Equities

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

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

Highlights An analysis on Colombia is available below. If EM share prices hold at current levels, a major rally will likely unfold. If they are unable to hold, a substantial breakdown will likely ensue. The direction of EM US dollar and local currency bond yields will be the key to whether EM share prices break down or not. We expect continuous EM currency depreciation that will likely trigger foreign capital outflows from both EM credit markets and domestic bonds. This leads us to reiterate our short position in EM stocks. We are booking profits on the long implied EM equity volatility and the short Colombian peso/long Russian ruble positions. Feature The Federal Reserve’s intra-meeting rate cut this week might temporarily boost EM risk assets and currencies. However, it is also possible that investors might begin questioning the ability of policymakers in general and the Fed in particular to continuously boost risk assets. In recent years, investors have been operating under the implicit assumption that policymakers in the US, China and Europe have complete control over financial markets and global growth, and will not allow things to get out of hand. Investors have been ignoring contracting global ex-US profits as well as exceedingly high US equity multiples and extremely low corporate spreads worldwide. In the past 12 months, investors have been ignoring contracting global ex-US profits (Chart I-1) as well as exceedingly high US equity multiples. This has been occurring because of the infamous ‘policymakers put’ on risk assets. As doubts about policymakers’ ability to defend global growth and financial markets from COVID-19 heighten, investors will likely throw in the towel and trim risk exposure. A sudden stop in capital flows into EM is a distinct possibility. The Last Line Of Defense EM share prices are at a critical juncture (Chart I-2). If they hold at current levels, a major rally will likely unfold. If they are unable to hold at current levels, a substantial breakdown will likely ensue. Chart I-1Profitless Rally In 2019 Makes Stocks Vulnerable Chart I-2EM Share Prices Are At A Critical Juncture   What should investors be looking at to determine whether EM share prices will find a bottom close to current levels, or whether another major down-leg is in the cards? In our opinion, the direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Chart I-3 illustrates that EM equity prices move in tandem with EM corporate US dollar bond yields as well as EM local currency bond yields (bond yields are shown inverted on both panels). Falling EM fixed income yields have helped EM share prices tremendously in the past year. Chart I-3EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM corporate US dollar bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when EM credit spreads are widening more than Treasury yields are falling; or (3) when both US government bond yields and EM credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for US government bonds, presently EM corporate US dollar bond yields can only rise if their credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently rests with EM corporate spreads. EM corporate and sovereign credit spreads are breaking above a major technical resistance (Chart I-4). The direction of these credit spreads is contingent on EM exchange rates and commodities prices as demonstrated in Chart I-5. Credit spreads are shown inverted in both panels of this chart. Chart I-4A Breakout In EM Sovereign And Corporate Credit Spreads? Chart I-5Falling EM Currencies And Commodities Herald Wider EM Credit Spreads   EM exchange rates are also crucial for foreign investors’ in EM domestic bonds. The top panel of Chart I-6 demonstrates that even though the total return on the JP Morgan EM GBI domestic bond index has been surging in local currency terms, the same measure in US dollar terms is still below its 2012 level. The gap is due to EM exchange rates. EM local currency bond yields are at all-time lows (Chart I-6, bottom panel), reflecting very subdued nominal income growth and low inflation in many developing economies (Chart I-7). Chart I-6EM Currencies Are Key To EM Domestic Bonds Total Returns Chart I-7Inflation Is Undershooting In EM Ex-China   Hence, low EM domestic bond yields are justified by their fundamentals. Yet foreign investors are very large players in EM local bonds, and their willingness to hold these instruments is contingent on EM exchange rates’ outlook. The sensitivity of international capital flows into EM US dollar and local currency bonds to EM exchange rates has diminished in recent years because of global investors’ unrelenting search for yield. As QE policies by DM central banks have removed some $9 trillion in high-quality securities from circulation, the volume of fixed-income securities available in the markets has shrunk. This has led to unrelenting capital inflows into EM fixed-income markets, despite lingering weakness in their exchange rates. Nonetheless, sensitivity of fund flows into EM fixed-income markets to EM exchange rates has diminished but has not yet outright vanished. If EM currencies depreciate further, odds are that there will be a sudden stop in capital flows into EM fixed-income markets. Outside of some basket cases, we do not expect the majority of EM governments or corporations to default on their debt. Yet, we foresee further meaningful EM currency depreciation which will simply raise the cost of servicing foreign currency debt. It would be natural for sovereign and corporate credit spreads to widen as they begin pricing in diminished creditworthiness among EM debtors in foreign currency terms.     Bottom Line: Unlike EM equities, EM fixed-income markets are a crowded trade and are overbought. Hence, any selloff in these markets could trigger an exodus of capital pushing up their yields. Rising yields will in turn push EM equities over the cliff. EM Currencies: More Downside We expect EM currencies to continue depreciating. EM ex-China currencies’ total return index (including carry) versus the US dollar is breaking down (Chart I-8, top panel). This is occurring despite the plunge in US interest rates. Notably, as illustrated in the bottom panel of Chart I-8, EM ex-China currencies have not been correlated with US bond yields. The breakdown in correlation between EM exchange rates and US interest rates is not new. This means that the Fed's easing will not prevent EM currency depreciation. EM currencies correlate with commodities prices generally and industrial metals prices in particular (Chart I-9, top panel). The latter has formed a head-and-shoulders pattern and has broken down (Chart I-9, bottom panel). The path of least resistance for industrial metal prices is down. Chart I-8More downside In EM Ex-China Currencies Chart I-9A Breakdown In Commodities Points To A Relapse In EM Currencies Chart I-10Chinese Imports Are Key To EM Currencies EM currencies’ cyclical fluctuations occur in-sync with global trade and Chinese imports (Chart I-10). Both will stay very weak for now. Finally, China is stimulating, and we believe the pace of stimulus will accelerate. However, the measures announced by the authorities so far are insufficient to project a rapid and lasting growth recovery. In particular, the most prominent measure announced in China is the PBoC’s special re-lending quota of RMB 300 billion to enterprises fighting the coronavirus outbreak. However, this amount should be put into perspective. In 2019, private and public net credit flows were RMB 23.8 trillion, and net new broad money (M2) creation was RMB 16 trillion. Thus, this re-lending quota will boost aggregate public and private credit flow by only 1.2% and broad money flow by mere 2%. This is simply not sufficient to meaningfully boost growth in China. Notably, daily, commodities prices in China do not yet confirm any growth recovery (Chart I-11). Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Bottom Line: The selloff in EM exchange rates will persist. As discussed above, this will likely lead to outflows from both EM credit markets and domestic bonds. Reading Markets’ Tea Leaves It is impossible to forecast the pace and scope of the spread of COVID-19 as well as the precautionary actions taken by consumers and businesses around the world. In brief, it is unfeasible to assess the COVID-19’s impact on the global economy. The direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Rather than throwing darts with our eyes closed, we examine profiles of various financial markets with the goal of detecting subtle messages that financial markets often send: Aggregate EM small-cap and Chinese investable small-cap stocks seem to be breaking down (Chart I-12). Chart I-11Daily Commodities Prices In China: No Sign Of Revival Chart I-12Investable Small Cap Stocks Seem To Be Breaking Down   The technical profiles of various EM currencies versus the US dollar on a total return basis (including the carry) are consistent with a genuine bear market (Chart I-13). Hence, their weakness has further to go. Global industrial stocks’ relative performance against the global equity benchmark has broken below its previous technical support (Chart I-14). This is a bad omen for global growth. Chart I-13EM Currencies Are In A Genuine Bear Market Chart I-14A Breakdown In Global Industrials Relative Performance   Finally, Korean tech stocks as well as the Nikkei index seem to have formed a major top (Chart I-15). This technical configuration suggests that their relapse will very likely last longer and go further. Chart I-15A Major Top in Korean And Japanese Stocks? All these signposts relay a downbeat message on global growth and, consequently, EM risk assets and currencies. A pertinent question to ask is whether the currently extremely high level of the VIX is a contrarian signal to buy stocks? Investors often buy the VIX to hedge their underlying equity portfolios from short-term downside. However, when and as they begin to view the equity selloff as enduring, they close their long VIX positions and simultaneously sell stocks. In brief, the VIX’s current elevated levels are likely to be a sign that many investors are still long stocks. When investors trim their equity holdings, they will likely also liquidate their long VIX positions. Thereby, share prices could drop alongside a falling VIX. Therefore, we are using the recent surge in equity volatility to close our long position in implied EM equity volatility. Even though risks to EM share prices are still skewed to the downside, their selloff may not be accompanied by substantially higher EM equity volatility. However, we continue to recommend betting on higher implied volatility in EM currencies. The latter still remains very low. Investment Conclusions We reinstated our short position on the EM equity index on January 30, and this trade remains intact. For global equity portfolios, we continue to recommend underweighting EM versus DM. Within the EM equity universe, our overweights are Korea, Thailand, Russia, central Europe, Mexico, Vietnam, Pakistan and the UAE. Our underweights are Indonesia, the Philippines, South Africa, Turkey and Colombia. We are contemplating downgrading Brazilian equities from neutral to underweight. The change is primarily driven by our downbeat view on banks (Chart I-16). This is in addition to our existing bearish view on commodities. We will publish a Special Report on Brazilian banks in the coming weeks. Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Among the EM equity sectors, we continue to recommend a long EM consumer staples/short banks trade (Chart I-17, top panel) as well as a short both EM and Chinese banks versus their US peers positions (Chart I-17, middle and bottom panels). Chart I-16Brazilian Bank Stocks Are Breaking Down? Chart I-17Our Favored EM Equity Sector Bets   We continue to recommend a short position in a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. We are also structurally bearish on the RMB. Today we are booking profits on the short Colombian peso / long Russian ruble trade (please refer to section on Colombia on pages 13-17). With respect to EM local currency bonds and EM sovereign credit, our overweights are Mexico, Russia, Colombia, Thailand, Malaysia and Korea. Our underweights are South Africa, Turkey, Indonesia, and the Philippines. The remaining markets warrant a neutral allocation. As always, the list of recommendations is available at end of each week’s report and on our web page. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Colombia: Upgrade Domestic Bonds; Take Profits On Short Peso Trade Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums Chart II-6Consumer Spending Has Been Supported By Borrowing Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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

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

Highlights At the current rate of work resumption, March’s PMI should rebound to its “normal range” from February’s historic lows. If so, our simple calculation, using China’s PMI figures and GDP growth in Q4 2008 as a template, suggests that China's economic growth in Q1 2020 should come in at around 3.2%. Chinese stocks passively outperformed global benchmarks in the last two weeks.  The likelihood of a stimulus overshoot in the next 6-12 months continues to rise, supporting our view that Chinese stocks will actively outperform global benchmark in the coming months. Cyclical stocks have significantly outperformed defensives lately. While this is consistent with our constructive view towards Chinese equities in general, the magnitude of a tech stock rally in the domestic market of late appears to be somewhat excessive. As such, investors should focus their sector exposure in favor of resources, industrials, and consumer discretionary. The depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. Feature Despite the past week’s plunge in global equities due to the threat of a worldwide COVID-19 pandemic, Chinese stocks have outperformed relative to global benchmarks. This underscores our view that epidemic risks within China are slowly abating, and China’s reflationary response to the crisis will likely overcompensate for the short-term economic shock. Tables 1 and 2 highlight key developments in China’s economy and its financial markets in the past month. On the growth front, both the February official and Caixin PMIs dropped to historic lows as a result of the virus outbreak and nationwide lockdown. On the other hand, economic data from January confirmed that pre-outbreak activity in China was on track to recovery. Daily data also suggests that production in China continues to resume. Moreover, monetary conditions have significantly loosened and fiscal supports have materially stepped up.  Chinese equities in both onshore and offshore markets dropped by 2% and 7% respectively (in absolute terms) from their January 13 peaks. Nevertheless, they have both significantly outperformed global equities, particularly in the past week. Equally-weighted cyclical stocks versus defensives in the onshore market have also moved up sharply, driven by a rally in the technology sector stocks. While the outperformance of cyclical stocks is consistent with our constructive view towards Chinese stocks, the magnitude appears to be excessive. Thus, we would advise investors positioning for a cyclical recovery in China to favor exposure in resources, industrials and consumer discretionary stocks. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary In reference to Tables 1 and 2, we have a number of observations concerning developments in China’s macro and financial market data: Chart 1Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand February’s drop in the official PMI below 40% is reminiscent of November 2008, which was the height of the global financial crisis. The raw material inventory sub-index of the PMI in February fell to a record low, a clear indication of strain in China’s manufacturing sector. While the finished goods inventory sub-index ticked up slightly compared with January, factories will likely run out of existing raw materials to produce goods if transportation logistics do not return to normal soon (Chart 1). A higher number in the new orders sub-index relative to production output also suggests the pressure on the supply side will intensify if the virus outbreak in China worsens and continues to disrupt manufacturing activities. This will in turn undermine the effectiveness of Chinese policy response.   Daily data from various sources suggests Chinese industrial activities continue to pick up. Between February 10 (the first official return-to-work day after an extended Chinese New Year holiday) and February 25 (the cutoff date for responding to PMI surveys), daily coal consumption in China’s six largest power plants was only about 60% of consumption compared from the same period last year (adjusted for the Lunar Year calendar). This is in line with the 35.7 reading in February’s manufacturing PMI, versus 49.2 a year ago. In the last four days of February, however, coal consumption reached nearly 70% of last year’s consumption. This figure is in keeping with a 10 percentage point increase in the rate of work resumption of enterprises above-designated size in China’s coastal regions.1 If energy consumption and work resumption rates reach about 90% by the end of March compared with Q1 2019, then PMI in March should pick up to 45% or higher. A 45% or higher reading in March’s PMI will imply economic impact from the virus outbreak is mostly limited to February. A simple calculation using China’s GDP growth in Q4 2008 as a template suggests that China's economic growth in Q1 2020 should come in at around 3.2% in real terms. This is in line with the estimate from BCA's Global Investment Strategy service.2 As we pointed out in November last year,3 China is frontloading additional fiscal stimulus in Q1 2020 to secure the economic recovery, which started to bud prior to the virus outbreak. The increase in January’s credit numbers confirms our projection. The monthly flow in total social financing in January (with only three work weeks effectively) reached above RMB 5 trillion. This figure exceeded that in January 2019, the highest monthly credit number last year. Local government bond issuance in January was almost double that a year ago, and a total of 1.2 trillion local government bonds were issued in the first two months of this year - a 53% jump from the same period last year. This suggests that fiscal stimulus has indeed stepped up in 2020. Money supply in January was slightly distorted by the earlier Chinese New Year (it fell in January this year instead of February as in most years) and the COVID-19 outbreak.  M1 registered zero growth from a year ago, whereas it grew by 0.4% in January 2019.4 Normally, during the month of the Chinese New Year, households have more cash in deposits whereas corporations have less as they pay pre-holiday bonuses to employees. This seasonality factor causes the growth rate in M0 to rise and M1 growth to fall. The seasonality was exacerbated by the nationwide lockdown on January 20 this year, as many real estate developers reportedly suffered from a significant reduction in home sales and delays in deposits for down payments. Household consumption in the service sector during the Chinese New Year was also severely suppressed. This explains near-zero growth in M1 and a larger-than-expected increase in household deposits in January (Chart 2). We expect the growth in both M0 and M1 to start normalizing in March, as production and household consumption continue to resume. While we do not expect large fluctuations in housing prices, we think growth in home sales may accelerate from Q2 2020. There are early signs that the government is starting to relax restrictions on the real estate sector, on a region by region basis. Land sales remain a major source of local governments’ income, accounting for more than half of total revenues as of last year. Chart 3 shows that as government expenditures lead land sales, a major increase in fiscal stimulus and local government spending means that a significant bump in land sales will be needed in 2020. A strengthening supply of land, coupled with the unlikelihood of large fluctuations in property prices, suggests that there will be more policy supports to the real estate sector and more incentives to boost housing demand. Chart 2Corporates Are Short On Cash Chart 3Land And Home Sales Likely To Pick Up In 2020 In the past two weeks, China’s equity market has registered a near-vertical outperformance in both investable and domestic stocks relative to global benchmarks (Chart 4). While this recent outperformance was passive in nature, our policy assessment supports future active outperformance. The recently announced pro-growth policy initiatives increasingly resemble those rolled out at the start of the last easing cycle in 2015/2016. These policy initiatives increase the odds that the upcoming “insurance stimulus” will overcompensate for the short-term economic shock, and will likely lead to a significant rebound in corporate profits in the next 6-12 months.  This supports our bullish view on Chinese stocks. Chart 5 also shows that, unlike during the 2015’s “bubble and bust” cycle, both the valuation and margin trading as a percentage of total market cap in China’s onshore market remain materially lower than 2015. Equally-weighted cyclical sectors continue to outperform defensives in both China’s investable and domestic markets, particularly the latter where stock prices in the technology sector were up 12% within the past month. While the outperformance of cyclical stocks relative to defensives is consistent with our constructive view towards Chinese equities in general, the magnitude appears to be somewhat excessive. Given this, we would advise investors positioning for a cyclical recovery in China’s economy to focus their sector exposure in favor of resources, industrials, and consumer discretionary stocks. Chart 4Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chart 5Onshore Market Trading Does Not Seem Overly Leveraged China’s three-month repo rate (the de facto policy rate) has fallen significantly in the past month, roughly 30bps below its lowest level in 2016 (Chart 6). China’s government bond yields have also reached their lowest level since 2016. While corporate bond yield spreads in other major economies have picked up sharply in the past month, the reverse is happening in China. This suggests that the market is pricing in further easing and the notion that policy supports will be effective in preventing a surge in corporate bond default rate. From a global perspective, yield spreads on China’s onshore corporate bonds have been elevated since 2016. This indicates that investors have long either priced in a much higher default rate among Chinese corporate bond issuers, or demand an unjustifiably large risk premium (Chart 7). Since we expect Chinese policymakers to continue easing, risks of a surge in China’s corporate bond default rate remain low this year. As such, until we see signs that the Chinese authorities are reverting to a financial de-risking mode, we will continue to favor onshore corporate versus duration-matched government bonds. Chart 6Monetary Policy Now More Accommodative Than 2015-2016 Chart 7Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chart 8The RMB Likely To Continue Outperforming Other EM Currencies As we go to press, the Federal Reserve Bank has just made a 50bps cut to the Fed rate, the first emergency cut since the global financial crisis. The USD weakened against the Euro, the Japanese Yen, as well as the RMB immediately following the rate cut. While this reflects the market’s concerns of a worsening virus outbreak and the rising possibility of an economic slowdown in the US, the USD as a countercyclical currency will likely appreciate against most cyclical currencies as the virus continues spreading globally. Hence, the depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. The continuation of resuming production in China and the expectations of a Chinese economic recovery in Q2 will support an appreciation in the RMB against other EM currencies (Chart 8).   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://app.21jingji.com/html/2020yiqing_fgfc/ 2   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at gis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2020, available at gis.bcaresearch.com 4   M1 is mainly made up by cash demand deposits from corporations, whereas M0 is mainly deposits from households Cyclical Investment Stance Equity Sector Recommendations

Neutral Market events last week compelled us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. Last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.1 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (third panel). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (second panel). Bottom Line: We took profits of 51% since inception in the S&P software index and downgraded to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK. For more details, please refer to this Monday’s Weekly Report.   1    Please see BCA US Equity Strategy Weekly Report, "Vertigo" dated February 24, 2020, available at uses.bcaresearch.com.