mentioned above except Colorado, whereas Sanders is probably a liability. Chart 21Balance Of Power In the US House Of Representatives, 2020 By contrast the Democrats are defending many more seats than Republicans in the House of Representatives (Chart 21). Yet Republicans would have to retain their five toss-up seats, three vacant seats, while poaching 18 of the Democrats 19 toss-up seats, to reclaim a majority (Table 2, Appendix). This is possible if there is a strong economic rebound in the second half of the year and Trump is “winning” on other policies, but it is unlikely. Thus a second-term President Trump is much more likely to be constrained by the House than a first-term President Biden is likely to be constrained by the Senate. It follows that Trump would focus on foreign policy, where he faces the fewest constitutional constraints – and in a second term he would be unshackled from reelection concerns. He would only be constrained by the desire for a magnificent legacy that keeps Ivanka Trump electable someday. This is not a constraint worth betting money on, especially not in the first two years when he is fresh off reelection (2021-22). The implication is more trade war with China, Europe, or both. Meanwhile Biden with the Senate would focus on the Democrats’ domestic legislative agenda – and would be likely to rack up successes. Without the Senate he too would be driven toward foreign policy, and given his age he would face a limited reelection constraint, like Trump. Bottom Line: Biden’s likely nomination solidifies our view that if Democrats win, they are likely to eke out a bare one-vote majority in the Senate, though not guaranteed. Biden is a Democratic asset for key Senate races while Sanders would be more likely to be constrained by a Republican Senate. If Democrats lose, they would have to lose in the context of a big economic rebound (or some other policy windfall for Trump) in order to yield the House of Representatives. In the context of the coronavirus shock, this seems unlikely. But it is likeliest if the economy is rebounding and the Democrats run a “socialist” for the presidency. Economic Policy Implications The most important investment takeaway from Super Tuesday is that the “Bernie Sanders Panic Index” risk will now tend to subside and the key sectors of the US stock market – tech and health – plus financials and energy will no longer have as big of a threat of punitive regulation hanging over their heads (Chart 22). Chart 22Bernie Panic Index Will Subside Biden’s approach to health would be to restore and expand Obamacare, which is already the law of the land and thus not nearly as disruptive as the attempt by Sanders to create a universal single-payer program that would eliminate private insurance (a large source of uncertainty since it would have been extremely difficult to achieve yet central to his agenda). Incidentally, Big Pharma faces headwinds under Democrats or Republicans, as the populist demand for lower prices will carry the day. President Biden would certainly re-regulate, reversing the deregulatory tailwind for corporate profits and animal spirits under President Trump (Chart 23). But there is much less negative of an impact on business optimism and the job market under Biden than Sanders. Business concern over tax hikes, as outlined, will largely depend on the Senate outcome (Chart 24). The consolation for the financial markets is that, with Biden the presumptive nominee, the tax cut rollback would not be complete: Biden aims for a 28% corporate rate, which is still a net seven percentage point cut from 2016. Chart 23Trump’s De-Regulatory Shock Chart 24The Oval Office Has A Pen And A Phone   The financial industry has faced a long and rocky recovery since the 2008 crash, reminiscent of the tech sector in the wake of the dotcom bubble (Chart 25). A Democratic victory will be negative on the margin, as even Biden will need to sharpen his knives when it comes to the banks. Even the Wall Street candidate Bloomberg had proposed a financial transactions tax. By contrast, Trump would clearly benefit this sector – as long as the business cycle recovers and the yield curve steepens. Chart 25Regulation Returns To Financial Industry? The loser, in either outcome, is the tech sector – which is the most richly valued. Both Republicans and Democrats are investigating Big Tech for anti-competitive practices. Wealth inequality, and the eventual end of the bull market and business cycle, will generate public unrest and encourage the government to identify and punish scapegoats, as in the past with leading companies that had excessive market concentration (Chart 26). Yet neither Trump nor Biden will be as aggressive on this front as Sanders would be. Chart 26Anti-Trust Suits Distract From Inequality, Late-Cycle Woes Chart 27Infrastructure Stocks Will Reboot There is little difference between Trump and Biden (or Sanders for that matter) on the question of infrastructure. Americans want better infrastructure but an economic slowdown is required to provide the impetus. Democrats are unlikely to grant new spending to Trump prior to the election unless he is reelected or a full-blown economic collapse is occurring (in which it is his final act). The performance of BCA’s Infrastructure Basket will improve after the election given that both parties are embracing expansive fiscal spending while China is launching another stimulus mini-cycle (Chart 27). The fiscal trajectory of the United States is unlikely to correct anytime soon. Trumpism has routed the fiscal hawks within the Republican Party and Biden is attempting to lead a Democratic Party that is making increasingly extravagant spending demands. The median American voter is demanding greater government provision of services and social spending. If Democrats win the White House and Senate, they will be able to claw back some revenue by repealing Trump’s tax cuts, but the pressure to spend will outweigh their ability to increase taxes (Chart 28). They will need to expand non-defense discretionary spending even as mandatory outlays rise inexorably due to the aging of the population (Chart 29). Chart 28More Fiscal Profligacy In The US Outlook Chart 29Zero Chance Of Entitlement Cuts Investment Conclusions The US election is eight months away and much can change between now and then. What we know is that Biden now has the clearest path to the Democratic nomination, while Sanders would require another rapid reversal in momentum in order to take the lead. Even if he does, the Democratic convention will favor a centrist as long as Sanders falls short of a commanding lead, which is likely given the 50%-versus-40% split in favor of centrists over progressives thus far. A two-man race will favor Biden as long as this dynamic persists. Biden is slightly more competitive against Trump than Sanders, and slightly more likely to take the Senate for the Democrats. Yet ultimately Trump’s presidency will live or die based on the economy. Otherwise a significant policy humiliation (or surprise right-wing third party candidate) would be required to undo his reelection bid. Chart 30Valuations Favor Non-US Stocks Unfortunately for Trump, the coronavirus outbreak presents precisely this two-pronged risk of worsening economy and policy failure. If this risk fully materializes then he is finished, but markets will most likely have the consolation that it is Biden, not Sanders, waiting in the wings. Our base case remains constructive over the next twelve months, particularly for global stocks ex-US, which are much more heavily discounted and will benefit from Chinese stimulus (Chart 30). The virus shock is clearly a massive risk, but as long as the death rate does not surprise to the upside the ultimate impact will be public resilience and global stimulus.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Appendix Table 1Democrats Likely To Win The Senate If They Win White House Table 2Republicans Unlikely To Reclaim House Even If They Keep White House Footnotes

Special Report

Highlights Crude oil prices fell ~ 10% Friday after Russia refused to support additional production cuts agreed by OPEC in Vienna (Chart 1). As we go to press, Brent is trading close to $45/bbl and WTI is trading ~ $41/bbl. OPEC producers could implement the go-to strategy they’ve employed in the wake of past demand shocks and cut production on their own, in order to balance the market. That said, there are indications the Saudis will not shoulder the market-balancing role alone. Russian producers have consistently demanded relief from production restraints since 2017, when OPEC 2.0 took over balancing the market. With shale-oil producers on the back foot owing to parsimonious capital markets, Russia could finally be able to deliver the coup de grâce it has been waiting for. This supply shock hits the market as COVID-19 threatens demand globally. Whatever Russia’s intent – be it removing the near-certainty of a production cut, which it always agreed to in the past, or crippling US shale production – two-way risk has returned to these Vienna meetings. Feature Oil markets once again are faced with a possible price collapse – not unlike the swan dive seen when OPEC’s market-share war took Brent from more than $110/bbl in mid-2014 to $26/bbl by early 2016. The proximate aim of that market-share war – led by the Kingdom of Saudi Arabia (KSA) – was to significantly reduce the revenue Iran would receive when it returned to export markets, following its agreement with the US to end its nuclear program in 2015. Tanking oil prices was the most expedient way of accomplishing this. Secondarily, shale-oil producers also may have been targeted, although such a goal was never clearly articulated by KSA’s leadership. Chart 1Russia's Supply Shock Craters Brent, WTI Prices OPEC’s market-share war did thin the US oil-shale herd, but it did not destroy the industry. If anything, it forced shale-oil producers to focus on their best drilling prospects with their best rigs and crews. This produced a leaner more productive technology-driven cohort of drillers, which posted record production levels on a regular basis. Indeed, by the end of 2019, US production topped 12.9mm b/d – 8.2mm b/d of which was accounted for by shale-oil output – making the US the largest oil and gas producer in the world. The market-share war also brought KSA and Russia together in November 2016 as the putative leaders of OPEC 2.0. The sole mission of this unlikely coalition was to clear the global inventory overhang left in the wake of the market-share war by managing OPEC and non-OPEC production. Russia’s Coup de Grâce Managing global production and inventories with KSA – while US shale-oil producers continued to raise their output to new records regularly – never sat well with Russia’s oil producers.   Managing global production and inventories with KSA – while US shale-oil producers continued to raise their output to new records regularly – never sat well with Russia’s oil producers. Ahead of OPEC 2.0 meetings in Vienna, Russian oligarchs could be counted on to demand higher output levels, and President Vladimir Putin could be counted on to deliver something close to agreed production cuts in time to assuage markets. This semi-annual ritual came to resemble a tightly choreographed set-piece, which may have inured market participants to the oligarchs’ resolve to ultimately increase production levels. Russia certainly was well-prepared when it delivered Friday’s supply shock. Time will tell, but Friday’s breakdown in Vienna could be the coup de grâce Russia’s oligarchs have been waiting to deliver to US shale producers since the formation of OPEC 2.0. Or it could be a well-timed reminder that nothing in oil markets is certain – particularly Russian compliance with production-restraint agreements. The once-certain 11th-hour agreement to adhere to whatever production-cutting agreements OPEC 2.0 came up with is now gone. And with it, the high-probability bet that, regardless of the tensions leading up to the Vienna meetings, a production-management agreement would be delivered, and shale-oil producers would live to fight another day. Chart 2Russia, KSA Foreign Exchange Reserves Whatever the case, Russia certainly was well-prepared when it delivered Friday’s supply shock. It has steadily built its foreign-exchange reserves since the price collapse begun in 2014, which now stand at $446 billion, up 45% from their nadir of 2015 (Chart 2). KSA’s foreign-exchange reserves, on the other hand, fell sharply in the wake of the 2014 – 2016 market-share war and have languished at lower levels since. Chart 3Russia, KSA Per-Capita Income Still, the Kingdom is not without stout resources. It’s gross national income per capita is ~ 2x that of Russia’s (Chart 3), and its days-forward import cover expressed in terms of days of foreign reserves is similarly stout (Chart 4). Chart 4Russia, KSA Import Cover The economies of both KSA and Russia are exquisitely linked to Brent oil prices (Chart 5). So tempting another market-share or price war is a strategy that could not be sustained by either country for an extended period of time. Chart 5Russia, KSA GDP vs Brent Prices Chart 6Russia, KSA GDP Highly Sensitive To Brent Prices The End Of OPEC 2.0? Post-GFC, we estimate Russia’s real GDP elasticity to changes in oil prices is close to twice that of Saudi Arabia. This suggests Russia’s strategy could have dismal consequences for its economy. Oil markets will gnaw on Friday’s breakdown in Vienna, sorting out the signals that were missed in Russian messaging, and figuring out what happens next. Neither Russia nor KSA have the resources to wage an indefinite war of attrition with US shale producers. Both are highly dependent on oil revenues to sustain their economies (Chart 6). Of the two, Russia’s economy is more sensitive to Brent oil prices than KSA’s, as it markets more of its output in trading markets. Post-GFC, we estimate Russia’s real GDP elasticity to changes in oil prices is close to twice that of Saudi Arabia. This suggests Russia’s strategy could have dismal consequences for its economy. Russia’s $50/bbl fiscal breakeven price vs. KSA’s $84/bbl price might give Russia more staying power in the short run, but with per-capita income at roughly half that of Saudi citizens, it will not want to revisit the dire days of 2014-16 when its economy last suffered through an oil-price collapse.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com  

Highlights The latest interest rate cuts by central banks confirms the narrative that the authorities view economic risks as asymmetrical to the downside. This all but assures that competitive devaluation will become the dominant currency landscape in the near future. If the virus proves to be just another seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The dollar will be the ultimate loser in both scenarios, but this path could be lined with intermediate strength. Our highest-conviction call before the dust settles is to short USD/JPY. We are also making a few portfolio adjustments in light of recent market volatility. Buy NOK/SEK and NZD/CHF and take profits soon on long SEK/NZD. Feature The DXY rally that began last December faltered below overhead psychological resistance at 100, and has since broken below key technical levels. The V-shaped reversal has been a mirror image of developments in equity markets, with the S&P 500 off 6% from its lows. The catalyst was aggressive market pricing of policy action from the Federal Reserve, to which the authorities yielded. The latest policy action confirms the narrative that most central banks continue to view deflation as a much bigger threat than inflation, since few have been able to achieve their mandate. This all but assures that competitive devaluation will become the dominant currency landscape, as each central bank prevents appreciation in their respective currency. Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.   The US 10-year Treasury yield broke below 1% around 1:40 p.m. EST on March 3rd. This was significant not because of the level but because it emblematically erased the US carry trade for a number of countries (Chart I-1). Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.  Chart I-1The Big Convergence To Buy Or Sell The DXY? If the virus proves to be only slightly more lethal than the seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. Chart I-2 shows that the global economy was already on a powerful V-shaped recovery path before the outbreak. More importantly, this recovery was on the back of easier financial conditions. Chart I-2V-Shaped Recovery At Risk Chart I-3A Second Wave Of Infections? Our roadmap is the peak in the momentum of new infections outside of China. During the SARS 2013 episode, the bottom in asset prices (and peak in the DXY) occurred when the momentum in new cases peaked. Currency markets are currently pricing a much worse outcome than SARS. The risk is that we are entering a second wave of infections outside Hubei, China, which will be more difficult to control than when it was relatively more contained within the epicenter (Chart I-3). As we aptly witnessed a fortnight ago, currency markets will make a binary switch to risk aversion on such an outcome. This warns against shorting the DXY index or buying the euro or pound in the near term. As we go to press, the virus has been identified on almost every continent except Antarctica. Even in countries such as the US, with modern and sophisticated health facilities, the costs to get tested are exorbitant for underinsured individuals.1 This all but assures that the number of underreported cases is likely non-trivial, which could trigger another market riot once they surface. Chart I-4DXY and USD/JPY Tend To Move Together Our highest-conviction call before the dust settles is therefore to short USD/JPY. As Chart I-1 highlights, the Bank of Japan is much closer to the end of their rope in terms of monetary policy tools. Long bond yields have already hit the zero bound, which means that real rates in Japan will continue to rise until the authorities are forced to act. One of the triggers to act will be a yen soaring out of control, which is not yet the case. Speculative evidence is that it will take a yen rally in the order of 12% to catalyze the BoJ. More importantly, the speed of the rally will matter. This was the trigger for negative interest rates in January 2016 as well as yield curve control in September of 2016. The first rally from USD/JPY 125 to around 112 and the subsequent rise towards 100 were both in the order of 12%. A similar rally from the recent peak near 112 will pin the USD/JPY at 100.   Bottom Line: The yen is the most attractive currency to play dollar downside at the moment. Remain short USD/JPY. If global growth does pick up and the dollar weakens, the USD/JPY and the DXY tend to be positively correlated most of the time, providing ample room for investors to rotate into more pro-cyclical pairs (Chart I-4). Competitive Devaluation? In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The Reserve Bank of Australia has already stated that QE is on the table if rates touch 0.25%.2 Other central banks are likely to follow suit. As the chorus of central banks cutting rates and stepping into QE on COVID-19 rises, the rising specter of currency brinkmanship is likely to unnerve countries pursuing more orthodox monetary policies. The currency of choice will be gold and other precious metals, though the dollar, Swiss franc, and yen are likely to also outperform.  The velocity of money in both the US and the euro area was in a nascent upturn, but has started to roll over.  Whether or not countries adopt QE, what is clear is that balance sheet expansion at both the Fed and the European Central Bank is set to continue. Chart I-5 shows that the velocity of money in both nations was in a nascent upturn, but has started to roll over. This tends to lead inflation by a few quarters. On a relative basis, our bias is that the pace of expansion should be more pronounced in the US. This will eventually set the dollar up for a significant decline, albeit after a knee-jerk rally. Chart I-5ADownside Risks To US Inflation Chart I-5BDownside Risks To Euro Area Inflation In terms of quantitative easing, it is most appealing when a country has low growth, low inflation, and large amounts of public debt. If we are right that inflation is about to roll over in the US, then the public debt profile and political capital to expand the budget deficit places the nation as a prime candidate for QE (Chart I-6). Fiscal stimulus is a much more difficult discussion in Europe, Japan, or elsewhere for that matter, and likely to arrive late. Chart I-6US Government Debt Is Very High The backdrop for the US dollar is a 37% rise from the bottom. The New York Fed estimates that a 10 percentage point appreciation in the dollar shaves 0.5 percentage points off GDP growth over one year, and an additional 0.2 percentage points in the following year.3 With growth now hovering around 2%, a strong currency could easily nudge US growth to undershoot potential.  The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. However, the path to QE will be lined by a strong dollar if the backdrop is flight to safety. This entails rolling currency depreciations among some developed and emerging markets. When looking for the next candidates for competitive devaluation, the natural choices are the countries with overvalued exchange rates that are exerting a powerful deflationary impulse into their economies. Chart I-7 shows the deviation of real effective exchange rates from their long-term mean, according to the BIS. Chart I-7Competitive Devaluation Candidates Bottom Line: The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. It will first occur among the safe havens (currencies with already low interest rates), before it rotates to more procyclical currencies. Where Does US Politics Fit In? Politics should start to have a meaningful impact on the dollar once the democratic nominee is sealed. Super Tuesday revealed a powerful shift to the center, pinning former Vice President Joe Biden as the preferred candidate (Chart I-8). The dollar tends to thrive as political uncertainty rises. While not a forgone conclusion, a Sanders–Trump rivalry would have been a very polarized outcome, putting a bid under the greenback. Markets are likely to take a more conciliatory tone from a Biden victory, which will be negative for the greenback.   Chart I-8US Politics Will Be Important Our colleague Matt Gertken, chief geopolitical strategist, just published his analysis of Super Tuesday.4 While a contested convention remains unlikely, it will likely favor Trump’s reelection odds. What is common about a Biden-Sanders-Trump trio is that fiscal policy is set to expand in the US. This will ultimately be dollar bearish (Chart I-9). Chart I-9The Dollar And Budget Deficits Bottom Line: The election is still many months away and much can change between now and then. For now, Biden is the preferred democratic nominee. Portfolio Adjustments Chart I-10Sell CHF/NZD The sharp rally in the VIX index has opened up a trading opportunity on the short side. The historical pattern of previous spikes in the VIX is that unless the market starts to price in an actual recession, which is quite plausible, the probability of a short-term reversal is close to 100%. Given our base case that we are not headed for a recession over the next six to 12 months, we are opening a short CHF/NZD trade today. The cross tends to benefit from spikes in volatility, correcting sharply as the market unwinds overreactions. More importantly, the cross has already priced in an overshoot in the VIX in an order of magnitude akin to 2008. Place stops at 1.75 with a target of 1.45 (Chart I-10). We are also placing a limit buy on NOK/SEK at parity. The risk to this trade is a further down-leg in oil prices, but at parity, the cross makes for a compelling tactical trade. Momentum on the cross is currently bombed out. We will be closely watching whether Russia complies with OPEC production cuts and act accordingly. Remain long NOK within our petrocurrency basket against the euro. We are also looking to take profits on our long SEK/NZD trade, a nudge below our initial target. The market has fully priced in a rate cut by the Reserve Bank of New Zealand, suggesting the kiwi could have a knee-jerk rally, similar to the Aussie on the actual announcement. Finally, we were stopped out of our short gold/silver trade for a loss of 5.5%. We will be looking to re-establish this trade in the coming weeks. Stay tuned. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Bertha Coombs and William Feuer, “The coronavirus test will be covered by Medicaid, Medicare and private insurance, Pence says,” CNBC, dated March 4, 2020. 2 Michael Heath, “RBA Says QE Is Option at 0.25%, Doesn’t Expect to Need It,” Bloomberg News, dated November 26, 2019. 3 Mary Amiti and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Federal Reserve Bank of New York, dated July 17, 2015. 4  Please see Geopolitical Strategy Special Report, titled “US Election: A Return To Normalcy?”, dated March 4, 2020, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI fell slightly to 50.9, dragged down by the prices paid and new orders component, while the non-manufacturing index ticked up to 57.3. Core PCE inflation increased to 1.6% year-on-year in January. Unit labor costs came in at 0.9% quarter-on-quarter in Q4 of last year. This is a deceleration from the previous print of 2.5%. The DXY index depreciated by 1.4% this week. Following a conference call with G7 central banks, the Fed made an emergency rate cut of 50bps. Chairman Powell cited risks to the outlook from Covid-19 but acknowledged that the Fed can keep financial conditions accommodative, not fix broken supply chains or cure infections. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Building A Protector Currency Portfolio - February 7, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: Core CPI inflation increased slightly to 1.2% year-on-year in February.  The producer price index contracted by 0.5% year-on-year in January. The unemployment rate remained flat at 7.4% in January. Retail sales grew by 1.7% year-on-year in January, remaining flat from the previous month. The euro appreciated by 3.6% against the US dollar this week. As the ECB is limited by the zero lower bound, the euro strengthened on expectations that rate differentials with the US will continue to narrow. The ECB could resort to policy alternatives such as a special facility targeting small and medium enterprises. Markets are pricing in an 81% probability of a rate cut as we go into the ECB meeting next week. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The Tokyo CPI excluding fresh food grew by 0.5% year-on-year in February from 0.7% the previous month. The jobs-to-applicants ratio decreased to 1.49 from 1.57 while the unemployment rate increased to 2.4% from 2.2% in January. The consumer confidence index declined to 38.4 from 39.1 in February. Housing starts contracted by 10.1% year-on-year in January from 7.9% the previous month. The Japanese yen appreciated by 2.5% against the US dollar this week. Lower US yields, combined with continued risk-on flows, have extended the rally in the Japanese yen. Weakness in the Japanese economy is broad based, but the BoJ has limited policy space and fiscal action looks unlikely anytime soon. Global central bank action will drive the yen in the near term. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: Consumer credit decreased to GBP 1.2 billion from GBP 1.4 billion while net lending to individuals fell to GBP 5.2 billion from GBP 5.8 billion in January. Mortgage approvals increased to 70.9 thousand from 67.9 thousand in January, while the Nationwide housing price index grew by 2.3% year-on-year in February from 1.9% the previous month.  The British pound appreciated by 0.2% against the US dollar this week. At a hearing this week, incoming governor Andrew Bailey stated that the BoE is still assessing evidence on the nature of the shock from Covid-19. The BoE has limited room to cut and is constrained by possible stagflation; we expect targeted supply chain finance and cooperation with fiscal authorities to take precedence.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: GDP grew by 2.2% year-on-year in Q4 2019, improving from 1.7% the previous quarter.  Imports and exports both contracted by 3% while the trade balance dropped to AUD 5.2 billion in January. Building permits contracted by a dramatic 15.3% month-on-month in January, compared to growth of 3.9% in December. The RBA commodity price index contracted by 6.1% year-on-year in February.  The Australian dollar appreciated by 0.8% against the US dollar this week. The Reserve Bank of Australia cut its official cash rate to 0.5%, an all-time low, citing the impact of Covid-19 on domestic spending, education, and travel. Watch to see if the signal from building permits is confirmed by other housing market indicators. The RBA might not be done easing. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The terms of trade index grew by 2.6% quarter-on-quarter in Q4 2019, improving from 1.9% in Q3. The ANZ commodity price index contracted by 2.1% in February, deepening from 0.9% the previous month. Building permits contracted by 2% month-on-month in January, from growth of 9.8% in December.  The global dairy trade price index contracted by 1.2% in March.  The New Zealand dollar appreciated by 0.3% against the US dollar this week. There is pressure on the Reserve Bank of New Zealand (RBNZ) to ease at its next meeting on March 27, with markets pricing in 42 basis points of easing over the next 12 months. However, the RBNZ has dispelled notions of a pre-meeting cut. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Annualized GDP grew by 0.3% quarter-on-quarter in Q4 2019, slowing from 1.4% the previous quarter.  The raw material price index contracted by 2.2% and industrial product price index contracted by 0.3% month-on-month in January.  Labor productivity contracted by 0.1% quarter-on-quarter in Q4 2019, compared to growth of 0.2% the previous quarter. The Canadian dollar depreciated by 0.1% against the US dollar this week. The Bank of Canada (BoC) followed the Fed and cut rates by 50bps. In addition to the confidence hit from Covid-19, the BoC cited falling terms of trade, depressed business investment, and dampened economic activity due to the CN rail strikes. The BoC stands ready to ease further, and Prime Minister Trudeau has raised the possibility of a fiscal response.   Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: GDP grew by 1.5% year-on-year in Q4 2019, from growth of 1.1% the previous quarter. The SVME PMI increased to 49.5 from 47.8 in February. The KOF leading indicator increased to 100.9 from 100.1 in February. CPI contracted by 0.1% year-on-year in February, from growth of 0.2% the previous month. The Swiss franc appreciated by 1.6% against the US dollar this week. A combination of strong domestic data and global risk-off flows contributed to strength in the Swiss franc. However, the Swiss government will be revising down growth forecasts and a recent UN report has estimated that Switzerland lost US$ 1 billion in exports in February due to Chinese supply disruptions. Combined with a strong franc, this puts the domestic outlook at risk.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The current account decreased to NOK 19.1 billion from NOK 29.5 billion in Q4 2019. The credit indicator grew by 5% year-on-year in January. Registered unemployment decreased slightly to 2.3% from 2.4% in February.  The Norwegian krone appreciated by 1.3% against the US dollar this week. Expect the petrocurrency to trade on news from the OPEC meetings in the coming days. The committee has proposed a production cut of 1.5 million barrels per day through Q2 2020, conditional on approval from Russia, to offset the demand shock from Covid-19.  Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: The Swedbank manufacturing PMI increased to 53.2 from 52 in February. Industrial production grew by 0.9% year-on-year, from a contraction of 2.6% the previous month. GDP grew by 0.8% year-on-year in Q4 2019, slowing from 1.8% the previous month. The Swedish krona appreciated by 1.5% against the US dollar this week. After hitting a 2-decade high near 10, USD/SEK has violently reversed and is now trading at the 9.45 level. What is evident from incoming data is that the cheap currency has been a perfect shock absorber, cushioning the domestic economy. We are protecting profits on long SEK/NZD today and we will be looking for other venues to trade SEK on the long side.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades