Disasters/Disease

Highlights The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks.  We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies.  Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated.  Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3  However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER).  Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7).  Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more.  The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms.  Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed?   A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12).    Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one.  At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming.  But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization.  When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14).  But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15).  Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve   All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm  6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations

Highlights Social distancing makes it impossible to do jobs that require close personal interaction, yet these are the very job sectors that have kept jobs growth alive in recent decades. If social distancing persists, then AI will penetrate these job sectors too. Aggregate wage inflation is set to collapse – not just temporarily, but structurally. Structurally overweight US T-bonds versus the core European bonds in Germany, France, Netherlands, Switzerland and Sweden. Structurally overweight big technology, structurally underweight banks. Structurally overweight S&P 500 versus Euro Stoxx 50. Fractal trade: long Australian 30-year bond versus US 30-year T-bond. Feature Social distancing will feature large in our lives for the foreseeable future, and it carries a profound consequence. Social distancing really means physical distancing. And physical distancing diminishes the ways that we can interact with other humans – through the qualities of empathy, sympathy, the ability to recognise and respond to emotional cues, and to express ourselves through complex movements. You cannot hug someone on Facetime. Social distancing makes it impossible to do jobs that require close personal interaction. From an economic perspective, social distancing makes it impossible to do jobs that require close personal interaction. It follows that in the recent bloodbath of job losses, the biggest casualties have been in employment sectors that rely on this close personal interaction: food services and drinking places (waitresses, bartenders, and baristas), ambulatory healthcare services, hotels, and social assistance (Table I-1). Table I-1Social Distancing Is Destroying Jobs That Require Close Personal Interaction A profound consequence arises because these are the very sectors that have kept jobs growth alive in recent decades (Table I-2). Millions of new jobs that rely on close personal interaction have more than offset the structural job destruction in manufacturing and finance. As well as being export-proof, jobs that require this close personal interaction have been ‘artificial intelligence (AI) proof’. That is, until now. Table I-2Jobs That Require Close Personal Interaction Have Been The Engine Of Jobs Growth One UK doctor told the New York Times “we’re basically witnessing 10 years of change in one week”. Before the virus, online consultations made up only 1 percent of doctors’ appointments. But now, three in four UK patients are seeing their doctor remotely. Moravec’s Paradox + Social Distancing = A Very Tough Jobs Market Regular readers will know that one of our mega-themes is the far-reaching societal and economic implications of Moravec’s Paradox. Named after the professor of robotics, Hans Moravec, the paradox points out that: For AI the hard things are easy, but the easy things are hard. By the hard things, we mean things that require ‘narrow-frame pattern recognition’ within a defined body of knowledge. For example, playing chess, translating languages, diagnosing medical conditions, and analysing legal problems. We find these tasks hard, but AI finds them effortless. By the easy things, we mean our social skills: empathy, sympathy, the ability to recognise and respond to emotional cues, and to express ourselves through complex movements. To us, all these things are second nature, but AI finds them very hard to replicate. The reason, it turns out, is that the higher brain that enables us to learn and play chess and solve similar abstract problems evolved relatively recently. Whereas the ancient lower brain that enables complex movement and the associated giving and receiving of emotional signals took much longer to evolve. As AI is just reverse engineering the human brain, AI has found it easy to replicate the less-evolved higher brain functions, but very difficult to replicate the skills that emanate from the deeply evolved lower brain. Millions of new jobs that rely on close personal interaction have more than offset the structural job destruction in manufacturing and finance. The far-reaching societal and economic implication is that we have misunderstood and mispriced what is difficult and what is easy. By reverse engineering the brain, AI is correcting this mispricing. So far, AI has been most disruptive to high-paying jobs requiring abstract problem-solving skills, such as in finance. AI has been less disruptive to jobs requiring close personal interaction (Table I-3). But if social distancing persists, then AI will disrupt those jobs too, especially during a recession. Table I-3New Jobs That Require Close Personal Interaction Have Offset Lost Jobs In Manufacturing And Finance Labour Market Disruption Intensifies During A Recession To paraphrase Ernest Hemingway, industries adopt labour-saving technologies gradually then suddenly. And the suddenly tends to be during a recession. This is because once an industry has already shed many workers, it is easier to restructure the industry with a new labour-saving technology that reduces labour input permanently. At the start of the Great Depression a substantial part of the US automobile industry was still based on skilled craftsmanship. These smaller, less productive craft-production plants were the ones that shut down permanently, while plants that had adopted labour-saving mass production had the competitive advantage that enabled them to survive. The result was a major restructuring of the auto productive structure. Likewise, until the late 1990s, the ‘typing pool’ was a ubiquitous feature of the office environment. But once the 2000 downturn arrived, these typing jobs became extinct to be replaced by the wholesale roll-out of Microsoft Word. After the 2008-09 recession, UK economic power became focussed in a few large firms that could access the finance to ensure their survival. As small firms went by the wayside, job growth came disproportionately from self-employment and the ‘gig economy’. In this case, the labour market disruption hurt productivity as an army of freelancers ended up doing their own sales, marketing and accounts in which they had no specialism (Chart I-1 and Chart I-2). Chart I-1The 1990s UK Recovery Produced No Increase In Self-Employment... Chart I-2...But The 2010s UK Recovery Produced A Huge Increase In Self-Employment The point is that all recessions produce major structural changes in the labour market and the current recession will be no different. If social distancing persists, it will nullify the social skill advantage that humans have over AI. Therefore, one structural change will be that AI disrupts the more ‘human’ job sectors that have so far escaped its penetration. All recessions produce major structural changes in the labour market. To repeat, labour market disruption arrives suddenly. Within the space of a few weeks, most UK patients have switched to receiving their medical care online or by telephone. Admittedly, the patients are still ‘seeing’ a human doctor, but the question and answer consultations are a classic example of narrow-frame pattern recognition. Meaning that it would be a small step to upgrade the human doctor to the superior diagnosis from AI. And if AI can produce a superior diagnosis to your human doctor, why can’t AI also produce a a superior legal analysis to your human lawyer? The Investment Implications Even when the labour market seemed to be humming and unemployment rates were at multi-decade lows, aggregate wage inflation was anaemic (Chart I-3 and Chart I-4). A major reason was the hollowing out of high paying jobs and substitution with low paying jobs. Now that unemployment rates are surging, and AI is penetrating even more job sectors, aggregate wage inflation is set to collapse – not just temporarily, but structurally. Chart I-3Unemployment Rates Have Been At Multi-Decade Lows... Chart I-4...But Wage Inflation Has Been ##br##Anaemic This leads to the following investment implications: 1. All bond yields will gravitate to their lower bound, so any bond yield that can go lower will go lower. 2. It follows that bond investors should continue to overweight US T-bonds versus the core European bonds in Germany, France, Netherlands, Switzerland and Sweden (Chart I-5). Chart I-5Any Bond Yield That Can Go Lower Will Go Lower 3. Underweight banks structurally. Depressed and flattening yield curves combined with shrinking demand for private credit constitutes a strong headwind. Banks are now underperforming in both up markets and in down markets (Chart I-6). Chart I-6Banks Are Underperforming In Both Up Markets And Down Markets 4. Overweight technology structurally. As AI penetrates even more job sectors, the superstar companies of big tech will continue to thrive. The duopoly of Apple and Google are designing proximity-tracking apps for every smartphone in the world. Big tech is laying down the law to governments, and there is not even a hint of antitrust suits. Tech is now outperforming in both up markets and in down markets (Chart I-7). Chart I-7Tech Is Outperforming In Both Up Markets And Down Markets 5. Finally, if big tech outperforms banks, the sector composition of the S&P 500 versus the Euro Stoxx 50 makes it inevitable that the US equity market will structurally outperform the euro area equity market (Chart I-8). Chart I-8If Big Tech Outperforms Banks, The S&P 500 Must Outperform The Euro Stoxx 50 Fractal Trading System* The steep decline in the US 30-year T-bond yield means that it has crossed below the Australian 30-year bond yield for the first time in recent history. Resulting from this dynamic, this week’s recommended trade is long the Australian 30-year bond versus the US 30-year T-bond. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-930-Year Govt. Bonds: Australia Vs. US In other trades, long IBEX versus Euro Stoxx 600 hit its 3 percent stop-loss, while long nickel versus copper is half way to its 11 percent profit target. The rolling 12-month win ratio now stands at 63 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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  

WTI crude oil delivered to Cushing in May 2020 is trading below $0.00/bbl as this note is typed, and falling fast (Chart 1). This is an historical print. WTI for June delivery is trading at ~ $22.00/bbl. What we are observing is the last of the May 2020 futures longs getting out of their positions before the contract goes off the board tomorrow. People tend to forget that the so-called WTI "paper" market – i.e., futures – is actually a market in which contracts for physical delivery at Cushing, OK, actually change hands. If you are left long when the contract for May delivery stop trading – tomorrow at the close of business – you will have to stand for physical delivery. If you are short, you must deliver physical barrels. These are binding, legal contracts. Chart 1Crude Oil In Extremis Liquidity is extremely low, as most everyone with any exposure in May 2020 WTI is out of their position. Storage is scarce. Anyone with storage can name their price – literally – as most of the storage in Cushing obviously is close to being full. Refiners are drastically reducing runs, and refined products are sitting in storage, as the US remains in shut-down. What we are observing is the physical market pricing a near-complete lack of storage in Cushing. Physical-market participants also are aware there’s 12mm barrels of crude from Saudi Arabia arriving in the US Gulf, following KSA’s chartering of 19 very large crude carriers (VLCCs) in March, six of which are bound for the US Gulf. There is no place to store the crude that’s going to be arriving in the Gulf and that’s backed up in Cushing. This situation should begin to reverse on May 1, as the COVID-19 demand destruction levels off and the global economy starts to return to normal. On the supply side, the OPEC 2.0 producers begin cutting production next month, and highly levered unhedged producers will be forced to shut in production and file for bankruptcy. The lower prices go in the short term – and the more damage this causes on the production side – the sharper the recovery later this year.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com  

Highlights Over the past year we have discussed “peak polarization” for the United States with many clients. We have held the contrarian view that political animosities within the US are nearing their peak. Feature Prior to COVID-19 we argued that polarization would either peak this year, with the US election, or in roughly two years – a scenario in which President Donald Trump won reelection and an epic partisan battle ensued with House Democrats over his second-term policy priority (probably the southern border wall). The global pandemic and recession have changed things. They are accelerating the peaking process, as a domestic consensus is forming on Big Government, border controls, and protectionism against China. It is also less likely that President Trump will scrape through with a narrow victory in November – rather, he will win or lose decisively. Policy consensus and a decisive electoral outcome should reduce polarization in the coming years. The risk to this view is that President Trump is reelected for a second time without a majority of the popular vote and then attempts major cuts to social spending to correct the country’s gargantuan budget deficits. This risk is vastly overrated. A corollary of our view is that US polarization will hit a boiling point in this election year. Polarization will remain extreme until the election results are confirmed, settled, and done. The conflict between Trump and the Democratic governors over when to reopen the virus-plagued economy is case in point. For investors, this view implies that, in the very near term, the dollar and global safe-haven flows will remain strong, defensive plays have further to run, and US equities will continue to outperform global. But over the long run, the dollar is already at extreme highs and global equities outside the US offer better value. The COVID Confederacy When we chose our theme for this year’s presidential election, “Civil War Lite,” we argued that the US faced a host of social and political challenges that would come to head by November 3. These challenges could manifest in violent social unrest or in an electoral or constitutional crisis that harmed government legitimacy. We did not expect COVID-19, but it has created exactly what our Civil War Lite theme implies: a clash between federal and state governments over who has the final say in the American system. Specifically, the Democratic-led states on the east and west coast are quarreling with the Trump administration over how and when to reopen their economies in the wake of tough “shelter in place” measures that have ground the economy to a halt in order to stem the pandemic. For the first time since the great realignment of US politics in the 1930s, the US is having an historic nationwide crisis in which the Republicans are asserting an overriding federal government and the Democrats are insisting on states’ rights. United States governors have formed two coalitions to determine when and how to reopen. On the West Coast, California Governor Gavin Newsom joined with the governors of Oregon and Washington states to set up a working group. On the East Coast – the epicenter of the pandemic in the US – Andrew Cuomo, Governor of New York, joined with his counterparts from New Jersey, Massachusetts, Connecticut, Delaware, Rhode Island, and Pennsylvania to set up a similar working group. Governor Cuomo fought a war of words with President Trump over who has the authority to invoke and revoke emergency health and security actions. President Trump declared, “When somebody is the president of the United States, the authority is total.” Cuomo rebuked him by saying, “we have a constitution … we don’t have a king.” Trump replied by suggesting that Cuomo and his fellow governors were engaging in “mutiny” and implied that he could use his enormous powers and funds as head of the federal government to decide the conflict. The conflict between President Trump and the “COVID Confederacy” heightens uncertainty in the near term. All parties have since softened their tone. Cuomo said he did not want confrontation, President Trump said that he would “authorize” all fifty governors to reopen their economies, and Newsom asserted his executive authority over California without addressing Trump’s comments directly. This conflict may be overrated from the point of view of long-term American stability – President Trump is not about to impose a naval blockade like Abraham Lincoln. But it is not overrated in the near term for financial markets. That is because the reopening plan remains undecided. The “COVID Confederacy,” as we facetiously call it, makes up a combined 38% of US gross domestic product (Table 1), which is shown here in our flow-based cartogram of the United States (Map 1). Each state is colored red or blue according to its Republican or Democratic Party Electoral College vote in 2016, and it is sized proportionally to its economic output. Map 1The COVID Confederacy: States That May Break With Federal Government Over Quarantines Table 1The COVID Confederacy As Share Of GDP We think this conflict matters because it heightens the uncertainty over the duration of quarantine measures, and hence the sufficiency of fiscal stimulus and the length of time until economic normalization. Markets do not like uncertainty. Second, the conflict could still escalate, given that President Trump could still try to push for an earlier economic opening than the Blue States are ready for. Third, even assuming that all sides recognize they need to cooperate amid crisis, the US election still hangs in the balance and the decision to open the economy will increase the death count and thus hypercharge the political contest. Bottom Line: We expect US politics to weigh on US and hence global equities in the near term, as they have already rallied by 24% since their trough in March. When And How Will The US Reopen? How will Trump’s conflict with the Democratic governors be resolved? President Trump is in an impossible situation. Reopening the economy earlier will lead to an increase in deaths – the US will move toward or past Sweden in Chart 1. This is in an election environment in which each death will be heavily politicized while the dangers of deeper recession will be more abstract. Not reopening the economy will add to the US’s historic losses in employment, production, and retail sales (Chart 2). Chart 1Reopening Will Improve Economy But Increase Deaths Per Million Chart 2Delayed Reopening Will Weigh On Stocks Even in the best-case scenario, in which the economy starts to reopen in May, mitigation efforts succeed, and deaths are limited, Trump will still be left with large-scale unemployment and recession. Historically unemployment is the best indicator for which direction the president’s approval will ultimately go (Chart 3). And bear in mind that interior Republican states will be at risk of subsequent outbreaks because they are on a later time frame for the virus peak and yet are most likely to comply with Trump’s reopening plan. The implication is that Trump is constrained and will ultimately decide to maintain the lockdowns longer than he is implying (May 1), and longer than the market expects. He would not want to be seen as losing the fight to the virus. As we go to press, Trump is finalizing “Opening Up America Again” guidelines. Leaving decisions to governors could mean accepting longer lockdowns. Chart 3AUnemployment Rate Leads The Way For Presidents Chart 3BUnemployment Rate Leads The Way For Presidents Meanwhile the Democratic governors who make up the COVID confederacy have a perverse incentive to hold out longer in maintaining strict social distancing. If they reopen too soon, deaths go up and they suffer the political consequences. Yet in normalizing the economy they risk helping Trump get reelected. To be sure, the governors cannot cut off their own economies to spite Trump. But they can continue to drag their feet. First, to show that they are “more competent” leaders who “rely on science” and thus ensure that Trump takes the blame for the increase in deaths. Second, because Trump’s declaration of “total authority” forces them to defend their power and prerogative as governors – this is a constitutional constraint on President Trump. A major problem for Trump is that, unlike Abraham Lincoln, he is asserting total authority over the states not to fight and win the war (in this case, against the virus), but to ease the recession. This is a risky position because subsequent outbreaks will hurt him. Public opinion polling suggests that 64% of voters think the government should prioritize fighting the virus while 29% think it should prioritize rebooting the economy – and this split is 51% versus 43% among Republicans (Chart 4). Chart 4Voters More Afraid Of Virus Than Recession Business leaders at the first meeting of Trump’s “Great American Economic Revival Industry Groups” testified that premature opening is counterproductive if virus testing is inadequate. It is risky for their employees, threatens dire legal consequences down the road, and may need to be reversed. To be sure, economic pressure will change voters’ and business leaders’ minds eventually. The Democratic governors will capitulate as demand for loosening grows. They may be bickering over a one or two week difference in reopening timelines. Testing is improving markedly, and New York is on track to be much better equipped to handle the required testing in the month of May. Still, there is a great risk that the governors delay at least two weeks beyond Trump’s timeline. And a two-week delay with these states costs, at minimum, $237 billion, or 3% of their GDP this year. There is also a risk that the dispute escalates and Trump resorts to coercion to pressure the states to reopen sooner, creating more uncertainty. If the federal government loosens guidance and Trump uses the “bully pulpit” to speed up reopening, the overall effectiveness of the state lockdowns will decline. This could cause the governors to tighten controls before they loosen them, or it could even cause the federal government to reverse course. House Democrats have cooperated on fiscal stimulus (see Appendix) with President Trump and Senate Republicans because they would not dare delay relief for households merely to undermine the president. But the political logic works differently for Democratic state governors when it comes to reopening the economy – they benefit politically from saving lives and opposing President Trump. Bottom Line: Ultimately the COVID confederacy of Democratic states will suffer immense pressure to reopen, so their contest with Trump may only amount to one or two weeks’ difference. But this “Civil War Lite” can get worse before it gets better. Investors face rising uncertainty over the coming month over the pace and extent of US reopening. Peak Polarization Chart 5Why We Called 2020 ‘Civil War Lite’ We chose our election theme because of the extreme levels of polarization in US politics. These will come to a head with the November 3, 2020 general election. It cannot be overstated that today’s polarization is empirically extreme – this is not subjective. Our quantitative election model shows that more and more states have a near-certain probability of sending their Electoral College votes to the party they already favor – meaning that these states are uncompetitive in the election due to the fixed opinion of voters (Chart 5, top panel). The difference in Republican and Democratic approval of the president is soaring far above the high points of the past forty years (Chart 5, bottom panel), a very simple sign of polarization. The most rigorous measure of polarization in American political science shows that polarization is the highest since the Civil War in the 1860s (a time when these data lose applicability). It is comparable to the Reconstruction era in the 1870s and the populist era in the early 1900s (Chart 6). Our quantitative model relies on leading economic indicators as of February and thus still gives President Trump victories in New Hampshire and Wisconsin. It predicts him winning the White House with 273 Electoral College votes, only a three-seat margin over the required 270 to win the Oval Office.1 The economic collapse will hurt his odds as data come in, as is clear when we “shock” our model with a 2008-sized slowdown (Chart 7). Chart 6US Polarization The Highest Since The Civil War Chart 7Our US Election Quant Model Shows A Tight Race The clearest and simplest sign of polarization is the long-term decline in presidential approval ratings and increase in disapproval ratings. Approval has not hit the low point, when George W. Bush presided over a financial meltdown on top of a foreign military quagmire, but it is near Truman and Nixon-era lows (Chart 8A). Chart 8AA Very Simple View Of US Political Polarization The lesson from this last chart is that Americans most approve of their presidents during times of prosperity at home and peace abroad, such as the late 1950s and early 1960s, the late 1980s (as the Soviets collapsed), and the late 1990s, during the post-Cold War “peace dividend.” Yet Trump’s first three years in office, despite peace and prosperity, did not witness a huge increase in approval. Extreme polarization will come to a head with the November election. Disapproval is even more telling. Historically, the disapproval rating peaks at a crisis point and then dramatically subsides – with a series of lower and lower peaks – in the subsequent years. This was true after the Korean War and Truman administration scandals, the Watergate scandal and Nixon’s resignation, and the first Iraq war and 1990-91 recession. But in the case of the Great Recession, polarization only briefly declined before it rapidly began mounting again, reaching a post-2008 peak under President Trump (Chart 8B). Chart 8BA Very Simple View Of US Political Polarization The last point suggests that the US was building toward a new crisis point and COVID-19 has created that moment. The question is whether Trump’s approval ultimately goes up or down as a result, and whether the nation bands together in the wake of the election as it did after past crisis elections (e.g. 1932, 1952, 1968, 1976). House Democrats and Republicans have cooperated on stimulus packages, as mentioned, but this cooperation will give way to cut-throat competition as the acute crisis subsides and the election approaches. Bottom Line: US polarization is historically extreme and will intensify ahead of the election. Election And Reconstruction Prior to COVID there were three main scenarios for polarization to escalate further in the 2020-22 period: Trump Narrowly Reelected: It is inherently rare for a president to win the Electoral College vote without winning the popular vote. It happened in 2000 and 2016, marking the polarized times. If it happened again it could easily be accompanied with vote recounts or Supreme Court intervention, like in 2000, or foreign meddling. Such a crisis would push polarization higher, once again emphasizing the parallel with the 1870s, such as the 1876 “Stolen Election.” Trump Narrowly Defeated: The same could be said if Trump were to lose narrowly. Disputed vote recounts, or faithless electors in the Electoral College, or other unexpected incidents would give rise to accusations of a Deep State coup d'état against President Trump, leaving his supporters disaffected. Wag The Dog: It is also conceivable that an international crisis could occur in which the President is accused of “wagging the dog,” orchestrating a rally-around-the-flag effect to get reelected. Our top contenders for such an event are Venezuela, Iran, or North Korea. The crisis has Iran even closer to the brink and it is continuing to spar with the US in the Gulf and in Iraq (Charts 9A & 9B). A war of choice would heighten polarization, particularly at a time when the public is war-weary. (Obviously a genuine, non-manipulated war could also occur, but it would reduce not heighten polarization.) Chart 9AIran Was Extremely Vulnerable … Chart 9B… Even Prior To COVID-19 COVID-19 has changed the outlook because it is much more likely now that Trump loses the election – yet it is also more likely that if he wins, he wins the popular vote. Chart 10Public View Of Trump’s Handling Of Pandemic Unclear Thus Far Trump is more likely to lose because he faces recession and charges of mishandling the pandemic. The “bounce” in his approval rating has already subsided (Chart 10). The bounce in his and Republican support have subsided faster than that of other comparable world leaders and ruling parties. Trump’s polling bounce was also extremely small relative to other major presidential bounces in modern history – especially bounces derived from an exogenous crisis that was not the president’s fault, like COVID. “Enemy” shocks tend to create a 20%-30% boost to approval (Table 2). This is especially worrisome evidence for Trump. Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces And yet Trump is more likely than he was prior to COVID to see his approval rise above 50% and win the popular vote. He briefly polled above 50% during the bounce. Look at Chart 10 again – his approval bounce is bottoming at 45%, higher than last year’s lows. There is still a 35% chance that Trump guides the country through the crisis and is rewarded at the voting booth. There are four reasons we still give Trump a 35% chance of winning. First, COVID itself is obviously not Trump’s fault (nor is it Xi Jinping’s). Second, the economy is going to benefit from historic stimulus. Third, COVID reinforces Trump’s major policy themes: tighter borders and more domestic manufacturing. Fourth, Biden is a weak challenger. Most importantly, a new national consensus is forming regardless of the US election outcome. The crisis has led to border shutdowns and highlighted the risk of globalization and border insecurity. Note that US policy on immigration first tightened under President Obama (Chart 11). In the post-COVID environment, candidate Biden will not be willing to be accused of wanting open borders. So this likely is an abiding theme in US politics – Biden will be more pro-immigration than Trump, but he will have to have some limits to protect against any future Trumpian populists. Chart 11AUS Will Tighten Immigration Laws One Way Or Another Chart 11BUS Will Tighten Immigration Laws One Way Or Another The COVID crisis has also exacerbated US-China tensions, urging “decoupling” and calling attention to US reliance on China to make testing kits, protective equipment, and key pharmaceuticals (Chart 12). As we have argued before, the US containment policy toward China began under President Obama’s “Pivot to Asia” and is likely to continue under a Biden administration, particularly in the wake of COVID. Biden will be less tariff-happy than Trump, but he cannot win the Rust Belt, and keep it, if he is soft on China. What about fiscal policy? The great debate is over taxes and spending. And yet COVID has laid the starkest divisions to rest. Trump was never a “limited government” Republican, but if he wins reelection on this basis there is very little chance that he will revert to a pre-COVID Republican position of slashing social spending and taxes. First, Democrats may still keep the House. Second, like Boris Johnson in the UK, Trump would need to solidify the new conservative beachhead among the working class. This would require fiscal accommodation, i.e. limited spending retrenchment, despite the extraordinary stimulus of the pandemic. Biden, for his part, will raise taxes but not as much as Democrats may desire due to the need for economic recovery. Thus polarization is much more likely to fall in the wake of COVID and the US election on a new policy consensus of more secure borders, trade protectionism, and greater government spending. This new consensus will be reinforced by the more left-leaning ideology of the Millennial generation, which will reinforce the shift toward Big Government that is occurring under a Baby Boomer Republican president (Chart 13). Chart 12US Will Diversify Supply Chain Away From China Chart 13The Democratic Party Ascendancy In the meantime the election conflict, rather than this new consensus, will dominate the national scene. Bottom Line: If Trump loses because of his handling of the pandemic and recession, it will likely be a landslide. Polarization will decrease, just as after earlier boiling points. His followers will be discouraged, leaving only a rump of loyalists. A new Democratic consensus is likely to emerge that incorporates policies that Obama and Trump had in common on borders and manufacturing. Polarization is likely to fall on a new policy consensus of more secure borders, trade protectionism and greater government spending.  If Trump wins because of his handling of the crisis, he is not likely to squeak by narrowly in the election. In this scenario he has by definition received a swell of support for his conduct amid a historic crisis. He would grow his mandate. This will reduce polarization under a new Big Government Republican consensus. Investment Takeaways Tactically we remain long defensive plays. We see no immediate end to dollar strength, safe haven flows, and US equity outperformance until the US pandemic stabilizes and a clear path for economic reopening begins to unfold. Even if US equities fall because of US political uncertainty this year, they can outperform international equities at least until Chinese and global growth stabilize and turn up. Strategically, we remain overweight global equities relative to US equities on the basis of relative valuations and looming US policy headwinds arising from more government intervention, more redistribution, and more on-shoring. China’s stimulus should help lift international equities over a one-year horizon. Note that in the near term this US equity underweight may continue to be offside. Housekeeping We are throwing in the towel on our long EUR-USD trade, which has lost 2% since inception, and our long German consumer services trade, which is down 6%. We are also closing our long Thai bonds trade relative to Malaysia for a miniscule gain of 1.4 basis points. We still recommend both of these markets as strong emerging market plays. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Over the past several months the model showed a tie, 269-269, which would have given Trump the victory through an arcane congressional process for selecting the president. Appendix: The Global Fiscal Stimulus Response To COVID-19

Highlights Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay. Such testing will become available, but probably not for a few more months.  Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains. Despite the fact that the supply of goods and services has fallen sharply during this recession, the overall effect has been deflationary. Deflationary pressures should subside later this year as demand picks up, commodity prices rise, and the US dollar weakens. Looking several years out, deglobalization and the increasing politicization of central banking could lead to accelerating inflation. Long-term investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. Now What? Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm's way. Or so you think. You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark. This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows. Yet, we have neither a vaccine nor a cure for the virus (although as we go to press, unconfirmed news reports suggest that Gilead’s drug, remdesivir, has had success in treating patients at a Chicago hospital). Chart 1Widespread Social Distancing Dampened The Spread Of All Flus And Colds COVID-19 is part of the coronavirus family, which includes four members that are responsible for up to 30% of common colds (most other colds are caused by rhino-viruses). Social distancing has driven the number of cold and influenza-like cases in the US to very low levels (Chart 1). But does anyone really think that the common cold or flu will be permanently eradicated because of recent measures? If not, what will prevent COVID-19, which is no less contagious than these other illnesses, from resurfacing? In short, the bear is still there, waiting for us to reopen the economy. A Deep Recession As we wait, the economic damage continues to mount. The IMF’s baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is far deeper than during the 2008/09 financial crisis (Chart 2). The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020 relative to the Fund’s already bleak baseline. A second outbreak next year would push global GDP almost 5% below the IMF’s baseline in 2021, while the combination of a longer outbreak this year and a second outbreak next year would cause the level of output to fall 8% below the 2021 baseline (Chart 3). Chart 2Severe Damage To The Global Economy This Year Chart 3Downside Risks To The IMF's Projections The Ties That Bind The sudden stop in economic activity has led to a dramatic surge in unemployment. US initial unemployment claims have risen by a cumulative 22 million over the past four weeks. The true scale of layoffs is probably higher than that, given that some state websites have been unable to handle the flood of insurance applications. Chart 4Only About One-Third Of Those Who Lose Their Jobs Apply For Benefits Historically, only about one-third of those laid off have applied for benefits (Chart 4). While the take-up rate will be higher this time – the CARES Act increases weekly unemployment compensation, while expanding eligibility to self-employed workers – it is still reasonable to assume that the claims data do not capture how much of the workforce has been laid idle. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed. In this respect, the recovery in employment following this recession may end up resembling that of another “man-made” recession: the 1982 downturn (Chart 5). Back then, policymakers felt that a recession was a price worth paying to quash inflation. Once inflation fell, central banks were able to cut rates, allowing economic activity to recover. Today, the hope is that by shutting down all nonessential businesses, the virus will be quashed, and life will return to normal. Chart 5Comparing The 1982 Recession Versus Today: Employment Edition Exit Plans It remains to be seen whether vanquishing the virus will be as straightforward as vanquishing inflation was in the early 1980s. As we noted last week, in the absence of a vaccine or an effective treatment, our best hope is that mass testing will allow businesses to reopen.1 The technology for such tests already exists; it just has yet to become available on a large enough scale. Just like during the Second World War, the production of weapons necessary to fight the virus will grow at an exponential pace (Chart 6). Chart 6Now Let's Do The Same For Test Kits Near-Term Pressures On Risk Assets Exponential change is a difficult concept for the human mind to grasp. What seems painfully slow at first can quickly become unfathomably fast later on. The apocryphal story about the origins of the game of chess comes to mind.2 This puts investors in a bit of a quandary. Growth is likely to recover in the latter half of 2020 as COVID-19 testing becomes pervasive and the effects of fiscal and monetary stimulus make their way through the economy. But, the near-term picture could be soured by news stories of continued acute shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. Indeed, bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. Our US equity strategists are projecting only $100 and $140 in EPS, respectively. Stock prices and earnings estimates generally travel together (Chart 7). On balance, we continue to favor global equities over bonds on a 12-month horizon, owing to the fact that the cyclically-adjusted earnings yield is quite a bit higher than the bond yield (Chart 8). However, we have less conviction about the near-term (3-month) direction of stocks, and would recommend that investors maintain above-average cash levels for now which can be deployed on any major selloff. Chart 7Negative Earnings Revisions Will Weigh On Stocks In The Near Term Chart 8Favor Equities Over Bonds Over A 12-Month Horizon   Inflation And Supply Shocks: A Keynesian Paradox? One of the distinguishing features of this recession is that it has involved a simultaneous supply shock and a demand shock. Businesses have had to curb supply in order to allow workers to stay at home, while workers have reduced spending out of fear of going to stores or other venues where they could inadvertently contract the virus. Worries about job losses have further dented demand.  There is no question about what happens to output when both demand and supply decline: output falls. In contrast, the impact on the price level depends on which shock dominates (Chart 9). Chart 9Inflation And Supply Shocks As Appendix 1 illustrates with a set of simple numerical examples, in theory, a negative supply shock spread evenly across all sectors of the economy should cause the price level to rise. This is because unemployed workers, who are no longer contributing to output, will still end up consuming some goods and services by tapping into their savings, taking on new debt, or by receiving income transfers from the government. In the current situation, however, the supply shock has not been spread evenly throughout the economy. Some businesses have been completely shuttered, while others deemed essential have been allowed to operate. As the appendix shows, in such cases, the drop in aggregate demand is likely to be larger than if all sectors were equally impacted. In fact, it is possible for a supply shock to trigger a demand shock that is larger than the supply shock itself, leading to a perverse situation where a decline in supply results in a surfeit of output. A recent paper by Guerrieri, Lorenzoni, Straub, and Werning argues that the current pandemic represents such a “Keynesian supply shock.”3 Intuitively, such perverse supply shocks can arise if workers are cut off from purchasing many of the goods that they would normally buy. When the menu of available goods shrinks, even workers who are still employed could end up saving much of their income. Deflationary For Now All this implies that the pandemic is likely to be deflationary until more businesses reopen. The data seem to bear this out. The US core consumer price index fell by 0.1% month-over-month in March on a seasonally adjusted basis, led by steep declines in airfares and hotel lodging prices. High-frequency indicators, as well as the prices paid components of various purchasing manager indices, suggest that deflationary pressures have persisted into April (Chart 10). Chart 10Deflation Reigns For NowShelter inflation was reasonably firm in March but should soften over the coming months. A number of major apartment operators have announced rent freezes. In addition, the lagged effects from a stronger dollar and lower energy prices will contribute to lower goods inflation, while higher unemployment will hold back service inflation. Inflation Should Bounce Back In 2021 The discussion of Keynesian supply shocks suggests that aggregate demand will increase faster than supply as more sectors of the economy reopen. This should ease deflationary pressures. In addition, a rebound in global growth starting in the second half of 2020 will prompt a recovery in commodity prices. The forward oil curve is predicting that Brent and WTI crude prices will rise by 42% and 79%, respectively, over the next 12 months (Chart 11). Inflation expectations and oil prices tend to move closely together (Chart 12). Chart 11H2 2020 Rebound In Growth Will Lift Oil Prices Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together As a countercyclical currency, the US dollar will weaken over the next 12-to-18 months as global growth rebounds, providing an additional reflationary impulse (Chart 13). Falling unemployment will also eat into labor market slack, helping to support wages. Chart 13Stronger Global Growth In The Back Half Of The Year Will Weaken The Dollar, Putting Upward Pressure On US Inflation The Structural Outlook For Inflation… And Bond Yields Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or abate. On the one hand, it is possible that the pandemic will cast a pall over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth. On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labor market recovers. This could eventually lead to economic overheating in two-to-three years. Chart 14Global Trade Was Already Stagnating A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up (Chart 14). The pandemic may further inflame nationalist sentiment. Against the backdrop of high unemployment, Donald Trump is likely to campaign as a “war president,” relentlessly chiding Joe Biden for having too cozy a relationship with China. On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on TIPS breakevens. Market-based inflation expectations are even more subdued in most other advanced economies. If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves.   APPENDIX 1: Keynesian Supply Shocks Suppose there are two sectors, A and B. The economy consists of 2,000 workers, with each sector employing 1,000 workers. To keep things simple, assume that workers in each sector evenly split their consumption between the two sectors. Thus, a worker in sector A spends as much on goods from sector A as from sector B, and vice versa. Also assume that each worker, if employed, produces $1,000 of goods and receives a salary of $1,000 for his or her efforts. With this in mind, let us consider three scenarios: Scenario 1: Both Sectors Are Open For Business In this scenario, $1 million of good A and $1 million of good B are produced and supplied to the market. Since each of the 2,000 workers spends $500 on good A and $500 on good B, a total of $1 million of both goods are demanded. Aggregate demand equals aggregate supply. Scenario 2: Partial Closure Of Both Sectors Suppose that half the workers in both sectors are laid off. While the unemployed workers do not earn any income, they still spend half as much as they used to by tapping into their savings ($250 on good A and $250 on good B for each unemployed worker). Each employed worker continues to spend $500 on good A and $500 on good B. Now there is $500,000 in total of each good produced, but $750,000 of each good demanded. Aggregate demand exceeds supply. Scenario 3: Sector A, Deemed The Essential Sector, Remains Completely Open, While B Is Closed In this case, all sector A workers are still employed, earning $1,000 each. Since good B is no longer available for purchase, sector A workers increase spending on good A by 20% (from $500 to $600 per worker). Workers in sector B are all unemployed. However, they continue to tap into their savings. Rather than spending $250 on good A as they did in scenario 2, they increase their expenditures on good A by 20% (from $250 to $300). A total of $900,000 of good A is now demanded ($600*1,000+$300*1,000), which is less than the $1 million of good A supplied. Aggregate supply now exceeds demand for the part of the economy that is still open. The chart and table below summarize the results. The key insight is that a 50% shock to the entire economy curbs aggregate demand less than a 100% shock to half the economy. This implies that demand is likely to grow faster than supply as mass testing allows more of the economy to reopen. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 2  In one account, the King of India was so impressed when the game of chess was demonstrated to him that he offered its inventor any reward he desired. After thinking for a while, the inventor said “Your Highness, please give me one grain of rice for the first square on the chessboard, two grains for the next square, four grains for the one after that, doubling the number of grains until the 64th square.” Stunned that the inventor would ask for such a puny reward, the King quickly agreed. A week later, the King’s treasurer informed His Highness that he would need to give the inventor 18 quintillion grains of rice, which is more than enough rice to cover the entire planet’s surface. “Holy Ganges, what have I done?” the King exclaimed, before having the inventor executed. 3  Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?” NBER Working Paper No. 26918 (April 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores