Developed Countries

The Fed’s inter meeting cut this week signals that the FOMC is panicky and has now acted a mere two days after the SPX fell 16% from the February 19 all-time highs. As a reminder, following the last 20% SPX correction in late 2018 it took the Fed seven months to cut rates! As the WSJ recently reported “Since 1998, the Fed has cut interest rates six other times between regularly scheduled meetings. Following each of those moves, the Fed has lowered rates again at its next policy meeting.” Thus, the fed funds rate is on the path to hitting the zero lower bound sooner rather than later, likely pulling longer term yields down with it. Tack on the safe haven flows the US Treasury market enjoys and the Treasury/Bund spread is also headed south. This spread has been an excellent leading indicator for the SPX over the past decades, as we have highlighted1 in the past, and warns that the S&P 500 will be lower in 9-12 months. Bottom Line: Stay cautious on the cyclical prospects of the broad equity market.   1    Please see U.S. Equity Strategy Insight Report, “Treasury/Bund Spread And The SPX,” dated April 18, 2019, available at uses.bcaresearch.com.

Highlights OPEC 2.0 ministers continue to negotiate oil production cuts to replace those expiring this month. We expect cuts of 1mm b/d – perhaps more – extending to end-June, undertaken to offset COVID-19-induced demand destruction. Making the not-unreasonable assumptions of no change in US sanctions-related output losses – 1mm b/d in Venezuela and 2mm b/d in Iran – and that 1mm b/d of Libyan output stays offline, the 1mm b/d cut coming out of this week’s meeting in Vienna will push average 1H20 OPEC 2.0 outages – planned and unplanned – to ~ 5mm b/d. The US economy is growing ~ 2.7% p.a., suggesting the Fed’s surprise 50bp rate cut this week is aimed at reducing global economic policy uncertainty (GEPU), lowering its accompanying USD safe-haven demand, and guarding against a collapse in US money velocity (Chart of the Week). This will weaken the USD, thereby supporting EM incomes and oil demand. We continue to expect policymakers in China to overshoot on fiscal and monetary stimulus, as they scramble to deliver 6% pa growth this year. Feature In the wake of ongoing negotiations – right into today’s meeting in Vienna – we expect OPEC 2.0 to deliver a production cut of at least 1mm b/d for 2Q20. Maybe more. Gulf Cooperation Council (GCC) states have been lobbying for a large cut – 1mm b/d at least. The Kingdom of Saudi Arabia’s (KSA) consistently lobbied for such cuts, and was instrumental in achieving the 1.7mm b/d output reduction for this quarter when the coalition met at the end of last year in Vienna. KSA’s partner in OPEC 2.0, Russia, has been slow to support production cuts going into this week’s meeting, which is the stance it typically takes during these negotiations. Nonetheless, it did agree in December to cuts, and we expect they will do so again this week. After this go-round, we’re likely to see an agreement to meet in June to determine whether cuts should be extended and/or expanded.1 Chart of the WeekFed Rate Cut Meant To Reduce Uncertainty The 1mm b/d in planned outages for 2Q20 coming out of this week’s meetings would add to the ~ 4mm b/d of unplanned outages in Venezuela, Iran and Libya this year. If the producer coalition fails to agree to a significant output cut this week, we would expect a sell-off in crude oil that takes Brent prices below $50/bbl, and WTI into the mid-$40s (Chart 2). An agreement to remove at least 1mm b/d of output likely will push Brent into the mid-$50s and WTI into the low-$50s during in 2Q20. Assuming the COVID-19 outbreak subsides by then, we expect Brent to rally in 2H20, with prices trading above $60/bbl and WTI trading $4/bbl below that on average. We will be updating our supply-demand balances and forecasts when we get fresh historical data from the key agencies (EIA, OPEC and IEA). The 1mm b/d in planned outages for 2Q20 coming out of this week’s meetings would add to the ~ 4mm b/d of unplanned outages in Venezuela, Iran and Libya. If these persist to end-June, planned and unplanned OPEC 2.0 production outages would average more than 5mm b/d in 1H20 (Chart 3). Chart 2A Failure To Cut Production Would Push Benchmark Crudes Lower Chart 3Core OPEC 2.0 Will Agree Cuts On the demand side, the big global hit to growth from China in 1Q20 should be out of the system by the end of 1H20, assuming the COVID-19 outbreak does not shut down global commerce the way it did in China. We think the odds of such a shutdown are low, given such policies only can be implemented by a central government in which all power is consolidated in a ruling party. Besides, given the massive hit to China’s manufacturing – auto production was down 80% y/y in February, e.g. – such policies are unlikely to be recommended in all but the most dire of circumstances. We continue to expect Chinese policymakers to overshoot on their fiscal and monetary stimulus, as they scramble to get 2020 GDP growth back above a 6% p.a. rate. Our view aligns with BCA’s China Investment Strategy, which last week observed, “It is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery.”2 Our colleagues go on to note, “Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016.” Fed Cuts Rates To Reduce Uncertainty The economic pressure arising from a strong USD is particularly acute for EM economies. Even before the COVID-19 outbreak in China at the end of last year, global economic policy uncertainty (GEPU) and the broad trade-weighted USD (USD TWIB) were hitting new highs. This was driven by trade wars, the emergence of left- and right-wing populists globally, uncertainty over the effectiveness of monetary policy, and a host of other issues that drove investors, firms and households to seek safe-haven assets like the dollar (Chart 4). In fact, these variables became highly correlated over the past 3-, 4- and 5-year intervals.3 The novel coronavirus outbreak in China, which literally shut down China’s economy in January and February, added to this uncertainty. It continues to lurk in the background now that the coronavirus has spread globally. This also contributes to safe-haven USD demand. While a rate cut cannot address the COVID-19 directly, it can loosen financial conditions – thus removing some uncertainty at the margin – and reduce USD strength. The economic pressure arising from a strong USD is particularly acute for EM economies, which are the dominant source of commodity demand growth globally (Chart 5). At the margin, this demand for dollars arising from increased global policy uncertainty suppresses oil demand growth in EM economies, by raising its cost in local-currency terms ex-US and ex-GCC producing states with currencies pegged to the dollar. It also incentivizes production at the margin, as local-currency costs are depressed, which reduces local costs, while revenues are realized in USD – the perfect arb. Chart 4Global Uncertainty Was High Before COVID-19 Hit Markets Chart 5EM Growth Suppressed By Strong USD Exploring The Dominant Currency Paradigm The USD’s dominance of global trade is receiving considerable attention in academia and at the Fed. The USD’s dominance of global trade is receiving considerable attention in academia and at the Fed. One theory we find useful is the “Dominant Currency Paradigm,” which holds the dollar is the dominant currency in the world and is used disproportionally vis-à-vis its GDP weight in the global economy (Chart 6). Its dominance is reflected in (1) invoicing of international trade, (2) bank funding, (3) corporate borrowing, (4) central-bank reserve holdings, and (5) the relatively low expected returns accruing to USD-denominated risk-free assets that violate uncovered interest-rate parity no-arbitrage conditions – i.e., the dollar’s so-called “exorbitant privilege.”4 Chart 6USD Is The Dominant EM Invoicing Currency Demand for USD rises when global economic policy uncertainty rises, which is why dollar liquidity is crucial: When demand for safe asset spikes, there is a need for aggressive liquidity (supply) of dollar to avoid a market collapse (Chart 7).5 By cutting US rates now, the Fed is effectively increasing USD supply and/or removing some of the demand for USD relative to other currencies. This will be especially important if global economic policy uncertainty remains strong. This somewhat buffers EM corporates and governments with high levels of USD-denominated debt against a rush to safe-haven USD holdings. We believe this will ease financial conditions in EM economies, which should, all else equal, provide more of a shock absorber for uncertainty generally. Chart 7Dollar Liquidity Mutes US Dollar Appreciation   Our modeling suggests higher global economic policy uncertainty (GEPU) can shock the USD TWIB, US 10-year Treasurys and EM trade volumes directly. In addition, USD-denominated debt is relatively pronounced in some EM economies (Chart 8). USD appreciation increases domestic banks’ liabilities vs. assets. This is negative for bank’s balance sheets and leads to a tightening in financial conditions, which limits growth. EM corporate bond issuers are exquisitely sensitive to USD movements as they affect their capacity to service foreign-currency debt. Chart 8A Strong US Dollar Hurts Vulnerable EM Economies It is important to remember the US economy continues to perform relatively strongly against other major economies, with 1Q20 US GDP growth estimated by the Atlanta Fed’s Nowcast at 2.7% p.a. The fact that the Fed surprised markets with a 50bp rate cut suggests to us it is concerned with EM growth slowing sharply if the coronavirus becomes a global threat. The Fed also is likely to be concerned that lower US consumer confidence will lead to a decrease in the velocity of money. This concern also is addressed by increasing money supply pre-emptively. Our modeling suggests higher global economic policy uncertainty (GEPU) can shock the USD TWIB, US 10-year Treasurys and EM trade volumes directly, and that these shocks can persist (Chart 9).6 The Fed's policy action today will, if our modeling is correct, reduce demand for USD as a safe haven, all else equal, reduce long-term US rates and boost EM trade volumes. Bottom Line: We expect OPEC 2.0 to deliver at least 1mm b/d of production cuts in 2Q20, which will be reviewed at the end of June to determine whether they should be extended or deepened. Global economic policy uncertainty remains high, supporting demand for the USD. We believe the Fed’s surprise rate cut this week was directed at alleviating some of the global uncertainty keeping the USD well bid, in an attempt to buffer EM economies affected by USD demand. It also is a safeguard against a collapse in the velocity of money in the US that could occur if uncertainty were to suddenly rise. Chart 9GEPU Shocks Are Transmitted To USD And US Treasurys   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight The EIA’s weekly inventory report gives no evidence of a COVID-19-induced backup in crude and product inventories in the US. Total stocks of crude and products fell almost 12mm barrels last week on the back of strong product draws, led by gasoline and distillates, both of which were down close to 5mm barrels on the week. Commercial crude oil inventories were mostly unchanged at ~ 445mm barrels. Crude oil exports rose almost 500k b/d last week to 4.15mm b/d, accounting for most of the 9.73mm b/d of crude and product exports from the US. (Chart 10). Base Metals: Neutral Expectations China will deploy aggressive stimulus targeting infrastructure and manufacturing activities in response to the COVID-19 outbreak, along with Brazil reporting a 15% month-on-month decline in exports of iron ore helped iron ore and steel futures post significant gains earlier this week, with the Singapore Exchange's 62% Fe Iron Ore futures closing 5.6% higher on Monday. However, these gains were short-lived – and will remain capped in the short-term – as weak Chinese demand persists and steel rebar inventories remain at record highs. Precious Metals: Neutral Amid a broader market sell-off gold prices dipped 4.5% on Friday – the worst performance since 2013 – but have since recovered, on the back of the Fed’s surprise rate cut this week. The US central bank delivered an emergency 50bps rate cut on Tuesday, gold erased all the losses with spot prices rising 3.2% at the close, to reach $1645.27/oz. Silver followed a similar pattern rebounding 2.9% on Tuesday, closing at $17.22/oz. We are long both metals and believe more upside is yet to come if central banks around the world coordinate on additional monetary easing (Chart 11). Ags/Softs:  Underweight Expectations of a stronger stimulus in response to COVID-19 pushed soybeans higher for a third consecutive day on Tuesday, with prices hitting a 6-week high intraday. Bean prices then retreat and close 0.3% higher than the previous session. Gains were capped by favorable weather conditions in Brazil, leading analysts to expect a record harvest this season. Wheat also rebounded on the Fed’s rate-cut news after a sluggish week that saw prices falling almost 5%. Uncertainty still reigns though, as the Australian Bureau of Agriculture crop report predicts wheat output to recover 41% to 21.4 Mn Mt in 2020, due to rainfall ending a period of severe drought. The most active wheat futures were up 0.8% at Tuesday’s close. Chart 10US Crude Oil Exports Are Rising Chart 11Lower Real Rates Will Support Gold       Footnotes 1     We do not rule out the possibility KSA or the GCC core producers shoulder the lion’s share of the cuts they seek, in order to balance the market. 2     Please see China: Back To Its Old Economic Playbook? published by BCA Research’s China Investment Strategy February 26, 2020. It is available as cis.bcaresearch.com. 3    This heightened uncertainty – i.e., the increase in “unknown unknowns” markets are attempting to process – is a recurrent theme in our research. See, e.g., 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets published December 19, 2019. It is available at ces.bcaresearch.com. 4    Please see Gopinath, Gita and Jeremy Stein. “Banking, Trade, and the Making of a Dominant Currency,” Working Paper currently under revision for the Quarterly Journal of Economics. 5    Gopinath (2016) finds that the dollar’s share as an invoicing currency for imported goods is approximately 4.7 times the share of U.S. goods in imports. Please see Gopinath, Gita. “The International Price System.” Jackson Hole Symposium Proceedings, published in January 2016. See also Obstfeld, Maurice (2019), “Global Dimensions of U.S. Monetary Policy,” presented at the Federal Reserve Board Conference on Monetary Policy Strategy, Tools, and Communication Practices (A Fed Listens Event) in Washington June 4, 2019. 6    Our results reflect the vector autoregression (VAR) model we use to study the interaction of GEPU shocks and the USD TWIB and US 10-year treasurys.   Investment Views and Themes Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight1 and this Monday’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel). Tach on the coronavirus outbreak, and if supply chain breakdowns increase over the course of the next few weeks, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel). Bottom Line: We trimmed the S&P tech sector to underweight. For more details, please refer to this Monday’s Weekly Report. ​​​​​​​ Footnotes 1    Please see BCA US Equity Strategy Weekly Report, "Crosscurrents" dated February 3, 2020, available at uses.bcaresearch.com.

Dear Client, We are publishing an abbreviated report this week. Last night, I sent you a special report written by Matt Gertken, BCA’s chief geopolitical strategist, containing his analysis of the US presidential race following Super Tuesday’s results. I hope you will take the time to read Matt’s excellent report. Best regards, Peter Berezin, Chief Global Strategist Highlights While a 1918 Spanish flu-type scenario cannot be ruled out, it is unlikely. Evidence is emerging that a handful of sensible measures can significantly slow the spread of the virus. The fact that the number of new cases outside of China fell from 2,410 on March 3rd to 2,160 on March 4th indicates that these measures may be working. The saga of the Diamond Princess cruise liner suggests that the true fatality rate may be under 1%. Tentative evidence that the virus has mutated into a less lethal form implies that the fatality rate could fall even more. Investors should remain overweight equities. The shift towards even looser monetary policy in the US and elsewhere has increased the probability that stocks will rip higher, perhaps even entering a full-fledged bubble like they did in 1998 after the Fed cut rates in the wake of Long-Term Capital Management‘s implosion. Global bond yields will rise modestly from current levels. While the Fed is highly likely to cut rates another 25 basis points later this month, we doubt that rates will stay as low for as long as markets currently anticipate. US yields will increase more than yields abroad, which should take some pressure off the dollar. Nevertheless, as a countercyclical currency, the greenback will likely trade lower over the remainder of the year as global growth begins to reaccelerate. Stay Overweight Stocks We upgraded our near-term view on global equities last Friday morning after having penned a report the prior week entitled “Markets Too Complacent About The Coronavirus”. Despite this morning’s setback, the MSCI All-Country World index is still up 5.5% in dollar terms since our upgrade. The rebound in stocks has prompted some clients to ask whether it makes sense to revert to a more cautious stance again. The stock market is certainly pricing in a less apocalyptic scenario than it was on Friday. Nevertheless, we think investors should maintain a bullish posture towards equities for the time being. The shift towards even looser monetary policy in the US and elsewhere has increased the probability that stocks will rip higher, perhaps even entering a full-fledged bubble like they did in 1998 after the Fed cut rates in the wake of Long-Term Capital Management‘s implosion. A Manageable Problem While a 1918 Spanish flu-type scenario cannot be ruled out, it is unlikely. For one thing, most people died from secondary bacterial pneumonia back then. The virus damaged the lungs and bronchial tubes of its victims, permitting common bacteria to infect the lungs. This problem can now be readily treated with antibiotics. Moreover, as China’s experience demonstrates, it is possible to contain the coronavirus. China has recorded just 42 new cases outside of Hubei since February 26. The number of cases in Hubei has also plunged. In fact, the government has already closed one of its makeshift hospitals built to house COVID-19 patients. One might argue that other countries will not be able to implement the same draconian measures that China was willing to take. We are sympathetic to this view, but would note that Singapore and Hong Kong have also been able to stem the outbreak without imposing mass quarantines. In fact, it is worth noting that the number of new cases outside of China fell from 2,410 on March 3rd to 2,160 on March 4th. While one day does not make a trend, it is an encouraging development. Keep Washing It may turn out that a handful of sensible measures can significantly slow the spread of the virus, and perhaps even in a best-case scenario, stop it in its tracks. These include frequent handwashing, avoiding mass gatherings, and wearing a face mask in public. Granted, a mask will not help you much if you are not already infected, but if a social norm is established that compels everyone to wear a mask in public for a period of a few months, then those who are infected but do not know it will pose less of a risk to others. Extreme shaming of people who waltz into work with cold symptoms would also be a good idea. Who knows, we might even end up realizing my lifelong dream of replacing the grubby western handshake with a much more elegant Thai wai. What’s The Current Fatality Rate? A simple calculation of the number of COVID-19 deaths divided by the number of confirmed cases implies that the current fatality rate is around 3%. However, this figure is probably overstated because the denominator excludes people with mild symptoms who were never tested. The outbreak on the Diamond Princess cruise liner offers a potentially important natural experiment. Of the 705 people on board who have contracted the virus, only six have died. All six were over the age of 70. This is actually a fairly low fatality rate, considering that those on board were probably exposed to concentrated viral loads, and in some cases, had their treatment delayed. Admittedly, not everyone on board has fully recovered. Thus, more deaths could still occur. Nevertheless, the cruise ship’s saga does suggest that the true fatality rate from COVID-19 may be less than 1%, with most of the deaths confined to the elderly and those with pre-existing respiratory conditions.  Two Virus Strains The other piece of good news has to do with the virus itself. A recent study conducted by researchers at Peking University’s School of Life Sciences and the Institut Pasteur of Shanghai has revealed that the virus has evolved into two major strains, designated L and S. Strain L is the more pervasive and aggressive of the two, but has become less common since early January.1  This is not surprising. Viruses that quickly leave people bedridden will spread less rapidly than those that produce milder symptoms. This suggests that the fatality rate from the virus could trend lower. Joementum The other market-relevant development this week was Joe Biden‘s better-than-expected performance in the South Carolina primary on Saturday and the Super Tuesday states. Betting markets are now giving Biden a 76% chance of becoming the Democratic nominee, up from 7% on February 11. Unlike in 1918 when the Bolsheviks consolidated power, Bernie “I don’t mind people calling me a communist” Sanders no longer has much of a path to becoming America’s first socialist leader. As president, Joe Biden would likely take a more conciliatory stance towards trade issues with China. That said, if the Democrats manage to capture the Senate, Biden would probably be willing to sign into law a bill that reversed at least part of Trump’s corporate tax cuts. On balance, the impact on markets would probably not be huge regardless of who wins the election. This suggests that US political risk could fade over the coming months. That is bullish for stocks. Investment Conclusions Investors should overweight global equities over both a 3-month and 12-month horizon. Bond yields will rise modestly from current levels. While the Fed is highly likely to cut rates a further 25 basis points later this month, we doubt that rates will stay as low for as long as markets currently anticipate. US yields will increase more than yields abroad, which should take some pressure off the dollar. Nevertheless, as a countercyclical currency, the greenback will likely trade lower over the remainder of the year as global growth begins to reaccelerate. The combination of stronger growth and a weaker dollar will lift commodity prices, while also giving cyclical stocks and financials a boost. Cyclicals and financials are overrepresented in non-US indices, which implies that international stocks will outperform their US peers.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1    Xiaolu Tang, Changcheng Wu, Xiang Li, Yuhe Song, Xinmin Yao, Xinkai Wu, Yuange Duan, Hong Zhang, Yirong Wang, Zhaohui Qian, Jie Cui, Jian Lu, “On the origin and continuing evolution of SARS-CoV-2,” National Science Review (March 3, 2020). Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Trades Closed In 2015-2020

Highlights Financial markets are now fully priced for an economic downturn lasting one quarter… …but they are not fully priced for a recession. To go tactically long equities versus bonds requires a high conviction that the coronavirus induced downturn will last no longer than one quarter. The big risk is that the coronavirus incubation period might be very long, rendering containment strategies ineffective. Hence, a better investment play is to go long positive yielding US T-bonds and/or UK gilts versus negative yielding Swiss bonds and/or German bunds… …or go long negative yielding currencies versus positive yielding currencies. Our favoured expression is long CHF/USD. Fractal trade: overweight Poland versus Portugal. Feature Chart I-1AFinancial Markets Are Priced For A One-Quarter Downturn... Chart I-1B...But Not For A ##br##Recession They say that when China sneezes, the rest of the world catches a cold. But the saying was meant as an economic metaphor, not as a literal medical truth.1 The current coronavirus crisis has two potential happy endings: ‘containment’, in which its worldwide contagion is halted; or ‘normalisation’, in which it becomes accepted as just another type of winter flu. The virus crisis also has a potential unhappy ending in which neither containment nor normalisation can happen. Containing Contagion To determine whether the virus crisis has a happy or unhappy ending, we must answer three crucial questions: 1. Does the virus thrive only in cold weather? If yes, then the onset of spring and summer should naturally contain the contagion (in the northern hemisphere). We are not experts in epidemiology or immunology, but we understand that the Covid-19 virus surface is a lipid (fat) which could become fragile at higher temperatures. Albeit this might just be a temporary containment until temperatures drop again. 2. Does the virus have a short incubation period before symptoms arise? If yes, then quarantining and containment will be effective because infected people are quickly identified. But if, after infection, there is a long asymptomatic period, then containment would be impossible – because for an extended period the virus would be ‘under cover’. In this regard, the dispersion of infections is as important as the number of infections. A thousand cases across a hundred countries is much more worrying than a thousand cases concentrated in two or three countries (Chart I-2). Chart I-2Covid-19 Has Spread To 80 Countries 3. Are most infections going undetected because the symptoms are very mild? If yes, then the true mortality rate of the Covid-19 virus is much lower than we think, and perhaps not that different to the mortality rate of winter flu, at around 1 in a 1000. In which case, the new virus could become ‘normalised’ as a variant of the flu. But if the current mortality rate, at ten times deadlier than the flu, is accurate, then it would be difficult to normalise (Chart I-3). Chart I-3The Covid-19 Mortality Rate Is Ten Times Deadlier Than The Flu. Or Is It? An unhappy ending to the crisis will happen if the answer to all three questions is ‘no’. The main risk is that the asymptomatic incubation period appears to be quite long, rendering containment strategies ineffective. Still, even if the happy ending happens, there are two further questions. How much disruption will the economy suffer before the happy ending? And what have the financial markets priced? The Economic Disruption The disruption to the economy comes from both the supply side and the demand side: the supply side because containment strategies such as quarantining entire towns, shuttering factories, and cancelling major sports and social events hurt output; the demand side because a fearful public’s reluctance to use public transport, visit crowded places such as shopping malls, or travel abroad hurt spending. In this way, both production and consumption will suffer a large hit in the first quarter, at the very least. However, when normal activity eventually resumes, production and consumption will bounce back to pre-crisis levels, and in some cases overshoot pre-crisis levels. For example, if the crisis lasts for a quarter, movie-goers will return to the cinemas as usual in the second quarter, albeit they will not compensate for the visit they missed in the first quarter; but for manufacturers, the backlog of components that were not made during the first quarter will mean that twice as many will be made in the second quarter. For the financial markets, it is not the depth of the V that is important so much as its length. Therefore, economic output will experience a ‘V’ (Chart I-4): a lurch down followed by a symmetrical, or potentially even larger, snapback. However, for the financial markets, it is not the depth of the V that is important so much as its length. Chart I-4Economic Output Will Experience A 'V' The Financial Market Disruption Anticipating the economy to experience a V, investors respond to the crisis according to the expected length of the V versus the different lengths of their investment horizons. By length of investment horizon, we mean the minimum timeframe over which the investor cares about a price move, or ‘marks to market’. Say the market expects the downturn to last three months, followed by a full recovery. A three-month investor, caring about the price in three months, will capitulate. He will sell all his equities and buy bonds. Whereas a six-month investor, caring about the price only in six months, will not capitulate because he will factor in both the down-leg and subsequent up-leg of the V. Meanwhile, a twelve-month investor will be completely unfazed by the short-lived downturn. Therefore, if the downturn lasts one quarter only, the market will bottom when all the three-month investors have capitulated, which is to say become indistinguishable in their behaviour from a 1-day trader. In technical terms, the tell-tale sign for this capitulation is that three-month (65-day) fractal structure of the market totally collapses. Last Friday, the financial markets reached this point, meaning that financial markets are now fully priced for an economic downturn lasting one quarter (Chart I-5). Chart I-5When 3-Month Investors Capitulate It Usually Signals A Trend-Reversal... However, six-month and longer horizon investors are still a long way from capitulation. Meaning that the markets are not yet priced for a recession – defined as a contraction in activity lasting two or more straight quarters. It follows that if the down-leg of the V lasts significantly longer than a quarter then equities and other risk-assets have further downside versus high-quality bonds (Chart of the Week). During the global financial crisis, three-month investors had fully capitulated by September 3 2008 when equities had underperformed bonds by a seemingly huge 20 percent. However, equities went on to underperform bonds by a further 50 percent and only found a bottom when eighteen-month investors had fully capitulated in early 2009 (Chart I-6). This makes perfect sense, because profits contracted for a full eighteen months (Chart I-7). Chart I-6...But In The Global Financial Crisis The Market Turned Only When 18-Month Investors Had Capitulated... Chart I-7...Because In The Global Financial Crisis, Profits Contracted For 18 Months All of which brings us to a very powerful investment identity: Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated = the length of the downturn. The message right today is to go tactically long equities versus bonds if you have high conviction that the coronavirus induced downturn will last no longer than one quarter. Given that the coronavirus incubation period appears to be quite long, rendering containment strategies ineffective, we do not have such a high conviction on this tactical trade. Central banks that are already at the limits of monetary policy easing cannot ease much more. Instead, we have much higher conviction that those central banks that are already at the limits of monetary policy easing cannot ease much relative to those that have the scope to ease. The conclusion is: go long positive yielding US T-bonds and/or UK gilts versus negative yielding Swiss bonds and/or German bunds. Conversely, go long negative yielding currencies versus positive yielding currencies. Our favoured expression is long CHF/USD (Chart I-8). Chart I-8Overweight Positive-Yielding Bonds, And Overweight Negative-Yielding Currencies Fractal Trading System* This week’s recommended trade is to overweight Poland versus Portugal. Set the profit target at 3.5 percent with a symmetrical stop-loss. In other trades, long EUR/GBP achieved its 2 percent profit target at which it was closed. And short palladium has quickly gone into profit, given that the palladium price is down 10 percent in the last week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9Poland Vs. Portugal When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 The original version of the metaphor is attributed to the nineteenth century Austrian diplomat Klemens Metternich who said: “When France sneezes all of Europe catches a cold”. Subsequently, the Metternich metaphor has been adapted for any economy with outsized influence on the rest of the world. Fractal Trading Model Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations