Consumer

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs More Stimulus Needed More Stimulus Needed Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators High-Frequency Bond Indicators High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers More Stimulus Needed More Stimulus Needed This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings Three Scenarios For Income And Savings Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC More Stimulus Needed More Stimulus Needed Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One More Scenario One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed More Stimulus Needed More Stimulus Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot Inflation Coming In Hot Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories More Stimulus Needed More Stimulus Needed The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success.   Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities More Stimulus Needed More Stimulus Needed Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The ultimate extent of credit losses in this cycle is unknown, … : Conventional models are ill-equipped to project the damage that the pandemic will inflict on the economy when monetary and fiscal policymakers are doing all they can to mitigate it. … but household borrowers have held up quite well so far and business borrowers have benefitted from a flood of liquidity: Generous transfer payments have kept household delinquencies in check, the capital markets have allowed bigger companies to pre-fund themselves, and a combination of forbearance and PPP loans has given smaller companies a lifeline. Cash hoards have protected households and businesses, but it is not yet clear when they’ll feel secure enough to spend them: Consumer spending had been on an upward trajectory before rising infection rates forced states to pause or reverse re-opening plans. We remain bullish on the SIFI banks, despite the uncertainty surrounding their outlook: The earnings power of the SIFIs’ franchises has allowed them to build up considerable loan-loss reserves without depleting their capital (ex-Wells Fargo). Stable book values make them too cheap to pass up in an otherwise pricey equity market. Clear As Mud The five largest banks reported their second quarter earnings last week. From the perspective of investing in the banks, the news wasn’t too bad. Excepting beleaguered Wells Fargo (WFC), the SIFI banks and U.S. Bancorp (USB) were able to maintain their per-share book values despite loan-loss reserve increases that exceeded the first quarter’s sizable builds. The results supported our investment thesis: as long as monetary and fiscal policy makers are able to limit the credit fallout from the pandemic, the earnings power of the SIFIs’ franchises can fully offset COVID-19 credit costs, preserving their book values and making their stocks compellingly cheap versus the broad market. Our current investment view aside, we monitor the banks’ calls for insight into the future direction of the economy. The largest banks are always well positioned to observe budding trends in consumption, borrowing and credit performance. They currently also offer a window into the success of policy measures intended to prevent the pandemic from catalyzing a negatively self-reinforcing default spiral. The economic picture the banks painted this quarter was murky, befitting the uncertainty surrounding the virus. They saw activity pick up as social distancing restrictions began to be eased in much of the country in May and June, but the virus’ resurgence (Chart 1) had them stressing that the immediate future is especially uncertain. The tone on this round of calls tended to be cautious, though the CEOs and CFOs acknowledged the potential for positive surprises and allowed that they may well be done building up loan-loss reserves. Chart 1US Daily New Infections The Big Bank Beige Book, July 2020 The Big Bank Beige Book, July 2020 The banks’ big-picture observations tended to reinforce each other. One view that they unanimously expressed in their first quarter calls was borne out in the second quarter: the March-April drawdown of corporate credit lines was indeed precautionary, as the draws were largely repaid at every bank once the corporate bond market was able to accommodate new issuance. Debit and credit card spending troughed at all the banks around mid-April and then rose steadily across May and June. Bank of America reported that its customers’ spending had increased on a year-over-year basis over the first two weeks of July. All the banks have been encouraged by the performance of consumer borrowers who have requested deferments or other forbearance measures. It is way too early for conclusions, but lenders have been pleasantly surprised by the sizable share of forbearance borrowers who have managed to keep making payments and the modest share who have requested additional deferments. Perhaps the consumer deferments are analogous to businesses’ drawdowns of credit lines in March and April – an emergency precaution unwound once other help, like aid from the CARES Act, arrived. All the banks set aside more money for future loan losses in the second quarter than they did in the first, and their aggregate reserve build rose by 50% quarter-on-quarter (Table 1). Vigorous reserving hurt this quarter’s earnings, but it will help gird the banks for a more protracted downturn than they foresaw on March 31st. Table 1Stacking Up The Loan Loss Reserve Sandbags The Big Bank Beige Book, July 2020 The Big Bank Beige Book, July 2020 The news was very good from an operational standpoint, though it may herald future softness for airlines, hotels and the owners of office and retail space. No bank reported any hiccups in transitioning to servicing their clients and customers remotely. Capital markets activity surged, even as trading floors were empty and million-mile-club investment bankers hunkered down at home. Pandemic shutdowns may point the way to a reduced-overhead future, as banks shrink their branch footprints, lease less office space, trim headcount and pare travel and entertainment budgets. 2Q20 Big Bank Beige Book Household Borrowing (Chart 2) And Spending (Chart 3) Chart 2Consumers Are Paying Down Their Debt Consumers Are Paying Down Their Debt Consumers Are Paying Down Their Debt Chart 3Whiplash Whiplash Whiplash Debit and credit sales volumes … consistently trended upward since the trough in the second week of April to down just 4% year-on-year in the last two weeks of June. T[ravel]&E[ntertainment] and restaurant spend continue to be down meaningfully. The most significant improvement … was in retail, with a strong recovery in credit card volume in the second half of the quarter and consistently strong growth in card-not-present1 volume throughout the quarter. (Piepszak, JPM CFO) [In April, our consumers’] spending was down 26% compared to April of 2019. However, for … June, that spending was relatively flat to 2019. [T]hrough the first couple weeks of July, we’re seeing … spending … above what it was last year. (Moynihan, BAC CEO) All big banks saw similar performance trends from participants in their consumer loan forbearance programs. It's too early to make conclusions, but the preliminary data are encouraging. April saw the lowest level of [auto] loan and lease originations since the financial crisis, but activity rebounded sharply in May and June, and … June [was] the best month for auto originations in our history. (Piepszak, JPM) [R]etail [mortgage] purchase applications … recover[ed] to well above pre-COVID levels in June due to a strong and broad market recovery. (Piepszak, JPM) [A]uto lending … [is] going to be a bright spot [in] the third quarter, but overall consumer lending is likely to be down simply because consumer spending has been down. (Dolan, USB CFO) Consumer credit card spend improved steadily starting in mid-April, but was still down approximately 10% from a year ago as of the end of June. (Shrewsberry, WFC CFO) Lower interest rates drove strong industry [mortgage] volume, with [the] second quarter estimated to [have] the largest origination … since the third quarter of 2003. (Shrewsberry, WFC) Consumer Forbearance Relative to peak levels … at the beginning of April, we’ve seen a significant decline in new [assistance] requests. … [A majority of borrowers requesting assistance] hav[e] made at least one payment while in the forbearance period. … [L]ess than 20% of [credit card] accounts [have] request[ed] additional assistance [after reaching the end of the initial 90-day deferral period]. (Piepszak, JPM) [F]irst-time enrollment volumes have come down significantly. … [R]e-enrollment … rates are running below expectation, … right around … the mid-teens. … [W]e’re seeing good signs of those rolling off [of forbearance] continuing to remain current. (Mason, C CFO) In the last few weeks, [loan deferral requests] have been … 98% below [the] peak [in the first week of April]. … More than 60% of the … card deferrals have made at least one payment[;] [o]ne-third have made every payment every month. (Donofrio, BAC CFO) 70% of customers [with credit card deferrals] have started to make normal payments after [the deferral periods end], … [and] about 20% [have] re-enroll[ed]. … So, so far, so good on the [card deferral] performance. (Runkel, USB Chief Credit Officer) Business (And Bank) Caution [Last quarter’s debt and equity issuance] is pre-funding. This is not capital. All this [cash] is not being raised to go spend. It’s being raised to sit [on] the balance sheet, so that you’re prepared for whatever comes next. And you’ve heard a lot of companies make statements [like] … we’ve got two years of cash, we’ve got three years of cash. [P]eople want to be prepared [for anything]. (Dimon, JPM CEO) [T]he commercial spend has been pretty cautious. It was down [around] … 30-35% in … April … , and it’s still down around somewhere between 25 and 30%. (Cecere, USB CEO) Commercial card spend remained significantly lower throughout the second quarter and was still down over 30% in the last full week of June compared to the same week a year ago, with declines across industry segments. (Scharf, WFC CEO) We’ve added $284 billion in deposits since year-end, [and] all of that has gone into cash, earning 10 basis points. [A]s we assess the future of this pandemic, as we … assess how much of [those deposits] is going to stick around, and we get a little bit more confident … , a portion of that … could be deployed into securities. (Moynihan, BAC) It’s Uncertain Out There [T]he extraordinary actions of the Fed and the Treasury leave … industry models kind of wanting for more insight, [because] we’ve never seen this type of action whether it’s the checks people receive, whether it’s … $500-plus billion [of the PPP], whether it’s the income tax payment holiday. (Corbat, C CEO) We cannot forecast the future. We don’t know. I think you’re going to have a much murkier economic environment going forward than you had in May in June, … which is why … the base case, an adverse case, an extreme adverse case … are all possible. And we’re just guessing the probabilities of those things. That’s what we’re doing. (Dimon, JPM) All the big banks reported that their business clients were proceeding cautiously; the banks themselves are, too, leaving their deposit windfalls in cash until they have a better sense of what's to come. [W]e go in feeling very well positioned against this. But we don’t want people leaving the call simply thinking that the world is a great place and it is a V-shaped recovery. … I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst is absolutely behind us and it’s a rosy path ahead. (Corbat, C) Buy The SIFIs As every SIFI management team stressed on last week’s calls, the environment is extremely uncertain. We are in unchartered waters and regression models can do no more than guess at how monetary accommodation, fiscal aid and lender forbearance will interact with COVID-19 transmission patterns, improved treatments and vaccine development efforts to influence credit performance. Investing in the SIFIs is by no means a slam dunk. The equity market is clearly skeptical about their prospects and our BCA colleagues are in no hurry to join us on the SIFI bandwagon. The group’s unpopularity, however, is precisely why it offers outsized prospective returns. As the longtime investment counselor for one of New York’s wealthiest families put it, “you can have cheap stocks or you can have good news, but you can’t have both.” The news is fraught right now, but we think a critical story line will take a turn for the better once Washington comes through with another major phase of fiscal aid. Given the hole left by consumption (Chart 4) and businesses’ suspended animation, government spending is the only way to keep the economy – and the administration’s faltering re-election prospects – afloat. Chart 4Plunging Consumption Has Left A Gaping Hole In The Economy Plunging Consumption Has Left A Gaping Hole In The Economy Plunging Consumption Has Left A Gaping Hole In The Economy We are well aware that investors are leery of the banks when low interest rates and a flat yield curve are depressing net interest income, but it’s far more of an issue for community banks that do nothing more than take deposits and make loans than it is for the SIFIs, which generate gobs of fee income and match the duration of their assets and liabilities to the first decimal place. Even the narrow relationship between bank net interest margins and the yield curve is greatly exaggerated (Chart 5), and relative equity returns have had no relationship with the yield curve since the crisis (Chart 6). Banks do not need a major rise in the 10-year yield to outperform; they just need to demonstrate that the earnings power of their franchises is enough to overcome the drag from projected credit losses. Chart 5Little Fundamental Relationship ... Little Fundamental Relationship ... Little Fundamental Relationship ... Chart 6... And No Market Relationship ... And No Market Relationship ... And No Market Relationship From our perspective, second quarter earnings provided just that demonstration, at least away from woebegone WFC, which has a raft of intrinsic issues to overcome. Despite two quarters of huge loan-loss reserve builds, the SIFI banks’ book values have emerged unscathed (Table 2). Pre-provision net revenue (PPNR) has been up to the task of absorbing massive write-downs so far this year (Table 3). If the base-case scenarios hold (unemployment doesn’t move materially higher and GDP has begun slowly recovering), the SIFI banks as a group have already accomplished the bulk of their reserve2 building and their per-share book values will grow at a healthy clip for as long as buybacks remain suspended. Table 2SIFI Book Values The Big Bank Beige Book, July 2020 The Big Bank Beige Book, July 2020 Table 3Taking The Reserve Builds In Stride The Big Bank Beige Book, July 2020 The Big Bank Beige Book, July 2020 Additional credit costs are a legitimate concern, but the banks can earn enough to keep from having to eat into their equity capital. The banks trade off of their book values, and book value gains should feed higher stock prices given that their multiples are already at bombed-out levels. It is unusual to have the chance to buy sound banks at or around their book value, and we expect that investors who buy them now and hold them for at least a year will be amply rewarded in relative performance terms. The SIFIs’ soundness will not be in doubt if Congress delivers a meaningful fourth phase of aid by early August. We believe Citi’s CEO had it right on its first-quarter call in mid-April, and we think his conclusion applies to all the SIFIs, even WFC: [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from [a] capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 A transaction in which the purchaser does not present his/her card to the merchant, typically conducted over the phone or the internet. 2 We are confident that policy makers will be able to continue propping up consumer borrowers, but the business borrower outlook is considerably more uncertain. However, the banks’ earnings calls contained a detail that may suggest that their aggregate loans to businesses got stronger last quarter. Bank loans are typically senior to bonds, and to the extent that last quarter’s massive issuance was aimed at proactively addressing future funding needs, rather than plugging a leak, it made obligations senior to the new bonds better credits. Bank loans to large investment-grade borrowers may be worth a little more than they were at the end of the first quarter.

Highlights US consumer spending will stall this summer in response to the rising number of Covid cases. Worries about the looming fiscal cliff could also dampen sentiment. Markets are likely to trade nervously over the coming days, but ultimately, stocks will resume their uptrend. The number of new cases already seems to be peaking in some southern US states, and there is no political will to rescind fiscal stimulus. Many institutional investors missed out on the equity rally and will be keen to “buy the dip” on any opportunity. The drop in government bond yields since the start of the year has more than offset the decline in earnings expectations. As odd as it sounds, the pandemic may have raised the fair value of equities. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a higher equity risk premium. While there is some truth to all three arguments, they are unlikely to hold much sway over the next 12 months, provided that global growth rebounds and governments and central banks maintain ultra-accommodative fiscal and monetary policies. Investors should remain overweight global equities, while tilting their exposure to beaten-down cyclically-geared stocks and non-US markets. The equity bull market will only end when central banks get panicky about rising inflation, which is unlikely to happen for the next three years. From ROMO To FOMO People often talk about FOMO (the Fear of Missing Out). But for many institutional investors, the past four months has been more about ROMO – the Reality of Missing Out. Chart 1Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks Many investment professionals missed the rally that began in March, and not much has changed since then. The July BofA Merrill Lynch Survey of Fund managers revealed that fund managers are almost one standard deviation overweight cash and nearly one standard deviation underweight equities. In fact, cash allocations increased further since June. The latest sentiment survey conducted by the American Association of Individual Investors (AAII) tells a similar story. Bears exceeded bulls by 15 points in this week’s tally, one of the highest spreads on record (Chart 1). This is not what market tops look like.   Near-Term Worries Granted, risks abound. The Google Mobility Index has hooked lower, reflecting the worsening Covid outbreak in the sunbelt states and parts of the Midwest. This real time index tends to track economic activity quite well (Chart 2). At this point, it is reasonable to expect the recovery in US consumer spending to stall this summer. Chart 2Covid Outbreak Is Weighing On Spending Global Equities Can Still Go Higher Global Equities Can Still Go Higher Worries about the fiscal cliff could also dampen sentiment. Unemployment benefits for the average American worker are set to fall by more than 60% at the end of July. The funds in the Paycheck Protection Program for small businesses are also running out. To make matters worse, many state and local governments, which began their fiscal year in July, are facing a severe cash crunch due to evaporating tax revenues and rising social spending obligations. Meanwhile, the US elections are only four months away. If the Democrats win the White House and take control of the Senate, the Trump tax cuts will be in jeopardy. Joe Biden has pledged to lift corporate tax rates halfway back to their original levels. This would reduce S&P 500 EPS by about 6%. Risks In Perspective While the discussion above suggests that stocks could trade nervously over the coming days, we should keep things in perspective. The number of new Covid cases has been trending lower in Arizona over the past week and may be close to peaking in the other southern states (Chart 3). Positive news on the vaccine front could also buoy sentiment.  Chart 3A Snapshot Of The Number Of New Cases In The Most Afflicted US States Global Equities Can Still Go Higher Global Equities Can Still Go Higher With respect to the fiscal cliff, there is a very high probability that Congress will reach a deal on a new aid package worth around $2.5 trillion. Table 1 shows stimulus remains politically popular nationwide and, more importantly, in the swing states. Table 1There Is Much Public Support For Fiscal Stimulus Global Equities Can Still Go Higher Global Equities Can Still Go Higher If Democrats prevail in November and raise corporate taxes, most of the revenue gained will be plowed back into the economy. Given that empirical estimates suggest that the spending multiplier from the corporate tax cuts was quite small, the net effect will probably be stimulative.1 The risk of an all-out trade war with China would also decline under a Biden administration, which is something the stock market would welcome. Some might contend that stocks are already pricing in a very rosy outlook. However, as we argue below, it is far from clear that this is the case. Has All The Good News Been Priced In? An NPV Analysis The fair value of the stock market can be represented as the expected stream of cash flows that shareholders will receive, deflated by an appropriate discount rate. The discount rate, in turn, can be expressed as a risk-free rate plus an equity risk premium (ERP). The ERP compensates investors for holding riskier stocks compared to safer government bonds. At the start of the year, Wall Street analysts expected S&P 500 earnings to increase by 9% in 2020 and by 11% in both 2021 and 2022. Today, analysts expect earnings to shrink by 23% in 2020, but then rebound by 29% in 2021. This would essentially take earnings back to last year’s levels. Looking further out, analysts expect earning to recover a further 17% in 2022, which would put them on track to reach their pre-pandemic trend by 2024. In contrast, market participants see little scope for a recovery in bond yields (Chart 4). According to the forward curve, the US 10-year is poised to rise from 0.62% at present to just 1.3% in five years’ time. At the start of 2020, investors thought the 10-year yield would be 2.5% in 2025. Along the same vein, the 30-year bond yield is down 106 bps since the start of the year. The 30-year TIPS yield has fallen by 82 bps. Since stocks are a long duration asset, the TIPS yield is a good proxy for the inflation-adjusted, risk-free component of the discount rate. Chart 4After Nosediving, Bond Yields Aren’t Expected To Rise By Much After Nosediving, Bond Yields Aren't Expected To Rise By Much After Nosediving, Bond Yields Aren't Expected To Rise By Much Chart 5 shows that if we combine the change in analyst earnings expectations with the drop in the TIPS yield, the net present value (NPV) of S&P 500 earnings has risen by a staggering 16.2% since the start of the year. Chart 5The Present Value Of Earnings: A Scenario Analysis Global Equities Can Still Go Higher Global Equities Can Still Go Higher Really? It might seem preposterous to conclude  that the fair value of the S&P 500 may have increased at a time when the US and the rest of the world have plunged into the deepest recession since the 1930s. Yet, it naturally flows from the premise that the hit to earnings from the pandemic will be temporary, while the decline in bond yields will be much longer lasting. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a much higher equity risk premium. Let us examine all three arguments in turn. Are Earnings Estimates Too Optimistic? The short answer is yes. However, this does not say very much. As Chart 6 shows, analysts are usually too optimistic. They typically start every year with overinflated estimates, and subsequently have to scale them down. This happens even during economic expansions. Thus, if estimates end up being trimmed over the coming months, this will not necessarily prevent stocks from moving higher. Chart 6Earnings Estimates Tend To Be Revised Down Even In The Best Of Times Are Earnings Estimates Too Optimistic? Earnings Estimates Tend To Be Revised Down Even In The Best Of Times Are Earnings Estimates Too Optimistic? Earnings Estimates Tend To Be Revised Down Even In The Best Of Times Of course, magnitudes matter a lot. If analysts end up having to revise estimates down more than usual, this could hurt stocks. But will they? That is far from a foregone conclusion. Earnings usually follow the path of nominal GDP. The Congressional Budget Office (CBO) expects the level of nominal GDP to be just half a percentage point lower in 2021 than it was in 2019. In this light, the notion that earnings next year will be on par with last year’s levels does not seem that farfetched. Moreover, one should also note that health care and technology are highly overrepresented on Wall Street compared to Main Street. Together, they account for 42% of S&P 500 market capitalization. Outside these two sectors, S&P 500 earnings are expected to be 9% lower in 2021 relative to 2019. In any case, the conclusion that the pandemic has increased the fair value of equities would not change much if we were to assume that earnings recover more slowly than anticipated. The red colored bar in Chart 5 shows the impact on the NPV in a scenario where earnings only return to their pre-pandemic trend by 2030: the NPV still rises by 13.5%. Even if we assume that earnings permanently remain 5% below their pre-pandemic forecast, the NPV would still increase by 9.2% (blue colored bar). In order to push down the NPV by a considerable amount, one would need to assume that the pandemic will not only reduce the level of corporate earnings, but it will reduce the growth rate of earnings as well. For example, if the pandemic reduces earnings growth by one percentage point, this would cause the NPV to fall by 7.5% (gray colored bar). Is this a sensible assumption, however? We don’t think so. While the pandemic will reduce capital spending temporarily, it is unlikely to damage the long-term growth rate of either productivity or the labor force, the two key drivers of potential output. Chart 7 shows that even after the Great Depression, per capita income eventually returned to its long-term trend. Chart 7No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth Are Bond Yields Distorted To The Downside? The notion that the pandemic may have increased the fair value of the stock market hinges critically on the view that the discount rate has fallen substantially this year. We will get to the question of what the appropriate level of the equity risk premium should be in a moment, but let us first examine the risk-free component of the discount rate. Many pundits argue that central bank bond purchases have pushed down yields below where they ought to be. That may be true, but it is not clear why that matters. If one is making present value calculations, one should look at the actual bond yield, not the yield that accords with one’s preconception of what is appropriate. Granted, if bond yields were to rise sharply in the future, the present value of future earnings would probably end up falling. However, this is unlikely to occur anytime soon. It will take a while for unemployment to return to pre-pandemic levels, during which time inflation will remain dormant. And even once inflation starts rising, central banks will likely refrain from hiking rates because they have been concerned about excessively low inflation for nearly two decades. Central banks could also face pressure from governments to keep rates low in order to suppress interest costs. As a result, real rates could fall initially, which would be supportive of stocks. The bull market in equities will only end when inflation reaches a level that makes markets nervous that central banks will have to raise rates. This is unlikely to happen for the next three years. The Equity Risk Premium Is More Likely To Fall Than Rise Chart 8Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields As noted above, there are many risks confronting investors. The key question is whether the stock market’s perception of these risks will subside or intensify. If it is the former, the equity risk premium will probably shrink, pushing stocks higher. If it is the latter, stocks will fall. Our bet is on the former. We have already learned a lot about the virus. We will learn even more over the coming months. This should reduce the cone of uncertainty investors are facing. On the economic side, central bank asset purchases, combined with large-scale fiscal stimulus, have reduced the tail risk of another market meltdown. If policy stays supportive for the next few years, as we expect, the equity risk premium will shrink. Starting points matter, too. Globally, the equity risk premium, which we calculate by subtracting the real bond yield from the cyclically-adjusted earnings yield, was quite high at the start of the year and is even higher now (Chart 8). This suggests that investors should favor stocks over bonds.   A Weaker Dollar Will Give Non-US Stocks An Edge The ERP is particularly elevated outside the US. Thus, valuations tend to favor non-US stocks. Of course, it helps to have factors other than valuations on your side when making investment decisions. In the case of regional and sector allocation, the outlook for the US dollar is critical. Chart 9 shows that cyclical stocks tend to outperform defensives when the dollar is weakening, while non-US stocks tend to do better than their US peers. There are five reasons to expect the US dollar to depreciate over the next 12 months. First, as a countercyclical currency, a revival in global growth should hurt the dollar (Chart 10). Second, the US has been harder hit by the virus over the past few months than most other economies. Thus, the spread between overseas growth and US growth is likely to widen more than usual (Chart 11). Chart 9Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Chart 10A Revival In Global Growth Should Hurt The Dollar A Revival In Global Growth Should Hurt The Dollar A Revival In Global Growth Should Hurt The Dollar Chart 11The Dollar Will Also Weaken On The Widening Gap Between Overseas Growth And US Growth The Dollar Will Also Weaken On The Widening Gap Between Overseas Growth And US Growth The Dollar Will Also Weaken On The Widening Gap Between Overseas Growth And US Growth Chart 12Interest Rate Differentials No Longer Favor The Dollar Interest Rate Differentials No Longer Favor The Dollar Interest Rate Differentials No Longer Favor The Dollar Third, interest rate differentials no longer favor the dollar, now that the Fed has brought rates down to zero (Chart 12). Fourth, momentum is not on the greenback’s side anymore (Chart 13). Fifth, the dollar is expensive based on measures such as purchasing power parity exchange rates (Chart 14). Chart 13Momentum Is Not On The Greenback’s Side Global Equities Can Still Go Higher Global Equities Can Still Go Higher   The right trade over the past few years was to be long the dollar and overweight US stocks. It is time to flip this trade and do the opposite. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 14USD Is Not Cheap USD Is Not Cheap USD Is Not Cheap Footnotes 1  An IMF analysis of the use of funds of listed companies found that only about one fifth of the increase in corporate cash since the adoption of the Tax Cuts and Jobs Act (TCJA) was used for capex and R&D. The rest was utilized for share buybacks, dividend payouts, and other activities. The same study also noted that actual GDP and business investment growth in 2018 fell short of the predicted impact of the TCJA based on empirical studies of postwar US tax changes. Please see Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, "U.S. Investment Since the Tax Cuts and Jobs Act of 2017," IMF Working Paper, May 31, 2019. Global Investment Strategy View Matrix Global Equities Can Still Go Higher Global Equities Can Still Go Higher Current MacroQuant Model Scores Global Equities Can Still Go Higher Global Equities Can Still Go Higher

Dear Client, US Investment Strategy will take the first of two summer breaks next week, so there will be no publication on July 13th. We will return on July 20th with the latest installment of our Big Bank Beige Book, reviewing the five largest banks’ second quarter earnings calls. Best regards, Doug Peta   Highlights Bottom-up S&P 500 earnings expectations for 2021 are probably high: I/B/E/S expectations incorporating periods six or seven quarters away are little more than extrapolations and investors shouldn’t get hung up on them. The higher corporate income tax rates that would follow a Democratic sweep are a bigger concern. Policymakers have decisively won the early rounds of their bout with the pandemic’s economic effects, … : Transfer payments pushed April and May personal income well above its February level, and households have accordingly stayed current on their rent and other financial obligations. … and they will win the fight provided Congress doesn’t tire, … : Volatility may rise amidst the back and forth of negotiations, but Republican Senators cannot risk allowing aid to elapse three months before the election. … but what’s good for the economy in the long run may come at the expense of active managers’ performance: Value investors can’t catch a break, and all stock pickers will have to contend with a policy backdrop that challenges their established modus operandi.   Feature We have not traveled any farther for work than the kitchen table in three and a half months. Renewing our expiring passport could take a year, and the clock is ticking on our ability to fly domestically on a driver’s license from the persona non grata state of New York. Unless the administration or the electorate has a change of heart, the REAL ID rules may prevent us from seeing a client in person until well into 2021. At least the construction at LaGuardia may be finished by then. Even if we’re not seeing clients face to face, however, communication continues. Several topics have come up repeatedly in virtual discussions and we devote this week’s report to examining them. Our overriding impression is that global investors have been surprised by risk assets’ resilience and are skeptical that it can be sustained. We share the surprise and some measure of the skepticism, though we are more constructive than most BCA clients because of our conviction that policymakers can bridge the economic gap created by the pandemic and the commercially restrictive measures undertaken to combat it. Yes, Estimates Are Too High (But It’s Mainly An Election Story) Q: Consensus S&P 500 earnings estimates for next year are in line with actual 2019 earnings, yet 2019 was the tenth full year of an expansion and we’re likely to begin 2021 with an unemployment rate close to 10%. Isn’t there something wrong with this picture? We agree that consensus estimates for 2021 S&P 500 earnings are too high. It seems unlikely on its face that 2021 earnings, currently estimated at $163, will match 2018 ($162) and 2019 ($163) when the public health and economic backdrops are so uncertain. An additional 14% of EPS growth in 2022 seems like a pipe dream. We put very little stock in consensus estimates more than two quarters into the future, however, because analysts put very little effort into producing them. They focus on the current quarter and the following quarter; estimates beyond that range are nothing more than simple extrapolation. Investors familiar with sell-side analysts’ processes presumably don’t look beyond near two-quarter estimates themselves. We therefore doubt that the equity market is hanging on stated 2021 estimates and will be at risk when they are eventually revised down. We simply conclude that the S&P 500’s forward four-quarter earnings multiple of 24 is somewhat more elevated than it appears to the naked eye. Stocks are not cheap, and investors have probably gotten somewhat complacent. Equities have little margin for safety now and are therefore vulnerable to a near-term decline. Valuation is a notoriously poor timing tool, however, and we are content to remain neutral on equities over the tactical zero-to-three-month timeframe. A much stronger case against the earnings outlook for 2021 and beyond comes from the president’s flagging re-election prospects. Our Geopolitical Strategy service continues to estimate Joe Biden’s probability of winning the election at 65%. The virtual betting market PredictIt places Biden’s odds at 62%, and has had him as the favorite since May 30th. It is too simplistic to say that a Democratic president, backed by majorities in both houses of Congress,1 would be bad for the economy, but a Biden victory would introduce two profit headwinds. First, reversing half of the decline in the top marginal corporate tax rate, as the Biden campaign has proposed, would directly strike at the earnings stream available to common shareholders. Precisely quantifying that drop is not easy. S&P 500 constituents’ effective tax rates vary widely, with only a small proportion paying the statutory rate, and they do not disclose the federal component of their tax bill. We make the simple back-of-the-envelope assumption that the maximum net earnings impact of the cut in the top marginal rate from 35% to 21%, beginning in 2018, was 21.5%, as .79 (1-.21) is 21.5% greater than .65 (1-.35). Similarly, the maximum net earnings impact of hiking the top marginal rate to 28% from 21%, beginning in 2021, would be -9%, as .72 (1-.28) is nearly 9% less than .79 (1-.21). Equities seem to be ignoring the negative profit margin consequences of an increasingly likely Democratic sweep. Chart 1The Tax Cut Materially Boosted Median S&P 500 Earnings Q&A Q&A The change in effective tax rates before and after the 2018 tax cuts was about half of our maximum ballpark estimate. In the two years before the rate cut, excluding 4Q17 and its myriad one-time adjustments, the median effective tax rate for S&P 500 constituents was around 28%; in the two subsequent years, excluding 1Q18, the median rate has hovered near 20% (Chart 1). The change suggests that the tax cuts have boosted median S&P 500 earnings by about 11%.2 In addition to raising taxes, a Biden administration would be considerably more friendly to labor than the Trump administration. A soft labor market in which full employment is at least a few years away argues against broad wage gains, but companies that have benefitted from a complaisant National Labor Relations Board for the last four years could face a rude awakening. If Biden wins, we wager that McDonald’s workers will be unionized before next summer,3 a scenario that McDonald’s stock clearly does not anticipate (Chart 2). Chart 2For McDonald's, A Biden Win Means An NLRB Reversal For McDonald's, A Biden Win Means An NLRB Reversal For McDonald's, A Biden Win Means An NLRB Reversal Bottom Line: A Democratic sweep would weigh on earnings via higher corporate income tax rates and revived advocacy for labor at executive branch departments like the NLRB. Considering these incremental drags, it is unlikely that S&P 500 earnings will match their 2019 levels in 2021. Policymakers Versus The Virus: The Fight So Far Chart 3D.C. Is Keeping Households Afloat ... D.C. Is Keeping Households Afloat ... D.C. Is Keeping Households Afloat ... Q: Your constructive cyclical take depends on policymakers’ ability to offset the pandemic’s economic consequences. How do the data say that’s going so far? The data say that it’s going swimmingly. Thanks to generous transfer payments from the federal government, personal income in April and May comfortably surpassed February’s pre-pandemic peak (Chart 3). Households have not spent much of their windfall (Chart 4), choosing instead to squirrel it away, driving the savings rate to 32% in April and 23% in May. The mountain of savings will make it easy for households to service their debt (Chart 5), which they have been paying down. Chart 4... And They're Saving The Money, ... ... And They're Saving The Money, ... ... And They're Saving The Money, ... Chart 5... Much To Their Creditors' Relief ... Much To Their Creditors' Relief ... Much To Their Creditors' Relief The apartment REITs will not likely disclose June rent collection data before their earnings calls, but the National Multifamily Housing Council rent tracker shows that June collections have built on May’s month-over-month improvement. Through June 27th, June collections are tracking ahead of April and May collections and are barely off of last year’s pace (Table 1). Table 1Apartment Tenants Are Paying Their Rent Q&A Q&A Table 2Consumer Borrowers Are Making Their Payments Q&A Q&A TransUnion’s monthly consumer loan delinquency data for May reinforce the conclusion that policymakers are achieving their goal of preventing a default spiral. Auto loan delinquencies rose sharply in May, but delinquencies in all other personal loan categories fell on a month-over-month basis (Table 2). Mortgage delinquencies are below their year-ago level, while credit cards and other personal loans have risen only slightly from a low base. Auto loan delinquencies are up appreciably from May 2019, but TransUnion’s data show that the true rot is concentrated in loans made by independent lenders. Their 60-day delinquencies rose to 7.2% in May from 4.5% in April, while bank (0.62%) and credit union delinquencies (0.51%) eased slightly in May. Bottom Line: Extremely generous income assistance has helped households amass formidable cash reserves. The aid has allowed households to pay their rent and service their debt, shielding landlords, banks and many specialty lenders from pressure. Policymakers Versus The Virus: Going The Distance Q: What might cause the Fed to waver in its resolution to help the economy battle the virus? Will the Senate block future stimulus efforts? Nothing will cause the Fed to waver in its resolution to shield the economy from the virus; investors can take Chair Powell’s pledge to do whatever it takes for as long as it takes to the bank. Capitol Hill’s commitment is much less certain and public posturing during Senate negotiations could stoke market volatility. Elected officials reliably respond to career incentives, however, and those incentives will keep recalcitrant Senate Republicans from blocking another round of fiscal largesse. Investors need not worry that Republicans in the Senate will pull the rug out from under the economy and markets – doing so would wreck their own political fortunes. The Republicans’ election prospects have been sliding for a month. Four months is an eternity in a campaign, and they have ample time to reverse their fortunes. But if Republican Senators were to obstruct the passage of the next aid bill, they would be signing their own death warrant. They simply cannot cut off ailing households’ lifeline, or strip municipalities of essential services, as the campaign enters the homestretch. Any individual Senator would be imperiling his/her own quest for influence, and the party’s majority status and relevance, if s/he were to cast one of the votes that blocked a new spending round, and it would be folly to do so over a minor matter like principle. Policymakers Versus Active Managers Q: If valuations no longer matter, how do we show our clients that we’re adding value? It chagrined us to acknowledge on a call last week that equity valuations have been greatly deemphasized in our base case scenario. That scenario calls for overweighting equities in balanced portfolios over a twelve-month timeframe on the view that the flood of emergency stimulus will linger in the system long after it’s needed, stoking aggregate demand and pushing up the prices of cyclically exposed assets. Provided that policymakers succeed in limiting defaults and bankruptcies, thus preventing a pernicious chain reaction from taking hold, we are willing to overlook elevated valuations. Massive accommodation makes active managers' jobs harder because there's no telling who's swimming naked when policymakers won't let the tide go out. Those valuations are supported arithmetically by discount rates which appear as if they will remain very low for an extended period as long as investors don’t become nervous and demand a higher equity risk premium, diluting the impact of nominally lower interest rates. Our base case is that they won’t, but there is no doubt that equity investors’ margin of safety is quite thin. We cannot use the term margin of safety without thinking of Benjamin Graham, and it gives us a pang to think that his disciples may face another few years of wandering in the wilderness. Value investing is predicated on making distinctions between individual companies, as is security analysis more generally. A rising tide lifts all boats, however, and the massive stimulus efforts that have been unleashed in all the major economies (Chart 6) have the effect of obliterating differences between companies. That potentially limits the value that skilled active managers can add to an investment portfolio via a focus on traditional bottom-up metrics. Chart 6All Together Now Q&A Q&A Our solution is to try to focus on the varying impact top-down factors will have on different companies and sub-industry groups. We are overweight the SIFI banks because we view them as the biggest beneficiary of policymakers’ attempt to suppress defaults and their rock-bottom valuations stand in sharp contrast with the rest of the market. We echo our fixed income strategists’ recommendations to buy the bonds the Fed is buying. We also think that positioning portfolios for regulatory changes that might ensue in 2021 and beyond could be a rich source of alpha if a blue wave really is poised to strike the US on the first Tuesday in November.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com     Footnotes 1 Our geopolitical team expects the Democrats to take the Senate if they win the White House. PredictIt markets imply that Democrats have a 61% probability of winning a Senate majority. 2After-tax earnings before the tax cut were 72 cents on the dollar (1-28%) = .72. After the tax cut, they rose to 80 cents (1-20%) = .80. 80 is 11.11% greater than 72. 3Please see the NLRB/McDonald’s discussion on pp.7-9 of the February 3, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 3: The Public-Approval Contest,” available at usis.bcaresearch.com.

Highlights The cost of housing is the one item that has held up US inflation vis a vis European inflation in recent years. But as the cost of housing flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. This means that US and European bond yields will also converge. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Underweight the dollar versus the most defensive European currency, the Swiss franc. Continue to favour long-duration defensive equities, technology and healthcare, whose net present values are most leveraged to a decline in the US T-bond yield. Fractal trade: long GBP/RUB. Feature Chart I-1Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Chart I-2...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? One of the biggest ongoing costs that we face is the cost of housing. Yet economists remain perplexed on how to measure this cost in a consumer price index. For people who rent their homes, the issue is straightforward – the rent paid every month captures the cost of the housing services that are consumed. But for owner occupiers, the biggest ongoing cost tends to be the mortgage interest payment. Therein lies a problem. Measuring Housing Costs Is A Challenge A consumer price index aims to measure the costs of consumption. But a mortgage interest payment measures the cost of borrowing money, rather than a cost of consumption. Therefore, capturing owner occupiers’ housing costs poses a challenge, and economists have developed several theoretical approaches to measure them (Box I-1). Box I-1The Different Methods Of Measuring Owner Occupiers’ Housing Costs Why Housing Costs Matter More Than Ever Why Housing Costs Matter More Than Ever This report focusses on the approach known as rental equivalence or ‘owners’ equivalent rent’. The reason is that rental equivalence is the approach used in the UK CPI including housing (CPIH) – though be aware that the Bank of England still targets inflation using the CPI excluding housing. Rental equivalence is also the approach used in the US CPI and PCE, and the Federal Reserve does target inflation including housing. The treatment of housing costs in inflation matters enormously. The UK versus US comparison reveals something odd. In the UK, owner occupiers’ housing inflation has been running well below overall inflation, whereas in the US it has been running hot (Chart I-1 and Chart I-2). In fact, remove the 25 percent weighting to owners’ equivalent rent from the US consumer price index – to make it comparable with Europe – and the US inflation rate would now be one of the lowest in the world at minus 1 percent! (Chart I-3). Hence, the treatment of housing costs in inflation matters enormously. Chart I-3Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent What Is Driving Housing Costs? A UK Versus US Comparison Rental equivalence uses the rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. The approach answers the question: “how much rent would I have to pay to live in a home like mine?” In other words, the housing services are valued by looking at the cost of the next best alternative to owning the home, namely renting an identical or near-identical property. As rental equivalence aims to measure the cost of housing services rather than the asset value of the house, it should not be expected to move in line with house prices in the short-term. Indeed, the rent for a property is likely to be lower in relation to the house price when the monthly mortgage payment is lower. This is because a lower monthly mortgage payment makes it more affordable to own a house, pushing down the prices of rents and rental equivalence. Economists remain perplexed on how to measure housing costs in a consumer price index. In the UK, mortgages tend to have a variable interest rate linked to the Bank of England policy rate. Hence, the change in short-term mortgage rates explains the profile of housing cost inflation. For the past few years, UK owner occupiers’ housing inflation has been subdued because short-term mortgage rates have been drifting down (Chart I-4). Chart I-4UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate But in the US, mortgages tend to have fixed rates resulting in a different explanation for the profile of housing cost inflation. US owners’ equivalent rent inflation moves in lockstep with actual rent inflation. In fact, the two series are almost indistinguishable (Chart I-5). Raising the question: what drives US rent inflation? Empirically, the most important driver is the (inverted) unemployment rate – which establishes the number of people who can rent a property. Chart I-5US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation This leads to a crucial finding. The last three times that the US unemployment rate moved into the high single digits – in the recessions of the early 1980s, early 1990s, and 2008 – rent inflation plus owners’ equivalent rent inflation flipped from being a strong tailwind to core inflation into a very strong headwind. Given the consistent relationship in each of the last three recessions, and with US unemployment rate now running in double digits, only a brave man would bet on it being any different in the 2020 recession (Chart I-6). Chart I-6Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind The combination of rent plus owners’ equivalent rent – shelter – comprises 34 percent of the US consumer price index, 42 percent of the core CPI, as well as a hefty weighting in the core PCE. It is the one item that has held up US core inflation vis a vis European core inflation in recent years (Chart I-7). But as shelter inflation flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. Chart I-7Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? The Implications Of Converging Inflation As US inflation converges down to European levels, the last few years of divergence in US bond yields from European yields will prove to be a brief aberration. Before 2016, US and European yields were joined at the hip. It is highly likely that they will soon re-join at the hip (Chart I-8 and Chart I-9). Chart I-8The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... Chart I-9...Will Prove To Be A Brief ##br##Aberration ...Will Prove To Be A Brief Aberration ...Will Prove To Be A Brief Aberration All of which reinforces three of our existing investment recommendations: Stay overweight US T-bonds versus high-quality European government bonds. In fact, if the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Meaning that an absolute overweight to the US long bond will also reap rewards. Turning to currencies, yield convergence should be bearish for the dollar versus European currencies. That said, the dollar has the merit of being well bid during periods of economic and financial stress which might prove to be regular occurrences in the coming year. On this basis, the best strategy is to underweight the dollar versus the most defensive European currency, the Swiss franc. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Finally, in the equity markets, continue to favour long-duration growth defensives – whose net present values are most leveraged to a decline in the US T-bond yield. This means technology and healthcare. Fractal Trading System* The rally in the Russian rouble is technically stretched and susceptible to a countertrend reversal. Accordingly, this week’s recommended trade is long GBP/RUB. Set the profit target and symmetrical stop-loss at 3 percent. Chart I-10GBP/RUB GBP/RUB GBP/RUB In other trades, long Australia versus New Zealand closed at the end of its 65 day holding period flat. The rolling 1-year win ratio now stands at 59 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen An Update On The Yen An Update On The Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Story Of Japan In One Chart The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1  last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE The Yen And QE The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Japan CPI At A Glance Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Strong Deflationary Pressures In Japan Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Point Of No Return For Japanese Banks? Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan.  First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall A V-Shaped Recovery Might Stall A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings More Jobs, More Savings More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2  they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Real Rates And The Yen Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated USD/JPY And DXY Are Positively Correlated USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a  rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month.  The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May.  The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April.  PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights If policymakers can neutralize default pressures arising from the lockdowns, the lasting impacts of this recession may not be so bad: As Jay Powell put it on 60 Minutes several weeks ago, policymakers just have to keep people and businesses out of insolvency until health professionals can gain the upper hand over the virus. Fiscal spending caused income and savings to spike, … : Generous transfer payments have left the majority of the unemployed better off than they were when they were working, and April household income and savings soared accordingly. … allowing consumers to meet nearly all of their obligations … : April’s income and savings gains showed up in reduced delinquencies across all categories of consumer loans and in solid April and May rent collections. May’s employment gains suggest that the private sector may not be too far away from taking the baton from Congress: The May employment report blew away expectations and sent risk assets surging, but the positive surprise may derail plans for further fiscal support. Feature Since March, investors have been presented with a simple choice: believe their eyes or believe in the government. They could either focus on horrendous economic data illustrating the crippling effects of widespread lockdowns, or they could trust in policymakers’ ability to shield most citizens and businesses from lasting damage. Our base case has been that policymakers would succeed, for the most part, provided they didn’t have to contend with acute COVID-19 pressures for more than six months. There are as many guesses about the virus’ future path as there are commentators, but it seems reasonably conservative to estimate that the most onerous restrictions will be eased by October. Chart 1DC To The Rescue D.C. To The Rescue D.C. To The Rescue In our view, preventing defaults is the key to mitigating the effects of the virus. If newly vulnerable debtors can be kept from defaulting until the economy can return to something resembling normal, a negatively self-reinforcing dynamic will not take hold, the infection will not spread to the financial system and creditworthy individuals’ and viable businesses’ temporary liquidity issues will not morph into solvency issues. Banking system data to confirm or disprove our thesis will not be available until August, however, as Fed and FDIC data are quarterly, and the shutdowns only began in late March. The unemployment safety net has turned into a trampoline; ... In this report, we have turned to a range of other sources for higher-frequency insights into what is happening in real time. We start with an academic paper showing that most laid-off workers are eligible for benefits comfortably exceeding their previous income, a conclusion reinforced by the April personal income data (Chart 1). We then look at April delinquency data from TransUnion, one of the major credit reporting agencies, and April and May rent-collection data from an apartment trade organization and large-cap publicly traded apartment REITs. We also review the Fed’s Survey of Consumer Finances to get a sense of household indebtedness across the income and wealth spectrums. For now, the data support the conclusion that policymakers have successfully defused credit distress pressures. What Comes In … Unemployment benefits typically fall far short of workers’ regular compensation, averaging about 40% of the median worker’s wage. To cushion the blow of unemployment from COVID-19, the CARES Act included a federal supplement to unemployment benefit payments distributed by the individual states. Added onto the average $400 weekly state benefit, the $600 federal supplement would make the average worker whole (mean earnings are a little less than $1,000 a week). As income inequality has intensified, the compensation distribution for all American workers has come to exhibit a pronounced rightward skew. That skew has pulled mean compensation (the average of all Americans’ earnings) well above median compensation (the earnings of the worker at the exact middle of the earnings distribution).1 By targeting mean compensation, the CARES Act opened the door for a lot of lower-income workers to make more money in unemployment than they did when they were working. According to a recent paper from three Chicago professors, 68% of unemployed workers are eligible to receive benefits that exceed their previous income, while 20% of unemployed workers are eligible for benefits that will at least double it. Overall, they calculate that the median worker is eligible to receive benefits amounting to 134% of his/her previous income.2 ... instead of keeping laid-off employees' incomes from falling below 40 cents on the dollar, it's launched them to $1.30. We offer no judgments about the policy merits of a 134% median replacement rate, but unusually generous benefits should help reduce the drag from unemployment that would otherwise ensue with a 40% replacement rate. Thanks to lower-income households’ higher marginal propensity to consume, consumption should rise at the margin (once activity resumes). Thanks to increased income, lower-income households should be better positioned to meet their financial obligations. We suspect the marginal consumption boost may be hard to see with the naked eye, but auto, credit card and mortgage delinquencies should be appreciably lower than any regression model not adjusted to reflect record replacement rates would predict. … And What Goes Out The Personal Income and Outlays data for April reflected the significant impact on household income of the up-to-$1,200 stimulus checks (economic impact payments) and the supplemental unemployment benefits. Despite an annualized $900 billion decline in employee compensation, personal income rose by nearly $2 trillion in April, thanks to a $3 trillion increase in transfer payments. De-annualizing the components, $250 billion in transfer payments offset a $75 billion decrease in compensation. At about $220 billion, the economic impact payments accounted for the bulk of the transfer payments, and they will fall sharply in May. The IRS did not disclose the amount of economic impact payments it had disbursed by April 30, but it appears that around 80% of the distributions have been made, leaving approximately $55 billion yet to be disbursed. Unemployment insurance receipts will rise in May on an extra week of benefits and an increase in the weekly sums of initial and continuing unemployment claims. We project that employee compensation rose about 3% in May, based on a 2% gain in employment and a 1% increase in average weekly earnings. Aggregating the February-to-May changes, it appears that May personal income ought to exceed February (Table 1). Absent another round of stimulus checks, however, personal income will slide below its pre-shutdown level beginning in June. Table 1May Personal Income Should Exceed Its Pre-Pandemic Level So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) Income is not the sole driver of households’ capacity to service their debt, however. Assets matter, too, and even if the surge in cash flow was a one-off event, it left behind an elevated stock of cash as households slashed consumption in both March and April. Real personal consumption expenditures have fallen 19% from February’s all-time high and are now back to a level they breached in January 2012 (Chart 2). Households saved 33% of their April disposable income, and on a level basis, April savings were up nearly fivefold from their 2019 average. They were a whopping 20 times April interest payments, ex-mortgages (Chart 3). Chart 2Eight Years Of Spending Undone In Two Months Eight Years Of Spending Undone In Two Months Eight Years Of Spending Undone In Two Months Chart 3Consumers' Interest Coverage Ratios Have Soared Consumers' Interest Coverage Ratios Have Soared Consumers' Interest Coverage Ratios Have Soared Household Borrowers Are Staying Current … Table 2Consumer Borrowers Are Hanging In There So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) It is possible to make too much of the April income and outlays data. We had been expecting another round of stimulus checks, but lawmakers’ comments even before the blockbuster employment report suggested one may not be forthcoming. Some of the savings activity was forced on homebound consumers, and some pent-up demand will surely be unleashed as the economy re-opens. Households amassed a mighty savings war chest across March and April, however, and it has left them better-positioned to service their debt obligations going forward. Despite an unemployment rate not seen since FDR, households made their scheduled payments in April. According to TransUnion, delinquency rates fell month-over-month across every major consumer loan category and delinquency rates for mortgages and unsecured personal loans declined on a year-over-year basis (Table 2). The TransUnion data comes from its inaugural Monthly Industry Snapshot, intended to provide a higher-frequency read on headline consumer credit metrics than its typical quarterly releases. In addition to crunching the delinquency numbers, the report noted that forbearance programs have helped ease consumer liquidity pressures, consumers have reduced their outstanding credit card balances and credit scores have slightly improved. None of the factors is decisive on its own, but they contribute to a marginally improved consumer credit outlook. … And Apartment Tenants Are Paying Their Rent It is more common for households in the lower half of the income and net worth distributions to rent their residence than own it. Just one in every five households in the bottom two quintiles of the income distribution (Chart 4, top panel), and one in four in the bottom half of the net worth distribution (Chart 4, bottom panel), have a mortgage. Rent is the single largest recurring expense for these households and the shutdowns made paying it a concern. Several newspaper stories have highlighted the plight of distressed renters while discussing grassroots rent-strike movements, but the National Multifamily Housing Council’s (NMHC) Rent Payment Tracker tells a different story.3 Chart 4Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes The Rent Payment Tracker distills the results of a national survey covering over 11 million professionally managed apartment units. Through May 27th, it reported that 93.3% of renters had made full or partial payments for the month of May. The share of paying tenants was down just 150 basis points year-over-year, and up 160 basis points month-over-month. The six apartment REITs in the S&P 500 reported April and May rent collections that were better than the NMHC data. By the end of May, the REITs had collected 94-99% of the April rent they were due, and 93-96% of their May rents (Table 3). (Equity Residential (EQR) reported its April collections through April 7th and did not provide an end-of-month update; on June 1st, it reported that its May collections through May 7th were in line with April’s.) Essex Property Trust (ESS), which owns a portfolio of apartments in southern California, the Bay Area and greater Seattle, provided a table showing how the economic impact payments and the supplemental unemployment benefit would affect the income of unemployed California and Washington state couples without children. Table 4 expands it to cover four income scenarios, illustrating just how far up the income distribution CARES Act relief stretches. Table 3Residential Tenants Are Paying Their Rent So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) Table 4The CARES Act For Essex Property Trust Renters So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) Who Borrows: Evidence From The Survey Of Consumer Finances Helping the households in the bottom half of the income distribution won’t materially limit credit distress across the economy if those households don’t have access to credit. The latest edition of the Fed’s triennial Survey of Consumer Finances, published in 2017, makes it clear that they do. Those households may be much less likely to carry mortgage debt (Chart 5), but they make up for it by borrowing via other channels. 64% of households in the bottom two quintiles have some debt, and the share grows to 70% when the middle quintile, which qualified for the full $1,200 economic impact payment, is included (Chart 6). Chart 5The Homeownership Income Divide The Homeownership Income Divide The Homeownership Income Divide Chart 6Households In The Lower Two Quintiles Have Debt To Service, Too Households In The Lower Two Quintiles Have Debt To Service, Too Households In The Lower Two Quintiles Have Debt To Service, Too Investment Implications The discussion above focused solely on the consumer, as we discussed the Fed’s efforts to assist lenders and business borrowers in a joint Special Report with our US Bond Strategy colleagues in April.4 Record corporate bond issuance in March and April – before the Fed bought a single corporate bond – testifies to the effectiveness of the Fed’s measures. Its corporate credit facilities bazooka was so large that it was able to soothe the roiled corporate issuance market without firing a single shot. Spreads have narrowed across the spread product spectrum and the primary and secondary markets are once again able to function normally. Too much economic improvement could be self-limiting, and the S&P 500 is trading at an ambitious multiple. We remain equal weight equities over the tactical three-month timeframe. The foregoing review of consumer performance reinforces our view that the SIFI banks should be overweighted relative to the S&P 500. The ongoing data indicate that the SIFI banks will not have to build up their reserves for loan losses as much as investors feared. Our conviction that the SIFI banks are unlikely to face material book value declines has only increased. It has become possible that second- and third-quarter reserve builds may be even less than our optimistic two-times-the-first-quarter view, but the virus will have the final say. The SIFI banks remain our favorite long idea. At the asset allocation level, we remain equal weight equities over the tactical three-month timeframe. We are encouraged by the green shoots visible in the employment report, but stocks are generously valued and the virus outlook is still unclear. The improvement on the ground could prove to be self-limiting if it kills the momentum for further fiscal assistance, or if it encourages officials and individuals to let their guard down regarding the social distancing measures that have been effective in lowering COVID-19 infection rates.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to the Census Department’s annual Current Population Survey, mean household income ($90,000) exceeded median household income ($63,000) by 42% in 2018. 2 Ganong, Peter, Noel, Pascal J., Vavra, Joseph S. "US Unemployment Insurance Replacement Rates During the Pandemic," NBER Working Paper No. 27216. 3https://www.nmhc.org/research-insight/nmhc-rent-payment-tracker/ Accessed June 1. 4 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com.

Dear Client, Next week we will be sending you a Special Report providing our insights on the much-anticipated China National People’s Congress. We think the messages sent from the conference will be highly relevant to both the global economy and financial markets. Please note: instead of Wednesday, the Special Report will be published on Thursday the 28th of May. Best regards, Jing Sima China Strategist Highlights Insert HiEarly signs suggest a renewed appetite among Chinese consumers for real assets and durable goods. China’s discretionary consumption will likely benefit greatly from pro-growth measures, and recover much faster than the aggregate consumption.   The unemployment rate has been rising and largely concentrated in lower-income workers. Elevated unemployment will be a drag on China’s overall consumption, but its impact on discretionary consumption is limited. We are initiating two trades: long investable consumer discretionary/short investable consumer staples and long domestic consumer discretionary/broad A-share market. Feature Chart 1Sectors Directly Benefiting From Stimulus Are Recovering Faster Sectors Directly Benefiting From Stimulus Are Recovering Faster Sectors Directly Benefiting From Stimulus Are Recovering Faster Economic data released last week showed that China’s economy continued to recover, particularly the infrastructure, construction and high-tech sectors (Chart 1). On the other hand, household consumption, which accounts for nearly 40% of the country’s economy, remained in a deep contraction in April. While we think the annual growth in China’s aggregate household demand will remain muted this year, the breakdown in April’s retail sales data suggests that the speed in consumer discretionary spending is already accelerating (Chart 2). During economic recoveries, consumer discretionary spending usually rebounds ahead of a recovery in overall consumption. Even though the current economic downturn is extra-ordinary, we believe that China’s discretionary consumption growth will pick up faster and stronger than the aggregate household consumption. Consumer discretionary stocks, an early cyclical sector in China’s equity market, troughed about 3 months ahead of a bottoming in Chinese investable and domestic stock prices in previous cycles. In line with our constructive view on Chinese stocks in the next 6 to 12 months, we recommend investors overweight Chinese consumer discretionary stocks relative to the benchmarks. In addition, we are initiating a long position in investable consumer discretionary versus investable consumer staples, and a long position in domestic consumer discretionary versus A-share market. Chart 2Discretionary Consumption Is Rebounding Faster Than Staples A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks China’s Stimulus-Driven Consumption Cycles Chinese consumption cycles since 2008 have mostly reflected the effectiveness of China’s pro-consumption and stimulus policies. So far, the Chinese government’s stimulus measures have been concentrated in the corporate sector rather than households. Nevertheless, government pro-growth measures, flush liquidity in the market and global travel restrictions should provide a lift to domestic sales of durable and luxury goods. Chart 3 illustrates how, in contrast to the US, China’s retail sales have grown faster than nominal GDP during every economic downturn since 2008. A reason for this counter-cyclicality in China’s consumption is that the monthly retail sales data consists of household, government and business purchases.  Since the Chinese government tends to increase its expenditures during economic downturns, the increases in government purchases help to offset the declines in household and business consumption. Chart 3Retail Sales In China Have Become 'Countercyclical' Since 2008 Retail Sales In China Have Become 'Countercyclical' Since 2008 Retail Sales In China Have Become 'Countercyclical' Since 2008 Chart 4China's Post-GFC Consumption Cycles Largely Driven By Stimulus China's Post-GFC Consumption Cycles Largely Driven By Stimulus China's Post-GFC Consumption Cycles Largely Driven By Stimulus A more important contributor to the faster retail sales growth during economic down cycles is government stimulus. Direct pro-consumption policies, such as sales tax cuts and subsidies, helped to boost auto sales in every cycle since 2008, whereas stimulus measures to enhance home sales indirectly led to an upcycle in the sales of home appliances in 2015-2016 (Chart 4).  April’s retail sales data showed a sharp rebound in Chinese household consumption in autos, appliances and furniture (Chart 5). The strong comeback in durable goods purchases in April was driven by a release of pent-up demand and government pro-consumption measures. Since March, local governments have handed out subsidies, vouchers and tax reductions on consumer durable goods purchases and discretionary spending, such as travel and restaurant dining. By end-April, an estimate of 40 billion yuan worth of consumption vouchers were issued by provincial and city-level governments, with more than 90 percent of them targeted at discretionary goods and services. We think the government will announce further policies to support consumption at the May 22-23 National People’s Congress.  Chart 5A Strong Comeback In Durable Goods Sales A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Chinese consumers took on more medium- and long-term loans in March and April, indicating a renewed appetite for purchasing real assets and durable goods (Chart 6). This is partially because consumers want to take advantage of lower interest rates and easier monetary conditions. Moreover, Chinese households may also be seeking real assets to hedge future inflation and financial market uncertainties. Housing in China in the past two decades has been perceived as countercyclical and a low-risk asset that holds value. Early signs indicate a renewed Chinese consumers’ appetite for real assets and durable goods. Both land sales and real estate investment growth returned to positive territory in April, while the contraction in floor space started, completed, and sold all narrowed. The upward cycle in the property market should continue to support a recovery in household appliances and furniture (Chart 7).   Chart 6Appetite For Real Asset Purchases May Be Returning Appetite For Real Asset Purchases May Be Returning Appetite For Real Asset Purchases May Be Returning Chart 7A Recovering Property Market Should Help Boost Home Appliance Sales A Recovering Property Market Should Help Boost Home Appliance Sales A Recovering Property Market Should Help Boost Home Appliance Sales In addition, global travel restrictions will likely remain in place through this year. This may prompt Chinese consumers to allocate a larger portion of their discretionary spending budgets to domestic, high-end consumer goods and services. Bottom Line: Early signs indicate a renewed consumer appetite for real assets and durable goods. The government’s pro-consumption and pro-growth measures should further boost discretionary spending. The Wealth Effect The consumption behavior of Chinese households will likely be driven by both the change in the value of their assets, and their expectations of the immediate or perceived future loss of employment and income. Housing is the largest part of Chinese households’ net worth.1 At the same time, financial assets account for a much lower share of Chinese households’ net worth versus their American peers.2 Home prices are much less volatile than stock prices, and we expect home prices in China to grow faster this year than in 2019. Hence the wealth effect of housing on Chinese consumers should remain positive. The unemployment rate has been elevated, but job losses so far are concentrated in the labor-intensive, lower-skilled manufacturing and service sectors (Chart 8). While lower-income workers account for more than half of China’s total population, their share of the country’s total household wealth and income is dismal compared with households in the top 10 percentile earnings3  (Chart 9). In fact, households in the bottom 40 percentile essentially have no discretionary spending capacity.4 Households in the top 40 group (middle- and upper middle-class urbanites) are the main driver of China’s discretionary and luxury goods market.5 Chart 8Job Losses So Far Concentrated In Lower-Skilled, Lower-Wage Manufacturing & Service Sectors A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Chart 9Higher-Income Chinese Households Will Drive Recovery In Discretionary Consumption A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Because poorer households tend to have a higher marginal propensity to consume than the richer ones, China’s high income inequality may reduce the aggregate demand and has the potential to structurally stagnate its household consumption growth. This is a topic we hope to provide insights on in our future research. Cyclically, however, accommodative monetary conditions and outsized stimulus during economic downturns often help augment richer households’ net worth as well as increase their discretionary purchasing power. Our constructive view on China’s discretionary consumption could change if a second wave of Covid-19 infections is virulent enough to trigger another round of global lockdowns. In this case unemployment may expand from lower-income to middle-class Chinese consumers and extend from temporary to permanent job losses.  Consumption will also be constrained by more widespread income declines and renewed physical lockdowns.  Bottom Line: Job losses are concentrated in the lower-income household group so far. While developments in the pandemic remain fluid, our baseline view suggests that the wealth effect will have a limited impact on Chinese middle-class consumers. Investment Conclusions The recovery is still in its early stages, but government stimulus is bearing fruit in discretionary consumption. Furthermore, the elevated unemployment rate should prompt the government to roll out more consumption and growth-supporting measures at this week’s NPC conference, which will help further boost Chinese consumers’ appetite for discretionary spending.  China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries. China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries (Chart 10). The overwhelming shares of China’s online tech titans in the investable market, such as Alibaba and JD, make a strong case to overweight the consumer discretionary sector given that both online platforms will continue to benefit from the Chinese government’s pro-consumption schemes. On the other hand, the behavior of consumer discretionary versus consumer staples in China’s A-share market has been atypical.  Chart 11 shows domestic consumer discretionary stocks have consistently underperformed consumer staples since 2015, even during the 2016/2017 upcycle in broad market stock prices. We think a few underlying factors may be at play: Chart 10The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... Chart 11...It Is Not The Case In The Onshore Market ...It Is Not The Case In The Onshore Market ...It Is Not The Case In The Onshore Market Food and beverage companies in mainland China have one of the highest ROAs and the lowest financial leverages, which is preferred by Chinese domestic investors; Chinese liquor brands such as Kweichow Moutai and Wuliangye, which are listed on the A-share market and within the consumer staples group, have become collectable luxury goods. They have helped driving up the prices of consumer staple equities (Chart 12);  Soaring food prices since 2017 have helped to widen profit margins among food processing firms (Chart 13).   Chart 12Some 'Consumer Staples' Have Become Luxury Goods Some 'Consumer Staples' Have Become Luxury Goods Some 'Consumer Staples' Have Become Luxury Goods Chart 13Soaring Food Prices Also A Contributing Factor Soaring Food Prices Also A Contributing Factor Soaring Food Prices Also A Contributing Factor For investors with a time horizon longer than a 12 months, consumer discretionary sector is a winner. However, for investors with a time horizon longer than 12 months, average returns in consumer discretionary stocks still beat staples in the past three market recoveries (Table 1). This is true for both onshore and offshore markets. As such, we recommend investors go long on consumer discretionary versus consumer staples in the investable market, and also go long on domestic consumer discretionary versus the broad domestic market. We are initiating these two trades today. Table 1CD Sector Still A Winner On A 12-18 Month Horizon A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Housing accounts for 59.1% in Chinese households’ net worth, compared with 30% in the US. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 220.4% of Chinese households’ total net worth is in financial assets. In the US, the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 3China’s low-income households account for about 60% of China’s population as of 2015. “How well-off is China’s middle class?” Center For Strategy & International Studies. https://chinapower.csis.org/china-middle-class/ 4 “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 5China Consumer Report 2020, McKinsey & Company, December 2019 Cyclical Investment Stance Equity Sector Recommendations

Highlights The duration of this crisis and the details of the plan to reopen the economy will determine whether the initial uptick in median home prices will prove to be transitory. Phase I provides room for construction to resume at least partially, while demand for homes is likely to recover more gradually. This temporary supply/demand imbalance is unlikely to result in a meaningful price contraction as significant mitigating factors are at play. Government actions to support households and the availability of credit as well as low mortgage rates should prop up the homeownership rate. Housing’s wealth effect has decreased and is unlikely to drive consumption in a pandemic-related recession. Construction employment was highly affected though resuming work in this sector is more likely to boost steel demand than have a significant impact on the unemployment rate. Feature A recession typically occurs amidst imbalances in the economy and the 2008 sub-prime episode arguably embodied the epitome of housing excesses. Housing’s contribution to GDP has significantly decreased over the past seventy years, and today’s well-balanced housing market is unlikely to be the center of attention, but home prices are cyclical and large fluctuations can have repercussions in other areas of the economy. Social distancing is leading supply to contract first, altering the typical recessionary chain of events. We examine the COVID-induced shock to housing and its potential ramifications. Under the working assumption that a vaccine and/or effective treatment will allow economic activity to fully resume within the next twelve months, we conclude that home prices are unlikely to contract meaningfully. The homeownership rate should remain well supported and consumption is more likely to be impacted by unemployment than housing wealth effects. Meanwhile, a tightening in lending standards at the margin should not get in the way of credit availability. A Sellers’ Market Chart 1COVID-19 Is Destroying More Supply Than Demand COVID-19 Is Destroying More Supply Than Demand COVID-19 Is Destroying More Supply Than Demand The latest housing data releases strikingly contrast with the employment data and GDP growth estimates. The median home price actually increased by 8% on a year-on-year basis while new home sales contracted by 10%, suggesting that supply has been decreasing at a faster pace than demand (Chart 1). In the typical recession sequence of events, home prices slip as falling employment dents demand which in turn leads homebuilders to defer new starts and reduce prices on the existing supply of new homes. This is not a typical recession, however, and the supply shock preceded the demand shock. Confinement measures prevented construction professionals from going to work, thereby immediately halting the production of new homes. Meanwhile, the fact that most job losses have been temporary thus far has led to a relatively slower pace of demand destruction. Moreover, real estate transactions take a couple of months to close and the latest data may simply reflect purchase decisions that were made before the US became an epicenter of the pandemic. Median home prices may also be holding firm because sellers are not compromising on their asking price when social distancing prevents in-person visits (Chart 2), or because sellers are waiting things out before re-listing their property for sale. The housing market is effectively in a time-out where a reduced number of transactions is preventing prices from adjusting in a timely fashion. Chart 2Prospective Buyers Taking Social Distancing To Heart Prospective Buyers Taking Social Distancing To Heart Prospective Buyers Taking Social Distancing To Heart Prices Subject To Mitigating Forces Chart 3A Well-Balanced Housing Market A Well-Balanced Housing Market A Well-Balanced Housing Market The duration of the COVID-19 crisis and the details of the phases of economic reopening will ultimately determine whether this initial uptick in median home prices proves to be transitory. The housing market can remain a sellers’ market for as long as the mortgage forbearance allowed under CARES Act protects mortgage owners from defaults. It currently allows applicants to postpone their mortgage payments for up to a year amid COVID-related economic hardships. These payments are then tacked on to the end of the forbearance period and paid back over time in a mortgage modification. The winds will change if a vaccine is not mass-produced by then and Congress does not provide new aid. A wave of defaults would lead to mass property listings by desperate sellers, exerting significant downward pressure on home prices. Local homebuilders’ associations are making their case to Washington to be considered essential. The current plans to reopen the economy would provide room for residential construction to resume at least partly under Phase I, as mandated social distancing measures can be implemented on an open-air construction site. The US Census Bureau estimates that the average length of time from start to completion ranges between 7 and 15 months depending on the type of construction. Even if no new project begins until the end of the recession, currently pending constructions will resume and add another 730,0001 new homes on the market by fall - a conservative estimate that excludes any potential existing homes that might go up for sale. Existing homes account for the lion’s share of total inventory. Meanwhile, it would take much longer for demand to recover even in the unlikely event that the virus miraculously disappeared and life returned to normal in a fortnight. It generally takes time for the unemployment rate to recover to pre-recession levels, as matching available workers with employers is time-consuming and feedback loops are at play whereby unemployment leads to less spending which in turn reduces the incentive for firms to hire. The temporary nature of the layoffs and the government financial support to households will be mitigating factors, but precautionary savings tend to rise after a recession and unemployed workers might have drawn down their bank accounts. All these factors should contribute to a slower pace of housing demand recovery. Even though demand might take longer to recover, a generally well-balanced market will support prices. This temporary supply/demand imbalance scenario is bearish for home prices. However, it is worth remembering2 that unlike the previous downturn, the housing market was well balanced before this crisis began, another important factor that should mitigate the magnitude of any potential price decline (Chart 3). Bottom Line: Under the working assumption that a vaccine will be available and mass-produced within twelve months, this atypical recession is unlikely to result in a severe home price contraction. Support For Credit Chart 4Loan Deferrals Exert Pressure On Banks... Loan Deferrals Exert Pressure On Banks... Loan Deferrals Exert Pressure On Banks... An increasing share of banks have tightened residential mortgage lending standards at the margin (Chart 4), an unsurprising outcome given that a recession has arrived and payment deferrals reduce the net present value of any given mortgage. Securitization may also become more difficult or costly as mortgage servicers’ resources are strained by delayed reimbursement from Fannie Mae and Freddie Mac for the interest payments they have to advance to holders of agency mortgage-backed securities. Three-quarters of residential mortgages are backed by federal agencies, and banks presumably have little appetite to tie up limited capital with new loans at the onset of what might be a brutal recession. They will presumably be eager to get loans off their balance sheets by selling them into securitization pools, but if servicers are wary in an environment when 7.5% of all mortgages are already in forbearance, they would be well-advised to underwrite them as if they were going to have to hold them. However, banks have exerted significant restraint since their pre-Great Financial Crisis frenzy.3 Their loan books - across all core lending categories, but most prominently in the real estate segment - have grown at a markedly slower pace in the past decade than they did in any other postwar expansion4 (Chart 5). Banks are also better capitalized than they used to be, strengthening their ability to sustain losses (Chart 6). Chart 5...But Their Restrained Behavior In The Late Expansion... ...But Their Restrained Behavior In The Late Expansion... ...But Their Restrained Behavior In The Late Expansion...   Chart 6...And Increased Equity Capital Strengthen Their Ability To Sustain Losses ...And Increased Equity Capital Strengthen Their Ability To Sustain Losses ...And Increased Equity Capital Strengthen Their Ability To Sustain Losses Bottom Line: Financing should remain available to prospective home buyers. There are no excesses in the overall banking system and regulators will not allow the mortgage securitization machinery to break down. Resilient Homeownership Rate Just as the pandemic is unlikely to result in a drastic decline in home prices, the homeownership rate is unlikely to deteriorate meaningfully. Chart 7Better Situated Households Taking Advantage Of Competitive Rates Better Situated Households Taking Advantage Of Competitive Rates Better Situated Households Taking Advantage Of Competitive Rates COVID-19 may have claimed a staggering 33 million jobs and counting, but CARES Act forbearance will shield the most vulnerable households for the next twelve months, propping up their current rate of homeownership. Meanwhile, low mortgage rates create opportunities for better-situated households. Data from Corelogic suggest that millennials have driven the bulk of the uptick in mortgage applications (Chart 7). They are also the cohort most inclined to transition from renting to owning and their increasing access to homeownership these past few years suggests that their financial situation is not as dire as widely believed (Chart 8). Chart 8Millennials' Transition From Renting To Owning Millennials' Transition From Renting To Owning Millennials' Transition From Renting To Owning Low mortgage rates have also increased homeownership’s competitiveness relative to renting (Chart 9). This trend is unlikely to reverse in the near term. Eviction protection programs and rent forbearance under the CARES Act will only temporarily cap rent growth. Meanwhile, mortgage rates are set to remain competitive beyond the timeframe of this recession. Chart 9Owning Is More Attractive Than Renting... Owning Is More Attractive Than Renting... Owning Is More Attractive Than Renting... Low mortgage rates and relatively easy lending standards have prevailed since 2013 but home price appreciation has outpaced wage growth, denting housing affordability (Chart 10). While the tendency to build smaller housing units would contribute to decreasing median home prices at the margin (Chart 11), income growth will take a while to catch up. The labor market will have to tighten anew before income growth can revive. Chart 10...Even Though Homes Have Become Less Affordable ...Even Though Homes Have Become Less Affordable ...Even Though Homes Have Become Less Affordable Chart 11Is Smaller Becoming Better? Is Smaller Becoming Better? Is Smaller Becoming Better? Still, declining affordability has not prevented the homeownership rate from recovering to its long-run average. It may stand at a lower level today than it did in 2007 when it reached 69%, but it reflects sounder lending behaviors. Bottom Line: The COVID-19 crisis does not pose an immediate risk to the currently healthy level of homeownership. Better-situated households can take advantage of low mortgage rates but decreasing housing affordability will prevent homeownership from grinding meaningfully higher. Fading Wealth Effect Amid COVID-19 Consumers tend to spend more when the value or perceived value of their assets rises. Housing accounts for a sizable portion of homeowners’ equity, but the wealth effect of housing may have become less significant than most investors believe. The contribution to spending from housing wealth mirrors the decrease in housing as a share of households’ aggregate net worth (Chart 12). The latter now stands at 15%, way off its 1980s and 2006 peaks, while pension entitlements and equity and mutual fund holdings have filled the void, each accounting for a quarter of homeowners’ net worth. Chart 12The Wealth Effect Of Housing Is Decreasing... The Wealth Effect Of Housing Is Decreasing... The Wealth Effect Of Housing Is Decreasing... The wealth effect of housing remains positive. However, fluctuations in home prices are not evident to consumers in real time (Chart 13) and COVID-19 has precipitated the swiftest recession on record. The immediate or perceived future loss of employment and income are much more likely to drive consumption than home prices. Chart 13...And Is Unlikely To Influence Spending In A Pandemic ...And Is Unlikely To Influence Spending In A Pandemic ...And Is Unlikely To Influence Spending In A Pandemic Bottom Line: In a pandemic-induced downturn, home prices alone are unlikely to have a meaningful effect on consumption patterns. A Marginal Impact On Employment Overall housing-related sectors of the economy account for a marginal share of total employment. Construction activity makes up a mere 5% while related sectors including the sale and manufacturing of furniture, appliances and wood products, amongst others, chip in another 4.5% (Chart 14). On a rate of change basis, however, housing has been at the forefront. While the airline and leisure and hospitality sectors have been the center of attention in the past couple of months, construction has also suffered markedly. Total construction employment contracted by a third in April alone, behind only leisure and hospitality (Chart 15). Chart 14Housing's Marginal Impact On Overall Employment Housing's Marginal Impact On Overall Employment Housing's Marginal Impact On Overall Employment Chart 15Construction Was Highly Affected By COVID-19 Housing In The Time Of COVID-19 Housing In The Time Of COVID-19 A Phase I economic reopening will make room for activity in housing and many other sectors to resume and restore at least a portion of the jobs temporarily destroyed. The leisure and hospitality sector, however, is most likely to be the real game changer. 40% of the job losses so far have been in this single sector. While restaurants will be able to resume partial activity under Phase I, traveling is unlikely to return to normal for some time, even after a vaccine is mass-produced. It took several years after 9/11 for individuals to feel safe traveling again and for air traffic to reach its pre-crisis levels. Bottom Line: Although housing employment has been highly affected by COVID-19, it accounts for a small share of nonfarm payrolls and a pickup in this sector is unlikely to have a meaningful impact on the overall unemployment rate. A Significant Source Of Global Steel Demand A revival in housing activity is more likely to significantly impact commodity prices than the overall unemployment rate. Homebuilders are a key driver of lumber demand and construction activity accounts for half of the demand for steel and copper (Chart 16). The US is the largest net importer, making it a heavy player in the steel market, but its influence on copper prices is dwarfed by the demand stemming from Asia. Chart 16A Revival In Construction Would Boost Demand For Commodities Housing In The Time Of COVID-19 Housing In The Time Of COVID-19 Putting It All Together Over the past seventy years, housing has accounted for a steadily decreasing share of the economy and homeowners’ net wealth. In the absence of excessive lending and overbuilding, its ramifications for employment, consumption and the rest of the economy should remain muted in this crisis. BCA researchers tend to leave the thorough bottom-up analysis to professional stock pickers and instead focus their attention on the fundamental 30,000-feet top-down macroeconomic perspective. Although we do not expect overall home prices to contract drastically, “location, location, location” has always been real estate’s modus operandi. We would note that home prices in cities like Las Vegas or Orlando with economic activity tied to tourism, arts and entertainment, restaurants and recreation might be disproportionally affected by COVID-related externalities. It is too early to assess whether the widespread social distancing measures will result in lasting structural changes on society, housing preferences and the way we conduct business. There is sound basis, however, to hypothesize that cooped-up city dwellers might find suburbs and satellite cities to be more attractive going forward, and that lasting work-from-home arrangements will enable them to make that life-style change.   Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Footnotes 1 The housing start data is seasonally adjusted. Starts averaged 1,466 million in 1Q20 and 1,443 million in 4Q19 meaning that a quarter of these projects actually started in 1Q20 and 4Q19 (367K and 361K starts, respectively). 2 Please see US Investment Strategy Special Report titled "Housing: Past, Present And (Near) Future", published November 19, 2018. Available at usis.bcaresearch.com. 3 Please see US Investment Strategy Special Report titled "How Vulnerable Are US Banks? Part 2: It’s Complicated", published April 6, 2020. Available at usis.bcaresearch.com. 4 Until the NBER makes the official designation, our working assumption is that the current recession began in March.

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest Pickup In M1 Still Modest Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2 Recovery To Gain Traction In H2 Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up #WWIII #WWIII Chart 2The Thucydides Trap The Thucydides Trap The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce The Great Economic Divorce The Great Economic Divorce Chart 4Decoupling Is Empirical Decoupling Is Empirical Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be ... But Tariffs Can And Will Be ... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US A Measure Of Inequality In The US A Measure Of Inequality In The US Chart 9US Nationalism On The Rise #WWIII #WWIII Chart 10Broad-Based Anti-China Sentiment In US #WWIII #WWIII As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite #WWIII #WWIII Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity #WWIII #WWIII Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations