Economy

Highlights Portfolio Strategy Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities remained untethered last week, and floated skyward to fresh all-time highs. The second panel of Chart 1 shows that from a technical perspective the SPX has returned close to the early-2018 blow-off top level, when the deviation from its 200-day moving average reached a zenith. Similarly, drilling beneath the surface the percentage of S&P 500 groups trading above their 50-day and 200-day moving averages in absolute terms is also running high (third panel, Chart 1). Investor complacency reigns supreme. The coronavirus scare lasted a few days and despite AAPL’s recent warning, which is likely the tip of the iceberg and other companies are slated to issue Q1 profit warnings, investors are ignoring all the bad news and piling into equities in general and teflon-tech stocks in particular. Keep in mind that 12-month forward profit growth remains positively correlated with the 10-year US treasury yield. The former crested in early 2020, predating the coronavirus epidemic (bottom panel, Chart 1). The end result is a new multiple expansion phase with the S&P 500 forward P/E clearing the 19 handle. Chart 1Dizzying Heights Such complacency transcends the equity market and spills over to the junk bond market. The hunt for yield remains intact and the Barclays US total return high yield index is following up the path of the SPX. Momentum is also tracking closely the broad equity market (top & middle panels, Chart 2). Nevertheless, we remain cautious. Last week we highlighted that the “tenuous trio” cannot go up indefinitely and a simultaneous rise in all three asset classes (stock prices, bond prices and the US dollar) typically portends an equity market crack.1 The big risk is that a surging greenback will short-circuit EPS growth and our worst case EPS scenario of -1% profit growth in calendar 2020 as we highlighted in mid-January will materialize.2 Worrisomely, while the S&P 500 made fresh all-time highs last week, the DXY came close to breaking above par, the VIX stayed stubbornly glued near 15 and gold bullion eclipsed $1,600/oz (third & bottom panels, Chart 2). Something has got to give. Meanwhile, Chart 3 updates our Corporate Pricing Power Indicator (CPPI) that recently came out of the deflation zone. This tick up in the CPPI coupled with still softening wage inflation have pushed our S&P 500 profit margin proxy slightly higher but still below the zero line, signaling that the margin contraction phase will likely run its course this year (bottom panel, Chart 3). Chart 2Spiking Greenback And Bullion Signal Trouble Chart 3Modest Profit Margin Improvement Drilling beneath the surface, our CPPI remains soft and vulnerable to a deflationary shock if the coronavirus epidemic severely wounds the global economy. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power A bit less than half of the industries we cover are lifting selling prices by more than 1%, and 35% are outright deflating. Worrisomely, 60% of the sectors we cover fail to raise prices at a faster clip than overall inflation. With regard to pricing power trends, roughly half of the industries we cover are either flat or in a downtrend (Table 2). Gold bullion remains on top of our table climbing at a 22%/annum rate despite the greenbacks recent rise, and only five additional commodity-related industries made it to the top thirty (Table 2). Most of the commodity complex is deflating courtesy of the appreciating US dollar, and the recent coronavirus epidemic will definitely sustain the downward pressure on commodity inflation as demand will likely suffer a major setback. Importantly, defensive sectors still occupy half of the top ten spots, similar to our last update in October 2019. On the flip side, four of the bottom eight industries are commodity related, a trend we expect to pick up steam in the coming quarters. This week we update our views on the two industrials sub-groups that are moving in opposite directions. Put The Aerospace Index On Downgrade Watch We are compelled to put the pureplay aerospace subgroup (currently rated neutral) on downgrade alert. A little over four years ago, we split the aerospace & defense coverage into pureplay aerospace and pureplay defense, as the profit drivers of these two industries started to steeply diverge. True, the yet to be completed UTX acquisition of RTN will re-complicate matters, but we will continue to cover these two groups independently. From a technical perspective, a head and shoulders pattern has likely formed, warning that the next leg down will be a rather painful one, especially if support at current levels gives way (top panel, Chart 4). Boeing (BA) dominates the pureplay aerospace subgroup and sustained delays to recertify the 737 MAX have weighed heavily on share prices. While the FAA and other country air safety regulators may give the green light for flights to resume for Boeing’s workhorse commercial jetliner, consumers may be reluctant to board this plane given all the negative publicity. This remains a big risk to BA and thus to the aerospace index. Chart 4Prior To Coronavirus Epidemic… On the macro front, prior to the coronavirus epidemic, the global PMI was on the path to recovery with a plethora of countries climbing above the boom/bust line (middle & bottom panels, Chart 4). In China specifically, Bloomberg’s story count of China slowdown has returned to the historical lower band of this time series, at a time when BCA’s Chinese credit & fiscal easing impulses were ticking higher (second & third panels, Chart 5). Tack on the ongoing Chinese monetary easing, and factors were falling into place for a robust recovery in demand for US aerospace products (bottom panel, Chart 5). Chart 6 shows why China is so important to this industry. Not only is future commercial aircraft demand growth centered round China, but also China at the recent peak accounted for 15% of total US aerospace exports. In fact, aerospace exports to China tripled since the GFC. Chart 5…Macro Data Were Firming Chart 6China Matters Most To Aerospace Unfortunately, the coronavirus epidemic changes all the China-related calculus and will further dampen demand for aerospace products, at least in the near-term. Granted, US aerospace sales are already nosediving and so are operating profits. Industry new orders are in a freefall of late courtesy of the 737 MAX grounding and halt in production (second & third panels, Chart 7). As a result, profit margins have collapsed probing the Great Recession lows (bottom panel, Chart 7). Similarly, aerospace shipments have taken it to the chin and inventories are sky high, whereas backlogs are contracting, albeit mildly (top, middle and fourth panels, Chart 8). Worrisomely, aerospace industrial production ground to a halt last month, with the resource utilization rate gaping down a whopping 560bps on a month-over-month basis (second & bottom panels, Chart 8). Boeing’s production ails will likely remain in place for the next three months, and sustain the downward pressure on output growth and capacity utilization. All of this suggests that profits are in for a rough ride. Chart 7737 MAX Ills… Chart 8…Weighing Heavily Executives’ knee-jerk reaction has been to tap credit lines in order to fend off this profit contraction phase, which has pushed the industry’s leverage to the stratosphere. In fact, the aerospace industry’s 3.5x net debt-to-EBITDA reading is the highest since the history of the data set, even higher than the aftermath of the 9/11 induced recession Chart 9). Finally, valuations have skyrocketed, rising to over three standard deviations above the past four decade mean. In marked contrast, relative technicals are washed out, probing two decade lows (Chart 10). Chart 9Rapid B/S Degradation Chart 10Overvalued, But Oversold In sum, Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Bottom Line: We are awaiting a bounce before downgrading the US aerospace index to a below benchmark allocation. It is now on our downgrade watch list. The ticker symbols for the stocks in the pureplay US aerospace index are: BA, UTX, TDG, TDY, TXT, HEI, SPR, HEI.A. Defense Rules Unlike their aerospace brethren, pureplay defense stocks are on fire on multiple fronts, and we reiterate our cyclical and secular (ten-year time horizon) overweight recommendations.3 Defense industrial production (IP) surpassed the end of the Cold War highs and is now in uncharted territory. On a year-over-year rate of change basis IP is running over 7% or fifteen percentage points higher than aerospace IP (Chart 11). This is a remarkable feat as overall IP is contracting and the US is still fighting off a manufacturing recession. Meanwhile, relative defense performance is in a V-shaped recovery, whereas relative aerospace performance is moving down along the right side of a lambda formation (top panel, Chart 11). As we mentioned above, M&A activity is also boosting takeover premia and the reduction of defense stock supply is bullish for stock prices (Chart 12). Chart 11Defense Is The Mirror Image Of Aerospace Chart 12Supportive M&A Upbeat defense outlays underpin relative share prices. Given that a global arms race is ongoing, demand for weapons will remain robust for the duration of this decade according to SIPRI’s estimates (Chart 13). Importantly, defense capital goods new orders are flirting with all-time highs, industry backlogs are not far behind and defense related exports are running red hot (Chart 14). Chart 13Insatiable… Chart 14…Demand… Besides the global rearmament, a global space race along with the real threat of cyberattacks – especially on governments – underscores that defense companies are well positioned to benefit from these two additional sources of revenues for years to come. This firm demand backdrop is reflected in near double digit sales growth outshining the broad market by a factor of 2:1. The last time defense sales were growing so briskly was during the Iraqi war in the early 2000s (Chart 15). However, one key difference between now and 2002 is margins. Back then profit margins were falling in the aftermath of the 9/11 induced recession. Fast forward to today and profit margins have doubled even eclipsing non-financial corporate sector margins (Chart 15). Given the industry’s high operating leverage, robust top line growth will flow straight to the bottom line and sustain the earnings-led relative share price outperformance phase. Keep in mind that not only are non-financial corporate sector profits contracting, but the sell-side community also expects defense EPS to continue to deflate in the coming twelve months (fourth & bottom panels, Chart 15). This represents a low bar for the defense industry to surpass. Defense stocks also have a fortress of a balance sheet: the net debt-to-EBITDA ratio runs below the broad market and the interest coverage ratio trounces the overall market. Tack on a soaring return-on-equity, and there is a long runway ahead for pureplay defense stocks (Chart 16). Chart 15…Underpins Operating Metrics Finally on the relative valuation front, while defense stocks trade at a massive premium to the broad market on a P/B basis, they are changing hands at a discount on both an EV/EBITDA and P/E basis. Defense stocks also command a higher dividend yield compared with the non-financial corporate sector (Chart 17). If our thesis continues to pan out, we deem that defense stocks will grow into their pricey P/B valuations, similar to what happened during the MAD doctrine era of the 1960s.4 Chart 16Fortress Of A B/S Chart 17Far From Overvalued On Most Ratios Netting it all out, red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Bottom Line: Stay overweight the pureplay defense index both on a cyclical and secular time horizon. The ticker symbols for the stocks in this index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available atuses.bcaresearch.com. 3    Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Special Report, “Brothers In Arms” dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The coronavirus is a wild card that may have a significant impact on the global economy, … : The COVID-19 outbreak is unfolding in real time, half a world away, and its ultimate course is uncertain. For now, our China strategists think the worst-case scenarios are unlikely, but we will not remain constructive if the virus outlook materially worsens. … but as long as there is not a significantly negative exogenous event, the US economy will be just fine, … : From a domestic perspective, the US expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will give increasing numbers of households the confidence and wherewithal to ramp up consumption. … and if there’s no recession, there will not be a bear market: Recessions and equity bear markets coincide, with stocks typically peaking six months ahead of the onset of a recession. If the next recession doesn’t come before late 2021/early 2022, the bull market should remain intact at least through the end of this year. What We Do US Investment Strategy’s stated mission is to analyze the US economy and its future direction for the purpose of helping clients make asset-allocation and portfolio-management decisions. As important as the economic backdrop is, however, we never forget that we are investment strategists, not economic forecasters. We don’t belabor the state of every facet of the economy because neither we nor our clients care about 10- to 20-basis-point wiggles in real GDP growth in themselves. They do want us to keep them apprised of the general trend, though, and we are always trying to assess it. Ultimately, macro analysis benefits investors by providing them with timely recognition of the approach or emergence of an inflection point in the cycles that matter most for financial assets. We view investment strategy as the practical application of the study of cycles, and we are continuously monitoring the business cycle, the credit cycle, the monetary policy cycle and the squishy and only sporadically relevant sentiment cycle. This week, we turn our attention to the business cycle, and the ongoing viability of the expansion, which is already the longest on record at 128 months and counting. If it remains intact, risk assets are likely to continue to generate returns in excess of returns on Treasuries and cash. The Message From Our Simple Recession Indicator We have previously described our simple recession indicator.1 It has just three components, and all three of them have to be sounding the alarm to conclude that a recession is imminent. Our first input is the slope of the yield curve, measured by the difference between the yield on the 10-year Treasury bond and the 3-month T-bill.2 The yield curve inverts when the 3-month bill yield exceeds the 10-year bond yield, and a recession has followed all but one yield curve inversion over the last 50 years (Chart 1). The yield curve inverted from May through September last year, and the coronavirus outbreak (COVID-19) has driven it to invert again, but the unprecedentedly negative term premium (Chart 2) has made the curve much more prone to set off a false alarm. Chart 1An Inverted Curve May Not Be What It Used To Be ... Chart 2... When A Negative Term Premium Is Holding Down Long Yields The indicator’s second input is the year-over-year change in the leading economic index (“LEI”). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in the last 50 years with just one false positive (Chart 3). The LEI bounced off the zero line thanks to January’s strong reading, and the year-ago comparisons are much easier than they were last year, but we are mindful that it is flirting with sending a recession warning. Chart 3Leading Indicators Are Wobbly, ... It takes more than tight monetary conditions to make a recession, but you can't have one without them. To confirm the signal from the yield curve and the LEI and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA’s model calculates an equilibrium rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 4). Tight monetary policy isn’t a sufficient condition for a recession – expansions continued for six more years despite tight policy in the mid-‘80s and mid-'90s – but it is a necessary one. Our indicator will not definitively signal an approaching recession until monetary conditions turn restrictive. Chart 4... But The Fed Is Nowhere Near Inducing A Recession Bottom Line: In our view, the yield curve and the LEI both represent yellow lights, though the LEI has a greater likelihood of turning red, especially in the wake of COVID-19. Monetary policy is unambiguously green, however, and we will not conclude that a recession is imminent until the Fed deliberately attempts to rein in the economy. Bolstering Theory With Observation A potential shortcoming of our recession indicator is its reliance on a theoretical concept. The equilibrium (or natural) rate of interest cannot be directly observed, so our judgment of whether monetary policy is easy or tight turns on an estimate. To bolster our assessment of whether or not the expansion can continue, we have been tracking the drivers of the main components of US output. Going back to the GDP equation from Introductory Macroeconomics, GDP = C + I + G + (X - M), we look at the forces supporting Consumption (C), Investment (I) and Government Spending (G). (Because the US is a comparatively closed economy in which trade plays a minor role, we ignore net exports (X-M).) Consumption is by far the largest component, accounting for two-thirds of overall output, while investment and government spending each contribute a sixth. As critical as consumption is for the US economy, it is not the whole story; smaller but considerably more volatile investment is capable of plunging the economy into a recession on its own. The Near-Term Outlook For Consumption Chart 5Labor Market Slack Has Been Absorbed Consumption depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and “hidden” unemployment dwindling as the supply of discouraged (Chart 5, top panel) and involuntary part-time workers (Chart 5, bottom panel) has withered. The prime-age employment-to-population ratio trails only the peak reached during the dot-com era (Chart 6), which bodes well for household income. The historical correlation between the prime-age non-employment-to-population ratio and wage gains has been quite robust, and compensation growth has plenty of room to run before it catches up with the best-fit line (Chart 7). Chart 6Prime-Age Employment Has Surged, ... Chart 7... And Wages Will Eventually Follow Suit Chart 8No Pressing Need To Save, Or Pay Down Debt Households can use additional income to increase savings or pay down debt instead of spending it, but it doesn’t look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels (Chart 8, top panel); households have already run debt down to its post-dot-com bust levels (Chart 8, middle panel); and debt service is less demanding than it has been at any point in the last 40 years (Chart 8, bottom panel). The health of household balance sheets, and the recent pickup in the expectations component of the consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at or above trend.   Household balance sheets are healthy enough to support spending income gains; there's even room to borrow to augment them.           The Near-Term Outlook For Investment Table 1GDP Equation Recession Probabilities Chart 9A Budding Turnaround We previously identified investment as the individual component most likely to decline enough to zero out trend growth from the other two components (Table 1), and it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the NFIB survey of smaller businesses (Chart 9, top panel) and the regional Fed manufacturing surveys (Chart 9, bottom panel) have both pulled out of declines. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the Phase 1 trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 has been subdued. Government Spending In An Election Year Chart 10State And Local Revenues Are Well Supported Heading into the most hotly contested election in many years, we confidently assert that federal spending is not going to go away. Regardless of party affiliation, everyone in Congress sees the appeal of distributing pork to their constituents. Spending by state and local governments, which accounts for 60% of aggregate government spending, should also hold up well, as a robust labor market will support state income tax (Chart 10, top panel) and sales tax (Chart 10, middle panel) receipts. Healthy trailing home price gains will support property tax assessments, keeping municipal coffers full (Chart 10, bottom panel). Coronavirus Uncertainties The coronavirus epidemic (COVID-19) is unfolding in real time, generating daily updates on new infections, deaths and recoveries. Any opinion we offer on the economy’s future is conditioned on the virus' ongoing course. If it takes a sharp turn for the worse, with more severe consequences than we had previously expected, it is likely that we will downgrade our outlook. For now, we are operating under the projection that the virus will cause China’s first quarter output to contract sharply enough to zero out global growth in the first quarter. Our base-case scenario, following from the work of our China Investment Strategy service, is fairly benign from there. For now, we are expecting that the worst of the effects will be confined to the first quarter, and that the Chinese economy and the global economy will bounce back vigorously in the second quarter and beyond, powered by pent-up demand that will go unfilled until the outbreak begins to recede. Our China strategists continue to be heartened by Chinese officials' aggressive (albeit belated) measures to stem the outbreak, revealed in the apparent slowing of the rate of new infections in Hubei province, the epicenter of the outbreak (Chart 11, top panel), and in the rest of China (Chart 11, bottom panel). They also expect a determined policy response to offset the drag from the epidemic (Charts 12 and 13), as officials pursue the imperative of meeting their goal to double the size of the economy between 2010 and 2020. Chart 11Stringent Quarantine Measures May Be Gaining Traction Chart 12The PBOC Is Doing Its Part, ... Chart 13... By Easing Monetary Conditions If the economy is expanding, investors' bar for de-risking should be high. Bottom Line: Our China strategists’ COVID-19 view remains fairly optimistic, though it is subject to unfolding developments. Our US view is contingent on BCA’s evolving COVID-19 views. Investment Implications As we noted at the outset, we are not interested in the economy for the economy’s sake; we are only interested in its impact on financial markets. The key business-cycle takeaway for markets is that bear markets and recessions typically coincide, as it is difficult to get a 20% decline at the index level without a meaningful decline in earnings, and earnings only decline meaningfully during recessions. No recession means no bear market, and it also means no meaningful pickup in loan delinquencies and defaults. The bottom line is that it is premature to de-risk while the expansion remains intact. We reiterate our recommendation that investors should remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within fixed income allocations, though we may turn more cautious as we learn more about the progression of COVID-19.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the August 13, 2018 US Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com. 2 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed’s future actions.

Overweight Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however, looking further out such demand destruction will likely prove transitory. The chart on the right highlights that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices. Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK. For additional details please refer to this Monday’s Weekly Report.  

Highlights Global equities have benefited from the fact that the number of new coronavirus (COVID-19) cases continues to drift lower. Falling bond yields have also supported stocks. Nevertheless, risks remain. Even if the outbreak recedes, global growth is still set to fall to zero in the first quarter, before bouncing back over the remainder of the year. Thus, a near-term hit to corporate earnings now looks unavoidable. More worryingly, the possibility remains that the number of new cases will spike again as Chinese workers return to their jobs over the next few weeks. While we and others have compared the current outbreak to the SARS episode, a more relevant comparison could be the H1N1 (swine flu) outbreak of 2009-2010. Despite early efforts to contain it, 61 million Americans ended up catching the H1N1 virus, resulting in about 12,000 US deaths over a 12-month period. Globally, at least 150,000 people perished. It appears that the fatality rate from COVID-19 is significantly higher than for H1N1, though well below that of SARS and MERS. A full-blown pandemic with a fatality rate of 2% could lead to 20 million deaths worldwide. This would likely trigger a global downturn as deep as the Great Recession of 2008/09. The only consolation is that the recovery would be much more rapid than the one following the financial crisis. Although we are inclined to lean on the side of optimism, the truth is that neither we nor anyone else knows what the likelihood of such a pandemic scenario is. Thus, while we continue to maintain our positive 12-month view on global stocks, we recommend a more cautious near-term stance. Global Growth Set To Grind To A Halt In Q1 Based on the SARS example, we noted three weeks ago that risk assets were likely to bottom once the number of new coronavirus cases peaked. Sure enough, Chinese shares troughed on January 31st, just as the number of confirmed infections had begun to level off. The S&P 500 has been on a tear since then, hitting one record high after another (Chart 1). Falling bond yields have also supported stocks. Despite the decline in new infections, we think it is too early for investors to breathe a sigh of relief. For one thing, the economic data out of China remains abysmal. Real-time indicators of economic activity have been off-the-charts bad – much worse than what we saw during the SARS outbreak. While there has been some recovery in recent days, road congestion remains well below normal levels. In Shanghai, property sales are currently about four times lower than what is usual for this time of  year. Movie ticket sales have all but disappeared. Daily coal consumption, which tracks electricity consumption, has fallen by 70% (Chart 2). More than three-quarters of companies surveyed last week by the American Chamber of Commerce in Shanghai said that they cannot run a full production line due to a lack of staff. Chart 1Just As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked   Chart 2Chinese Daily Activity Has Fallen Off A Cliff In our preliminary estimate of the impact of the virus on global growth, we penciled in zero growth for China on a quarter-over-quarter basis in Q1 of 2020, implying that the level of output in the first quarter would be the same as in the fourth quarter. Unfortunately, at this point, that looks far too optimistic. Chinese economic output will decline on a sequential basis. The only question is by how much. Despite the decline in new infections, we think it is too early for investors to breathe a sigh of relief. Chart 3 shows our updated baseline profile for global growth in Q1 and the remainder of this year. Assuming that production returns to normal over the coming weeks, it should be possible to limit the unannualized quarter-over-quarter decline in Chinese real GDP in Q1 to 1% (4% annualized). On a year-over-year basis (2020Q1 versus 2019Q1), this would drag Chinese growth down to 3.5%, the slowest pace in three decades. Relative to our earlier estimates, we expect larger spillover effects to the rest of the world, mainly stemming from the severe contraction in global tourism. Chart 3The Global Economy Will Come To A Standstill In Q1 The direct and indirect effects of the outbreak should be enough to push global growth down to zero on a quarter-over-quarter basis in Q1. Under our baseline scenario, growth will recover in the second quarter, leaving the level of global GDP down 0.5 percentage points for the year as a whole compared to what would have transpired if the virus had never emerged.   The Calm Before The Storm? Even after this downgrade to our assessment, we still see the risks to global growth from the COVID-19 outbreak as being tilted to the downside. This largely reflects our concern that contrary to our baseline scenario, the outbreak could reintensify over the next few weeks as more Chinese workers return to their jobs. As the dire situation on the Diamond Princess cruiseliner docked in the port of Yokohama illustrates, the COVID-19 virus remains highly contagious. Despite numerous efforts by medical authorities to keep those on board at a safe distance from one another, 621 of the 3,011 passengers and crew aboard the ship who have been tested have been infected with the virus. Worryingly, the virus also appears to be contagious even when carriers are not showing any symptoms. Just this week, the Japanese media reported on a case where the son of an infected doctor tested positive for the virus even though he had last seen his father three days before the doctor started displaying symptoms.  While the number of new infections has fallen in China, new clusters have appeared elsewhere. South Korea just reported 73 new cases in a little more than two days. Iran disclosed two deaths from the virus in Qom, a holy city just outside Tehran that receives 20 million visitors annually. This suggests that there are probably at least 100 infected people in the city. The World Health Organization has estimated RO, the average number of people someone with the COVID-19 virus will infect, to be between 1.4 and 2.5. A recent survey of 12 studies found a larger mean RO of 3.28.1  An RO above one would produce an exponential increase in the number of cases. Heavy-handed quarantine measures such as those imposed by China could probably drive RO below one. However, some governments may not be able to implement such measures, and even if they could, they might not be sustainable for months on end.  The H1N1 (Swine Flu) Template? All this raises the possibility that the COVID-19 outbreak could end up resembling the H1N1 (swine flu) pandemic of 2009-10. Despite initial hopes, early efforts to contain the H1N1 outbreak failed. The US Centers for Disease Control and Prevention calculated that 61 million Americans caught the virus over the course of the proceeding 12 months, resulting in over 12,000 deaths. Globally, an estimated 700 million-to-1.4 billion people contracted the virus. A paper published in the Lancet put the number of fatalities worldwide at 151,700-to-575,400.2 The reason one hears less about H1N1 than SARS is that the latter killed 5%-to-10% of those who contracted it, whereas the former killed 0.01%-to-0.08%. Based on very preliminary evidence, it appears that the fatality rate from COVID-19 is significantly higher than for H1N1, though well below that of SARS, and lower still than for MERS, a particularly nasty strain of the coronavirus that killed about one-third of those who contracted it. That said, COVID-19’s true fatality rate remains highly uncertain. In Hubei province, the fatality rate is running at 3.1%. Elsewhere in China, it stands at 0.9%. Outside China, the fatality rate appears to be 0.5%. Part of the gap between Hubei and elsewhere may be due to greater underreporting of mild and moderate cases in the stricken province. However, it is also likely that Hubei’s higher fatality rate reflects the tremendous pressures its medical system is currently under. If the COVID-19 outbreak were to morph into a pandemic, such pressures would only escalate since medical resources from less-afflicted areas could no longer be deployed to fight every local breakout. The Economic Impact Of A Pandemic: Deep But Brief Chart 4The Private-Sector Surplus In Developed Economies Is In Good Shape Assuming the COVID-19 virus infects a billion people with a fatality rate of 2%, this would translate into 20 million deaths worldwide. Such a pandemic would rattle the global economy, leading to a recession as deep as the one in 2008/09. Demand for most items other than necessities would collapse. Business and leisure travel would fizzle. The global supply chain would seize up. The only consolation is that the recession would likely be followed by a vigorous “V-shaped” recovery. Sluggish “U-shaped” recoveries tend to occur when there are many imbalances that need to be worked off. For example, the recovery in the US following the Great Recession was impeded by the need for households to pare back debt and for the excess supply of newly built homes to be run down. Today, the larger developed economies are in decent shape. The private-sector financial balance in advanced economies – the difference between what the private sector earns and spends – stands at a surplus of 3.4% of GDP. In 2007, the private-sector financial balance fell to 0.4%, hitting a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 4). Chinese debt levels have soared over the past decade. However, it is worth noting that China’s private-sector financial surplus reached 7.1% of GDP in 2019 – higher than in Japan or Germany (Chart 5). Rather than suffering from excess debt levels, China suffers from excess savings. It is these excess savings that have forced the authorities to push state-owned companies and local governments to engage in debt-financed investment spending in order to prop up aggregate demand and employment. It is also these savings that will allow the government to stimulate the economy to prevent an outright economic collapse. Chart 5The Private Sector Spends Less Than It Earns In Most Economies Life Goes On… For Most Chart 6'Til Death Do Us Part While it would take time, as horrific as a pandemic would be, most people would eventually adjust to living in a world where one’s longevity is less assured than it is today. That is the world in which humanity lived for centuries. It is also the world that prevailed during the Cold War. Keep in mind that in the US, an average 59 year-old man has a 1% chance of dying at some point within one year, and a 6% chance of dying over five years (Chart 6). Death is a part of life. As the virus circulates throughout the population, some people will perish. However, the vast majority will acquire immunity either by fighting off the disease or, if a vaccine becomes available later this year or in 2021, by being inoculated. All this will bring the pandemic to an end.  Investment Conclusions No one knows if the COVID-19 outbreak will recede or whether it will morph into a true pandemic. As macro strategists, all we can do is run through various scenarios and try to figure out the likely market impact. Chart 7Global Manufacturing Was On The Upswing Before The Outbreak Occurred If the number of new infections continues to decline, investors will likely look through the Q1 plunge in growth. Judging from the purchasing manager indices, global growth had already turned the corner in the weeks before the viral outbreak (Chart 7). With pent-up demand having accumulated in the intervening weeks, growth would bounce back in the second quarter. Under this benign scenario, equities still have upside, while bond yields will start rising again. As a countercyclical currency, the US dollar would also give up some of its recent gains. In a pandemic scenario, the recovery in growth will obviously be delayed. And when output does recover, it will be from significantly lower levels. Markets will end up going through their own version of Kubler-Ross' five stages of grief: denial, anger, bargaining, depression, and acceptance. Unfortunately, before we reach the acceptance stage, global equities could easily fall by 20% from current levels. On balance, while we continue to lean on the side of optimism by maintaining our positive 12-month view on global stocks, we recommend a more cautious near-term stance until there is greater clarity as to how the outbreak will evolve.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1Ying Liu, Albert A Gayle, Annelies Wilder-Smith, and Joacim Rocklöv, “The reproductive number of COVID-19 is higher compared to SARS coronavirus,” Journal of Travel Medicine, February 2020. 2 Please see Sundar S. Shrestha, et al., “Estimating the Burden of 2009 Pandemic Influenza A (H1N1) in the United States (April 2009–April 2010),” Clinical Infectious Diseases (52:1), January 2011; Peter Doshi, “The 2009 Influenza Pandemic,” The Lancet Infectious Diseases (13:3), March 2013; and Heath Kelly, et al., “The Age-Specific Cumulative Incidence of Infection with Pandemic Influenza H1N1 2009 Was Similar in Various Countries Prior to Vaccination,” PLoS ONE 6(8), August 2011. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades