Developed Countries

Highlights 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. The intensity of the US-China rivalry can escalate dramatically. We maintain our defensive tactical positioning and are going long US 10-year treasuries. Feature 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 Chart 2The 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 Chart 4Decoupling 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. Chart 5Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be 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). 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 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 Chart 9US Nationalism On The Rise Chart 10Broad-Based Anti-China Sentiment In US 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 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. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity 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. 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 dismiss 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. 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  

Neutral On Monday’s Weekly Report we put the S&P managed health care index on downgrade alert and instituted a 5% rolling stop on the position in order to protect gains for our portfolio. This downgrade alert reflected the following rising risks: First, that rising unemployment will weigh on health care enrollment as now over 30mn Americans have filed for unemployment insurance claims over the past six weeks. Second, falling interest rates will also weigh on industry profitability given that these insurers invest their premia in the risk-free asset. And finally, relative valuations were perky and technicals overbought. On Wednesday this rolling stop was triggered. We are compelled to obey this risk management portfolio tool we recently implemented, and crystalize handsome gains since the April 2019 inception (see chart). Bottom Line: Trim the S&P managed health care index to neutral and book profits of 26% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH-UNH, ANTM, HUM, CNC.

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2020.  The model has not made significant changes this month. Now Spain, Australia, Sweden and the US are the top four overweight countries, while Japan, the UK, France and Switzerland remain the four underweight countries, as shown in Table 1.  Table 1GAA DM Model Vs. MSCI World As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in April by 105 bps. The Level 1 model outperformed by 32 bps because of the overweight in the US. The Level 2 model outperformed by 241 bps thanks to the overweight of Australia and Canada, and the underweight in Japan, the UK, France and Switzerland. Since going live, the overall model has outperformed by 105 bps, with 135 bps of outperformance by the Level 2 model, and 29 bps of outperformance from the Level 1. Chart 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of April 30, 2020. Chart 4Overall Model Performance The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model turned negative on cyclical sectors in the beginning of March as the COVID-19 crisis intensified and growth indicators deteriorated. Throughout March, April and now May, the model continues to tilt towards defensive sectors. This has helped mitigate the shortfall in early March. However, that came at a cost as the model underperformed the benchmark by 33 basis points over the past month. The global growth proxy used in our model remains negative. This will continue to make the model's positioning focused on less cyclical sectors. The momentum component led the model to overweight Consumer Discretionary over the past month at the expense of Utilities. The unprecedented global monetary measures taken by global central banks should keep the liquidity component favouring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, we continue to highlight that the Info Tech’s valuation component has broken into overweight territory (yet the model awaits a downwards confirming momentum signal to recommend an underweight). The model is now overweight four sectors in total, two cyclical sector versus two defensive sectors. These are Information Technology, Consumer Discretionary, Consumer Staples, and Health Care. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Overall Model Performance Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Senior Analyst amrh@bcaresearch.com

Highlights Competitive devaluation will remain the dominant policy landscape in the near term. This means that paradoxically, currencies with high and/or positive long-term interest rates remain at risk. The CAD may be the next shoe to drop. Crude oil may have put in a structural bottom, but conditions for long-term appreciation in the CAD are not yet in place. That said, the broad US dollar trend will be the key driver of CAD in the shorter term. This means upside later this year as global growth picks up and risk assets ride a liquidity wave. The CAD will, however, continue to underperform at the crosses. Our favorite vehicles to express this view are long AUD/CAD, short CAD/SEK, and short CAD/NOK. Also remain long the SEK both against the euro and the USD. Feature Chart I-1A One-Way Bet For Yields? This week saw four major central banks convene for their scheduled policy meetings. The currency implications from all four were clear: Competitive devaluation will remain the dominant policy landscape in the near term, as no central bank will tolerate tightening in financial conditions.1  This means that paradoxically, currencies with high and/or positive long-term interest rates remain at risk, while low-beta currencies could be the outperformers in the near term (Chart I-1). Specifically: The Bank Of Japan kicked things off by introducing unlimited buying of government bonds. The previous ¥80 trillion target had been largely symbolic, since purchases have been below that level since 2016, and are currently running at around ¥20 trillion. The yen rallied on the news, as long-term interest rates in Japan are already at zero. Other measures included increasing the amount of commercial bonds and paper that the BoJ can purchase,  while easing collateral requirements and funding costs for loans, scheduled for small and medium-sized enterprises.  The Riksbank left policy unchanged with the repo rate at zero, and quantitative easing capped at SEK 300 billion by September 2020. With other central banks stepping into unlimited QE, this was interpreted as a hawkish surprise by the market. The SEK surged. That said, even unlimited QE may not have produced a different result, given how low government debt in Sweden is. The Federal Reserve strengthened its forward guidance, suggesting the rapid pace of balance sheet expansion is set to continue. This will continue to boost the US money supply. A commitment to continue pumping more dollars into the economic plumbing system knocked down the DXY. The European Central Bank left its policy rate unchanged, with long-term interest rates in the core countries already below zero. However, it did introduce PELTRO, or Pandemic Emergency Long-Term Refinancing Operations. Starting from June, it will also lend money to banks as cheaply as -1% via its TLTRO program. Short of unlimited QE, the euro rallied on the news.   Usually, the normal relationship between currencies and interest rates is positive, in that high or rising interest rates are usually accompanied by currency appreciation (Chart I-2). However, in competitive devaluation, currencies with high interest rates are at risk, since no central bank wants a tightening in financial conditions. Chart I-2AThe Dollar And Interest Rates Have Diverged Chart I-2BThe Dollar And Interest Rates Have Diverged This, in turn, means that, so long as fears over the pandemic continue to loom large, the outperformers will be the low-beta currencies with long-term interest rates already at zero. This was the unified currency market response to policy actions this week. This in turn means that while the SEK and JPY could continue to outperform the dollar in the near term, the CAD, NZD and AUD could underperform. Competitive devaluation will remain the dominant policy landscape in the near term.  Bottom Line: Maintain a barbell strategy for the time being by going long the cheapest currencies (SEK) together with some safe havens (JPY). This view was reinforced by our model results last week.2   The Loonie: The Next Shoe To Drop? It is well known that an important driver for the loonie has been the price of crude oil (Chart I-3). While the drop in the price of the WTI blend to -$40 per barrel may have been the structural bottom, conditions for long-term appreciation in the CAD are not yet in place. For one, crude oil continues to trade in an extremely volatile pattern, with double-digit gains and losses daily. Meanwhile, long-term prices still remain below cash costs for many Canadian producers, suggesting a prolonged period of low prices could lead to severe capital destruction. Three factors suggest that even if crude oil recovers, the Canadian dollar rally is likely to be lukewarm as it underperforms at the crosses. There has been a paradigm shift in oil production, with US shale producers aggressively grabbing market share from both OPEC and non-OPEC producers. Currently, Canada produces only 5.5% of global crude versus 15% for US production. Admittedly, Canadian market share has also been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie (Chart I-4). Chart I-3Loonie And Oil Still Tied To The Hip Chart I-4Oil Production: US Versus Canada As low prices and falling relative productivity in the Canadian oil patch start to infect peripheral businesses, part of the rise in the unemployment rate will prove to be structural (Chart I-5). Admittedly, the more recent job losses have been concentrated in the service sectors as the economy has been on lockdown. Most of these jobs should return as the economy reopens. But more importantly, Canadian jobs started deteriorating in October last year when crude oil was still well above $50 per barrel. Housing remains a pillar of household wealth in Canada, and the recovery in prices has been uneven (Chart I-6). The risk is that this continues to restrain spending, as nationwide house price growth slows to a standstill. Chart I-5Worst Jobs Report In Decades Chart I-6Uneven House Price Recovery The path for Canadian housing prices is likely to be as follows: 1) Government support combined with macroprudential measures will likely continue to lead to a convergence in prices between low- and high-priced cities. Specifically, Vancouver (and to a certain extent Toronto) should continue to see soft pricing growth, while Montreal and other cities recover; 2) As prices start to deviate away from nominal incomes in lower-priced cities, the risk of wider macroprudential measures greatly increases. Both rising indebtedness and falling affordability are likely to present a key macro risk to the Canadian economy. The second point is crucial, since the rise in Canadian home prices has been more pronounced than in other countries, say Australia or the US. This means that both rising indebtedness and falling affordability are likely to present a key macro risk to the Canadian economy. Residential construction is a non-negligible part of the Canadian economy (Chart I-7). Chart I-7Residential Construction Is Important Chart I-8More Scope To Increase Debt In Canada A weaker consumer in Canada means the government is likely to step in as the spender of last resort. Meanwhile, there is much more scope for the Canadian government to increase spending (Chart I-8), but much less so for the Canadian consumer (Chart I-9). This means that incrementally, the potential for the Bank of Canada to monetize deficits is rising. This will weigh on the CAD longer term, as investors will require a cheaper currency to finance the deficit. There is much more scope for the Canadian government to increase spending, but much less so for the Canadian consumer. That said, these are longer-term trends. The path of the DXY index will be the key driver of the CAD in the shorter term. This means upside later this year as global growth picks up and risk assets ride a liquidity wave. What is clear is that the CAD is likely to still underperform at the crosses. Long AUD/CAD and short CAD/SEK and CAD/NOK are our favorite vehicles to express this view (Chart I-10). Chart I-9A Debt Ceiling For The Canadian Consumer Chart I-10Short CAD/SEK and CAD/NOK Aside from falling productivity, transportation bottlenecks in Canada will prove to be a formidable hurdle in closing the current discount between WCS and Brent (Chart I-11). While Canadian crude is likely to remain trapped in the oil sands, North Sea crude will face less transportation bottlenecks in the near term. This suggests the path of least resistance for the CAD/NOK is down. Chart I-11A Structural Discount To Canadian Oil Bottom Line: Stay short the CAD at the crosses as a strong-conviction view.   Stay Long The SEK Chart I-12EUR/SEK Is Stretched Not only the CAD will suffer from a stronger SEK. We continue to favor long SEK positions, both against the euro and the US dollar. Swedish data has been outperforming that in the rest of the euro area. The latest manufacturing PMI data was 43.2 for Sweden versus 33.6 for the euro area. There was an even bigger divergence in the service PMI print: 46.9 in Sweden versus 11.7 in the euro area. Sweden, which mostly kept its economy open during the pandemic, has seen better economic data at the expense of higher fatalities. Technically, the EUR/SEK cross is mean-reverting from an overbought extreme, having faced powerful overhead resistance above the 11 level (Chart I-12). The SEK is much cheaper than the euro. According to our PPP models, the SEK is undervalued by 35% while the euro is undervalued by 18%. Bottom Line: Remain long the SEK against a basket of the EUR and the USD.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Are Competitive Devaluations Next?”, dated March 6, 2020, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Introducing An FX Model”, dated April 24, 2020, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: Real GDP contracted by 4.8% quarter-on-quarter in Q1, led by rapid declines in demand. Core PCE grew by 1.8% quarter-on-quarter in Q1, up from 1.3% the previous quarter. Durable goods orders slumped by 14.4% month-on-month in March.  The goods trade deficit widened from $60 billion to $64 billion in March. Initial jobless claims increased by another 3.8 million, higher than the expected 3.5 million. The DXY index fell by 0.4% this week. On Wednesday, the Fed decided to keep the interest rate steady and repeated its willingness to do “whatever it takes” to support the economy. The Fed will continue to purchase Treasury securities and agency residential and commercial mortgage-backed securities in the amounts needed to support the flow of credit to households and businesses. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: The economic sentiment indicator plunged from 94.2 to 67 in April. Headline inflation dropped from 0.7% to 0.4% year-on-year and core inflation slipped by 10 bps to 0.9% in April. However, they were both higher than expectations. GDP contracted by 3.3% yearly in Q1, the lowest reading over the past three decades. Money supply (M3) surged by 7.5% year-on-year in March, fuelled by the Pandemic Emergency Purchase Programme (PEPP). EUR/USD appreciated by 0.4% this week. The ECB held off on major policy moves this week but said it is ready to increase stimulus as needed, given the worst GDP numbers in recent history. EUR/USD rallied, suggesting this was a hawkish surprise. 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 Japanses Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The unemployment rate ticked up from 2.4% to 2.5% in March. The jobs-to-applicants ratio dropped from 1.45 to 1.39. Retail sales plunged by 4.6% year-on-year in March, down from 1.6% increase in February. Industrial production fell by 5.2% year-on-year in March, slightly better than the previous reading of -5.7%. USD/JPY fell by 0.5% this week amid broad dollar weakness. On Monday, the BoJ kept interest rates unchanged while taking further steps to expand its monetary stimulus. The BoJ pledged to buy an unlimited amount of government bonds and boost the purchases of corporate bonds and commercial papers to 20 trillion yen. Together with the record 1.1 trillion yen spending package announced last week, this will help ease the financial pain caused by 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 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: The business barometer plunged from 6 to -32 in April. Consumer confidence remains low at -34 in April. Retail sales declined by 5.8% year-on-year in March. The CBI’s Distributive Trades Survey reported the sharpest fall in sales since the GFC. Nearly all (96%) retailers reported cash difficulties, and nearly half (40%) reported facing difficulties to meet tax liabilities. The British pound is up by 0.4% against the US dollar this week. Last Friday, the BoE announced that weekly auctions of one month and three month sterling funds under the Contingent Term Repo Facility (CTRF) will remain in place until the end of May. Encouragingly, there are signs that the government’s support is providing great relief to retailers, with many of whom are opting for tem porary rather than permanent lay-offs. 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 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Headline inflation came in at 2.2% year-on-year in Q1, up from 1.8% the previous quarter, the highest over the past 5 years. Import prices fell by 1% quarter-on-quarter, while export prices soared by 2.7% quarter-on-quarter in Q1. Private sector credit grew by 1.1% month-on-month in March. The Australian dollar appreciated by 0.4% against the US dollar this week. While the RBA achieved its inflation target in Q1, consumer prices are expected to drop in Q2 amid the global COVID-19 crisis and are likely to remain subdued for the rest of the year. Moreover, the sharp decline in energy prices will be a headwind for inflation and the economy. 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 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: The trade deficit widened from NZ$3.3 billion to NZ$3.5 billion in March. ANZ final business confidence fell further by 3% to -67%, but this was a small improvement versus the preliminary April reading of -73%. The New Zealand dollar rose by 1.5% against the US dollar this week. The final April ANZ New Zealand Business Outlook released this Wednesday was slightly less bleak than the preliminary results published earlier this month, showing “a glimmer of light at the end of the tunnel”. Besides, the inflation expectations bounced back from 1.2% in March to 1.7% in April, suggesting that the launch of QE has had some success in keeping inflation closer to target. 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 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly negative: GDP growth stalled in February, following 0.3% monthly growth in January. Bloomberg Nanos confidence was little changed at 37.1 for the week ended April 24. The CFIB business barometer increased from 37.7 to 46.4 in April. The Canadian dollar appreciated by 0.6% against the US dollar this week, alongside the rebound in oil prices. The latest Statistics Canada GDP report showed that the mining, quarry and oil/gas extraction sector declined for the sixth consecutive month in February, prior to the COVID-19 crisis, due to lower international demand. Transportation, manufacturing and financial sectors have also seen significant slowdown in February. Please refer to our front section this week for a more detailed analysis on the Canadian dollar. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: ZEW expectations soared from -45.8 to 12.7 in April. Real retail sales contracted by 5.6% year-on-year in March. Total sight deposits increased by 14 billion CHF to 651 billion CHF last week. KOF Economic Barometer plunged from 91.7 to 63.5 in April, close to Great Financial Crisis lows. The Swiss franc rose by 0.5% against the US dollar this week. While Switzerland normally runs budget surpluses, it is now predicted to have a budget deficit of roughly 30 to 50 billion franc this year due to rising unemployment. The Swiss Finance Minister Ueli Maurer expressed intentions to use payouts from the SNB exclusively to finance spending. 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 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: GDP contracted by 1.5% quarter-on-quarter in Q1, the largest contraction since 2010. Retail sales fell by 0.9% month-on-month in March, down from 2% increase the previous month. The Norwegian krone rebounded by 2% against the US dollar this week, fuelled by rising oil prices. The slowdown of Norwegian economy in Q1 was mostly led by accommodation and food service activities. Arts, entertainment and other services and transportation have also seen significant declines. 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 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: PPI declined further by 3.6% year-on-year in March, following a contraction of 1.2% in February.   The trade surplus shrank by 8.6 billion SEK to 4.1 billion SEK in March. Retail sales grew by 0.6% year-on-year in March, compared with 3.7% expansion the previous month. The Swedish krona appreciated by 2% against the US dollar this week. The Riksbank held its interest rate unchanged at 0% on Tuesday. The majority of economists had expected no change in interest rates while 25% were expecting a rate cut. The Riksbank argues that they prefer to focus on credit supply to counteract a rise in rates rather than applying negative rates. However, they also said that negative rates are not ruled out should conditions worsen later this year. 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

Feature Global equities have seen an astonishing rally since mid-March, rising by 28%. This leaves them only 13% below their level at the beginning of the year. This is particularly remarkable given the unprecedented decline in economic activity with, for example, US GDP shrinking by an annualized 4.8% quarter-on-quarter in Q1, and the consensus forecasting it to fall by as much as 30% in Q2. Given this, risk assets are pricing in a highly optimistic trajectory over the coming months: a rapid return to normalcy, a V-shaped economic recovery, and minimal side-effects from the sudden stop to the world economy. In our Q2 Quarterly, we wrote we would turn more cautious if the S&P 500 moved quickly above 2,750.1 With it now at 2910, we are therefore lowering our recommendation on global equities on a 12-month horizon from Overweight to Neutral. The balance of probabilities – and the possibility of a second wave of the pandemic, rising corporate defaults, and problems among EM borrowers – simply does not justify an outright risk-on stance. Bear markets typically end 3-4 months before the economy bottoms (Table 1). If March was the low for stocks, therefore, this implies that the recession will end in June or July. BCA Research’s view is that the recovery is more likely to be U-shaped than V-shaped. Table 1Stocks Bottom On Average 3-4 Months Before The Recession Ends Chart 1New COVID-19 Cases Have Peaked What triggered the rally? Most notably, it anticipated a peaking of new COVID-19 cases in the world outside China (Chart 1). Several countries, notably Spain and Italy, have already felt able to ease quarantine rules, and others will do so during May. This raises the possibility that the pandemic will largely be over by July (except perhaps in a few developing countries, such as Brazil, where strict containment was shunned). The rally was fueled by unprecedented fiscal and monetary measures taken by the authorities everywhere. In the US, for example, the various new Federal Reserve liquidity programs add up to $4.2 trillion (20% of GDP) (Chart 2). The balance-sheets of major global central banks, particularly the Fed's, have ballooned in just a few weeks (Chart 3). As a result, US money supply and dollar liquidity have soared (Chart 4). Normally, when there is a flood of liquidity over and above what is needed to fund the real economy, that excess liquidity flows into asset markets, weakens the dollar, and boosts commodities and Emerging Markets. But these are not normal times. Liquidity injections amid deteriorating economic conditions cushion the downside but do not necessarily improve the outlook immediately – as we witnessed in 2007-2008.   Chart 2Multiple New Stimulus Programs… Chart 3...Made Central Bank Balance-Sheets Balloon... Chart 4...And Dollar Liquidity Soar Chart 5Pandemics Usually Have Several Waves The biggest risk is that the pandemic lingers. Epidemiologists agree that COVID-19 will not disappear until (1) a vaccine is available, likely to be 12-18 months (if one is possible at all – there is still no vaccine for HIV or SARS), or (2) 65-80% of the population has had the disease, creating “herd immunity”. Maybe a vaccine will be ready sooner, or a therapeutic treatment will drastically lower the mortality rate – but investors should not bet on it. It is worth remembering that the last big pandemic, the Spanish ‘flu of 1918-1919, had several waves, with the second the deadliest (Chart 5). It is possible that each time governments ease containment measures, the number of new cases will rise again. And even if they don’t, how likely is it that consumers will go back to shopping, eating in restaurants, or travelling as before? Big data from China show a general return to work but not to going out for entertainment (Chart 6). This is likely to remain a drag on the economy for a considerable period.   Chart 6Chinese Remain Reluctant To Go Out Moreover, the fiscal and stimulus packages will help to tide over households and companies in advanced economies during the toughest times – replacing lost wages, and providing bridging loans – but they do not solve the fundamental problem for firms that have lost most of their revenues. US corporate debt is at its highest percentage of GDP in recent history – and the ratio is even higher in parts of Europe, Japan, and China (Chart 7). Bankruptcies are likely to rise, which will make banks more cautious about lending, further tightening credit conditions. Moreover, stimulus packages won’t help Emerging Market borrowers, which have around $4 trillion of outstanding foreign-currency-denominated debt. With the sharp rise in EM credit spreads and fall in currencies over the past three months, many will struggle to service and repay this debt (Chart 8). Chart 7Corporate Debt Is At A Worrying Level Chart 8EM Dollar Borrowers Will Struggle     Portfolio construction is about probabilities. The scenario priced into risk assets currently – a rapid return to the status quo ante – could turn out to be correct. But there is a significant probability that it does not. We therefore recommend taking some risk off the table. We would not switch into quality government bonds as a hedge, since current yields would give little return even in a disastrous economic scenario – and could produce very negative returns if inflation picks up. We, rather, recommend Overweights in cash and gold, and a relatively low-beta tilt within equities.  Equities: Valuations, especially in the US, have not hit typical market-bottom levels. The price/book ratio for US equities, for example, troughed only at 2.9 in March, compared to a bear-market low of 1.5 in 2009 (Chart 9). Earnings will probably be revised down further: the consensus still expects only a 12% decline in S&P 500 EPS in 2020 (and a 21% jump next year); earnings revisions are usually closely correlated to stock prices (Chart 10). We, therefore, remain cautious in our regional equity positioning, with an Overweight on US stocks, and a somewhat defensive sector tilt (Overweights in IT and Healthcare, along with Industrials as a play on Chinese stimulus). One factor to watch: any sustained pickup in value and small-cap stocks, which showed some signs of appearing in late April (Chart 11). This has historically signaled the beginning of a bull market. Chart 9US Valuations Are Not At Usual Bottom Lows Chart 10Weak Earnings Can Drag Markets Down Further     Chart 11When Will Value And Small Caps Pick Up? Fixed Income: Quality government bonds look highly unattractive at current yields. Our calculations suggest only an 6.7% return from 10-year US Treasuries and 4.6% from Bunds even if their yields fall to the lowest possible level, 0% and -1% respectively. Inflation-linked bonds, especially in the US, the UK, Australia and Canada, look very undervalued, however.2 US 10-year breakevens have fallen to as low as 1.1% (Chart 12). In spread product, the best strategy at the moment is to buy what central banks are buying. That means investment-grade bonds in the US and Europe, Fallen Angels3  (since both the Fed and ECB will backstop bonds that were downgraded to junk in the past month), US Aaa CMBS and ABS, Agency CMBS, and munis. But the riskier end of the junk-bond universe looks unattractive. Even a moderate default cycle (with a 9% default rate for junk bonds – compared to 15% in the last recession – and a 25% recovery rate) would point to an excess return from B-rated corporate bonds of -20% over the next 12 months (Chart 13). Chart 12TIPS Look Very Cheap Chart 13Avoid The Lower End Of Junk Currencies: The dollar has moved sideways on a trade-weighted basis over the past two months. We remain Neutral, since in the short term the dollar could face upward pressure as a safe-haven play, especially versus Emerging Market currencies, if investors start to worry again about growth. In the longer run, however, the dollar looks expensive relative to purchasing power parity (Chart 14), and interest-rate differentials no longer favor it as they have done over much of the past decade (Chart 15). BCA Research’s FX strategists recommend a barbell strategy in currencies, with Overweights in cheap cyclical currencies such as the Canadian dollar and Norwegian krone, as well as safe havens such as the yen.4 Chart 14Dollar Is Expensive... Chart 15...And No Longer Benefits From Higher Rates     Commodities: After the extraordinary behavior of near-month WTI futures in April, the crude price should settle down. BCA Research’s energy strategists argue that renewed production cuts from Saudi Arabia and Russia, combined with a near-normalization in demand in H2, should push crude-oil balances back into a supply deficit by Q3 (Chart 16). Chart 16Oil Price Should Rise In H2 They forecast Brent to rise to $42 a barrel by the end of 2020, compared to $24 now. Industrial metals prices have generally remained depressed, despite the recovery in risk assets (Chart 17). But the effects of Chinese stimulus, combined with a weaker dollar, should cause them to recover later in the year (Chart 18). Gold remains a good hedge against further economic shocks or an eventual resurgence in inflation. Chart 17Metal Prices Haven't Recovered... Chart 18...But Should Soon Benefit From Chinese Stimulus   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 2  Please see Global Fixed Income Strategy, "Global Inflation Expectations Are Now Too Low," dated April 28, 2020. 3  Bonds that have recently been downgraded from investment grade to sub-investment grade. 4  Please see Foreign Exchange Strategy, "QE And Currencies," dated April 17, 2020. GAA Asset Allocation  

Highlights WTI futures contracts delivering into Cushing, Oklahoma, in June could trade or go off the board below $0.00/bbl next month, just as the May contracts did this month, when they changed hands at a low of -$40.32/bbl last week.  Oil storage at this critical hub is approaching its practical limit of 80% full, raising the odds of sub-zero pricing (Chart of the Week). Pricing pressures will accelerate the rate of oil-supply destruction in the US, particularly in the prolific shale-oil basins.  We are revising our estimate of US production losses upward to 1.6mm b/d this year, and to 2.3mm b/d from January 2020 to December 2021. Retail speculation – in the US via ETFs and long-only index exposure, and in China via bank wealth-management products – is compounding WTI price volatility. The CME Group, which operates the NYMEX WTI futures and options markets, will be forced to address storage constraints in Cushing, and will have to better manage retail-spec positioning: These factors increase the probability of negative pricing and exacerbate price volatility as contracts go off the board. Feature The stunning -$40.32/bbl print for May 2020 WTI futures last week marks the first time this global oil benchmark has traded below $0.00/bbl. Negative prices are nothing new to non-storable commodities. In electricity markets, for example, wholesale prices go negative to force generation offline to balance supply and demand so that markets clear.1 Negative pricing also is seen in natural gas markets. It is occurring in the Permian basin with greater frequency, due to insufficient pipeline take-away capacity for all of the associated gas being produced there as oil output in the basin soars. This leaves no alternative to producers but to either shut in oil production or flare the associated gas. Indeed, forward natgas prices at the Waha Hub in Pecos County, Texas, recently have traded below zero for prolonged periods, owing to the surge in Permian oil production (Chart 2).2 Chart of the WeekCushing Approaches Crude Storage Limit Chart 2Lack Of Storage Pushes Natgas Prices Below Zero   Markets once again were reminded WTI futures are far more than electronic blips on computer screens: They are binding legal contracts to physically deliver light-sweet West Texas Intermediate (WTI) crude oil into the Cushing, Oklahoma, pipeline and storage hub. The stunning -$40.32/bbl print for May 2020 WTI futures last week marks the first time this global oil benchmark has traded below $0.00/bbl since the 1983 introduction of the NYMEX crude oil futures (Chart 3). Markets once again were reminded WTI futures are far more than electronic blips on computer screens: They are binding legal contracts to physically deliver light-sweet West Texas Intermediate (WTI) crude oil into the Cushing, Oklahoma, pipeline and storage hub. Going off the board long requires contract holders to take delivery into a pipeline or storage facility; going off short requires contract holders to make delivery. Chart 3WTI June Futures Could Go Below $0.00/bbl Owing to structural flaws in the delivery mechanism for WTI futures, and what appears to be a lapse in monitoring positions in the spot-month contract as May 2020 WTI was going off the board last week, the likelihood June 2020 WTI contracts pricing below $0.00/bbl is high. These flaws must be addressed by the CME Group’s NYMEX division and federal regulators, given the WTI futures contract’s importance to the global physical market and the capital at risk. Implications Of Negative WTI Prices Storage at Cushing is, for all intents and purposes, full. Cushing accounts for ~ 15% of the total 653mm barrels of US crude oil storage, which was only at 60% of capacity in mid-April, based on the US EIA’s reckoning. However, Cushing is the delivery point of the physically settled WTI futures contracts traded on the NYMEX. With close to 80% of capacity filled – ~ 58mm barrels of the total capacity of ~ 76mm barrels – the operational limit of storage has been reached at Cushing. This is amply seen in the June-vs-July intermonth spread between futures, which, earlier this week, settled at more than $5/bbl – i.e., more than 10x the then-elevated 50 cents/bbl/month being charged to store oil in Cushing in March (Chart 4). Intermonth spreads are used as proxies for the cost of storage for physically delivered contract that actually can be stored, like oil. If physical surpluses cannot be moved out of regions where storage is full – and pipelines also are full – prices are forced lower and lower until enough production is shut in to allow storage to drain and inventories to return to normal levels. This is happening now in Oklahoma and the prolific Texas shale basins, and other shale basins in the US where horizontal rigs are being laid down and drilling crews are being laid off (Chart 5). Chart 4Intermonth-Spread Blow Out Indicates Full Cushing Storage Chart 5Texas Horizontal Rig Counts Collapse We are revising our estimate of US production losses upward for this year, and to 2.3mm b/d from January 2020 to December 2021. In our most recent modeling of US shale-oil production, we expect these pricing pressures to accelerate the rate of oil-supply destruction, particularly in the prolific shale-oil basins. In fact, we are revising our estimate of US production losses upward for this year, and to 2.3mm b/d from January 2020 to December 2021 (Chart 6). Depending on how long WTI prices stay depressed in the key producing basins, this supply destruction could be even more pronounced. The same is true of global storage: Kpler, the oil-storage tracker, last week estimated global onshore inventories were 85% full.3 Until sufficient supply destruction occurs to offset the COVID-19-induced demand destruction, inventories cannot draw. Floating storage also is surging, as the crude and product forward curves fall deeper into contango, and incentivize holding stocks on the water (Chart 7). Chart 6Lower Prices Will Push US Oil Output Lower Chart 7Floating Storage Volumes Surge Price will go low enough – negative if needs be – to clear surplus supply to rebalance markets. Storage acts as a shock absorber for physical commodities like crude oil – when there is more supply than demand, the physical surplus is moved to storage until it is needed, and vice versa when there is a physical deficit. When inventories fill in Cushing – arguably the most important crude-oil delivery hub in the world, given WTI is the most liquid crude oil futures contract in the world – it is as if there is no storage at all there. At this point, market for WTI behaves a lot like electricity, which cannot be stored (at least at utility scale), or natgas at Waha, where storage and pipeline takeaway capacity are in very short supply. In such circumstances, price will go low enough – negative if needs be – to clear surplus supply to rebalance markets. This appears to be what spooked markets last week when WTI futures for May delivery traded as low as -$40.32/bbl. Retail Specs Push WTI Volatility Higher Speculators perform a vital and necessary function in futures markets – they willingly accept risk hedgers want to shed. Natural longs – i.e., producers – do not want to sell when prices are low, which is when natural shorts want to buy. Likewise, natural shorts – i.e., consumers – don’t want to buy when prices are high, which is when natural longs want to sell. Speculators provide the liquidity that allows producers and consumers to hedge. When prices are relatively high, they can provide a bid to oil producers looking to hedge production – they may be short-term traders or have a view prices are going higher, or they may be getting out of short positions they put on earlier. When prices are low, speculators provide offers – selling futures because they are short-term traders, or have a view prices are going lower, or they are getting out of long positions. Speculators trade on information and typically never stand for delivery of futures like WTI, which means they typically are out of prompt-month contracts before they are getting ready to go off the board. At that point, only physical-market participants – producers, consumers and physical traders – are left in the market balancing their physical books. When speculators find themselves trading WTI futures as they are getting ready to go to delivery, something in their risk-management systems has gone terribly wrong. Not only do they not trade the physical oil, but they don’t know who to call to take them out of their risk. Something also has gone terribly wrong at the regulatory level: At the CME, which, as the operator of the NYMEX oil trading markets, and at the US Commodity Futures Trading Commission (CFTC) in Washington, D.C. The CME is the self-regulatory organization responsible for ensuring its rules are followed and markets trade in an orderly fashion, and, at the federal level, the CFTC exercises oversight and enforces laws and regulations. It appears Bank of China (BOC), the fourth largest bank in China and the world, has found itself holding long positions in WTI futures delivering in May on the last two days of trading last week. These contracts supported wealth-management products – known as “bao” or treasure – the state-owned bank offered its retail clients.4 Other banks in China also offer such products, but it appears BOC was the only one that did not roll out of its delivery exposure in a timely manner.5 The exposure BOC was trying to trade out of was not huge by normal standards, but after settling its open May futures at -$37.63/bbl, BOC clients apparently lost close to $1.3 billion.6 How the CME or the CFTC allowed a commercial bank with no capability to take delivery of WTI in Cushing against a long NYMEX WTI futures contract as it was going off the board is a mystery. Markets will have to wait for a detailed post-mortem to determine what exactly happened, and how. Retail Piles Into WTI Exposure The experience of BOC – and, most likely, the shock of such deeply negative WTI prices realized upon settlement of these contracts – and a change in US regulations on spot-month position limits for futures used by commodity-pool operators prompted a wholesale exodus from spot-month WTI futures – the June 2020-delivery WTI futures that deliver in Cushing – this week. As a result, the commodity-pool operator running the United States Oil Fund (USO) ETF and S&P Dow Jones, which designs and markets long-only commodity index products for investors – e.g., the S&P GSCI index – rolled their June WTI futures into July and later months in an effort to avoid holding length in the June contract out of fear these futures could trade negative.7 USO is geared to retail investors, and inflows are negatively correlated with front-month WTI futures prices – when prices tank retail investors pile into the ETF (Chart 8). This can dramatically increase the number of futures the fund has to buy to provide its product to retail investors. Chart 8Retail Piles Into WTI Futures Exposure Markets were exceptionally volatile early in the week as these fire sales were being executed. The $3.6 billion USO ETF, in particular, apparently was ordered to spread its spot-month exposure (June WTI) across the forward curve by the CME over the first three days of this week. This action was taken to keep the USO ETF from exceeding new position-limit levels in the spot-month contract, which go into effect May 1, and state no entity can have more than 25% of total open interest in the WTI spot contract.8 Markets were exceptionally volatile early in the week as these fire sales were being executed. This rolling out of June WTI exposures should reduce – but not eliminate – the selling pressure on front-month WTI futures contracts by providers of retail and institutional commodity exposure as June goes off the board next month. However, if storage at Cushing remains at tank tops, the rolling by these ETFs that source futures liquidity to hedge their exposures could again push spot prices below $0.00/bbl as the June WTI futures go off the board May 19.9 That said, it is difficult to ascertain exactly what exposure retail investors are getting now when they buy the USO ETF – its WTI futures now span contracts into next year, based on news reports. This could prompt investors to jettison positions, setting up another round of fire sales in WTI futures. Markets also will expect a post-mortem explaining how the CME and CFTC allowed this retail-focused fund could exceed position limits in spot-month WTI futures contracts so significantly at any point in time, let alone when Cushing infrastructure is so extraordinarily taxed. WTI Futures Contract Flaws Contribute To Volatility The CME has failed to find a way to ensure those holding futures that are going off the board are bona fide hedgers capable of making and taking delivery, as the BOC experience showed. The CME Group has not acquitted itself well in the termination of May 2020 futures trading. And, as researchers at the Oxford Institute for Energy Studies note, the past couple of weeks have exposed deep flaws in the WTI futures contracts’ physical-delivery mechanisms, which have been persistent.10 The lack of sufficient storage at Cushing to accommodate the volume of trading in WTI futures is not a new problem. In 2009, the Kingdom of Saudi Arabia changed its pricing benchmark for US sales to the Argus Sour Crude Index for its crudes sold into the US Gulf, because the WTI contract detached from fundamentals then owing to infrastructure constraints at Cushing. The CME has failed to find a way to ensure those holding futures that are going off the board are bona fide hedgers capable of making and taking delivery, as the BOC experience showed. In addition, the CME has shown it has no institutionalized automatic delivery procedures that kick in when Cushing storage is full – e.g., making and taking delivery, say, in the US Gulf using a WTI contract loaded for export, as the OIES researchers observe. Lastly, as of April 22, the CME is using an options-pricing model based on the original theory on random walks developed by the great Louis Bachelier in 1900, which assumes prices are normally distributed and can go below zero, vs. its previous methodology using Fischer Black’s commodity option pricing model, which assumes prices are log-normally distributed and have a lower boundary of zero.11 We’ll be exploring this in further research.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Exports from OPEC countries increased by more than 2mm b/d in April – led by Saudi Arabia and UAE – according to Petro-Logistics – a seaborne oil trade analytics company. This is flooding global markets while global demand is expected to drop to its lowest level since 2Q03 this month. Separately, we are revising up our Canadian oil sands shut-in estimates to ~ 800k b/d in 2Q20 from ~ 500k b/d, as US demand for Canadian oil will be hit more severely than we previously anticipated and local storage is filling rapidly. Rystad Energy now expects Canadian capex to fall 41% y/y in 2020. This will have a lasting impact on the industry’s production capacity. Base Metals: Neutral The LMEX rose 3% since the start of April – led by nickel and copper prices moving up by ~ 6%. Base metals – chiefly aluminum and copper – are poised to rebound in 2Q20 if China’s economy continues to improve and is not hit by a second wave of COVID-19 infections. According to BCA’s China Investment Strategy, the country’s fiscal response is now expected to reach 10% of its GDP this year. This will support further upside in base metals prices (Chart 9). Precious Metals: Neutral Despite the record fiscal and monetary stimulus deployed globally, consumer and market-based inflation expectations remain low, as markets focus on the deflationary effects of the COVID-19 shock and the uncertainty about the speed of the recovery (Chart 10). The low realized inflation post-GFC stimulus could influence investors’ expectations down. We see inflation risks as materially higher which will warrant larger protection in a diversified portfolio over the coming year. Inflation expectations will normalize later this year and next, boosting inflation hedges. Nominal bonds’ protection will remain expensive as rates in major DM countries are expected to stay low for a prolonged period. Chart 9 Chart 10       Footnotes 1     Please see Bajwa, Maheen and Joseph Cavicchi, “Growing Evidence of Increased Frequency of Negative Electricity Prices in U.S. Wholesale Electricity Markets.” IAEE Energy Forum, 4th Quarter 2017. 2     Please see U.S. Gas Prices Turn Negative at Texas Waha Hub published by the Pipeline & Gas Journal March 3, 2020. The article notes, “The first swing to negative spot prices in almost seven months occurred due to pipeline constraints and as mild weather cut heating demand. Prices in the forward market have been trading below zero for weeks on expectations there will not be enough pipelines to transport record amounts of gas from the region’s shale oil fields. That gas that comes from oil wells, called associated gas in the industry, helped propel U.S. gas output to record highs, driving prices to their lowest in years as production outpaces demand for the fuel. Analysts expect gas prices in 2020 to fall to their lowest since 1999.” 3    Please see Oil prices sink as world runs low on storage capacity amid frail demand published by reuters.com April 28, 2020. The IEA estimates total onshore storage globally at close to 7 billion barrels, according to the Center for Strategic & International Studies in Washington, D.C. Please see The Oil Inventory Challenge published by the CSIS April 20, 2020, which notes the US has ~ 1.3 billion barrels of storage, while China has an estimated 1.5 billion barrels. Of that ~ 7 billion barrels of nameplate capacity, ~ 80%, or ~ 5.6 billion barrels, represents the operational limit. 4    Please see The world's 100 largest banks published by S&P Global Market Intelligence April 5, 2019. 5    Please see China's ICBC closes commodity-linked products to new investment published by reuters.com April 27, 2020. 6    Please see Bank of China says main investors to settle crude oil product at -$37 published by reuters.com on April 22, 2020. 7     Please see Futures contract moves endangering WTI prices again published by worldoil.com April 28, 2020. 8    Please see USO ETF pushes oil futures exposure out to June 2021 published by etfstrategy.com April 27, 2020. Earlier this month, the USO ETF has accounted for close to 30% of June WTI futures. Please see Biggest Oil ETF Shakes Up Structure published by etf.com April 17, 2020. 9    The USO ETF is not the only fund sourcing futures liquidity to provide retail exposure to WTI, but it is by far the largest. Please see Oil ETF roils already volatile crude markets published April 27, 2020, by investmentnews.com. 10   Please see Oil Benchmarks Under Stress published by OIES April 28, 2020. 11    Please see Davis, Mark, and Alison Etheridge. Louis Bachelier's Theory of Speculation: The Origins of Modern Finance. Princeton University Press, 2006; and Black, Fischer, “The Pricing of Commodity Contracts,” Journal of Financial Economics, Vol. 3, (1976), pp. 167-79, reprinted with permission in Interrelations Among Futures, Option, and Futures Option Markets (1992), the Board of Trade of the City of Chicago publisher.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades

Special Report

Highlights In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession. The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. Even when narrowly-defined, the announced (or likely) fiscal response of the US, China, and Germany is quite large and appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. This is not the case, however, in other euro area economies (France, Italy, and Spain), or in emerging markets. Our analysis also suggests that the global fiscal response will need to increase if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year. This underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. Feature The global economic expansion that began in 2009 has come to an abrupt end due to the COVID-19 pandemic. Aggressive containment measures necessary to control the spread of the disease and prevent the collapse in health care systems around the world have caused a large and sudden stop in global economic activity, which has prompted unprecedented responses from governments around the world. In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession (characterized by a very prolonged return to trend growth). The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. But for now, we (tentatively) conclude that the fiscal response appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. However, there are two important caveats. First, while Germany has provided among the strongest fiscal responses globally, measures in France, Italy, and Spain are still lacking and must be stepped up. Second, the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year – more will have to be done. For policymakers, this underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. In this regard, the gradual re-opening of several US states by early-May, while positive for economic activity in the short-run, is a non-trivial risk to the US and global economic outlooks over the coming 6-12 months. This risk must be closely watched by investors. The Global Fiscal Response: Comparing Across Countries And Across Measures The flurry of policy announcements from national governments over the past six weeks has led to a great degree of confusion about the size and disposition of the global COVID-19 fiscal response. Our analysis is based heavily on the IMF’s tracking of these measures, albeit with a few adjustments. We also rely on analysis from Bruegel, a prominent European macroeconomic think-tank, as well as our own Geopolitical Strategy team and a variety of news reports. Chart II-1 presents the IMF’s estimate of the total fiscal response to the crisis across major countries, as of April 23rd, broken down into “above-the-line” and “below-the-line” measures. Above-the-line measures are those that directly impact government budget balances (direct fiscal spending and revenue measures, usually tax deferrals), whereas below-the-line measures typically involve balance sheet measures to backstop businesses through capital injections and loan guarantees. Chart II-1The Global Fiscal Response Is Huge When Including All Measures Chart II-1 makes it clear that the fiscal response of advanced economies is enormous when including both above- and below-the-line measures. By this metric, the response of most developed economies is on the order of 10% of GDP, and well above 30% in the case of Italy and Germany. However, using the sum of above- and below-the-line measures to gauge the fiscal response of any country may not be the ideal approach, given that below-the-line measures are contingent either on the triggering of certain conditions or on the provision of credit to households and firms from the financial system. Below-the-line measures also likely increase the liability position of the private sector, thus raising the odds of negative second-round effects. Instead, Chart II-2 compares the countries shown in Chart 1 based only on the IMF’s estimate of above-the-line measures, and with a 4% downward adjustment to Japan’s reported spending to account for previously announced measures.8 The chart shows that countries fall into roughly three categories in terms of the magnitude of their above-the-line response: in excess of 4% of GDP (Australia, the US, Japan, Canada, and Germany), 2-3% (the UK, Brazil, and China), and sub-2% (all other countries shown in the chart, including Spain, Italy, and France). Chart II-2The Picture Changes When Excluding Below-The-Line Measures Analysis by Bruegel provides somewhat different estimates of the global COVID-19 fiscal response for select European countries as well as the US (Table II-1). Bruegel breaks down discretionary fiscal measures that have been announced into three categories: those involving an immediate fiscal impulse (new spending and foregone revenues), those related to deferred payments, and other liquidity provisions and guarantees. Bruegel distinguishes between the first and second categories because of their differing impact on government budget balances. Deferrals improve the liquidity positions of individuals and companies but do not cancel their obligations, meaning that they result only in a temporary deterioration in budget balances. Table II-1The Type Of Fiscal Response Varies Significantly Across Countries Table II-1 highlights that Bruegel’s estimates of the sum of above- and below-the-line measures are similar to the IMF’s estimates for the US, the UK, and Spain, but are smaller for Italy and larger for France and Germany (particularly the latter). These differences underscore the extreme uncertainty facing investors, who have to contend not only with varying estimates of the magnitude of government policies but also a torrent of news concerning the evolution of the pandemic itself. Chart II-3 presents our best current estimate of the above-the-line fiscal response of several countries (the measure we deem to be most likely to result in an immediate fiscal impulse), by excluding loans, guarantees, and non-specified revenue deferrals to the best of our ability.2 Chart II-3 is based on a combination of data from the IMF, Bruegel analysis, and BCA estimates and news analysis. Chart II-3When Narrowly Defined, Several Countries Are Responding Forcefully, But Many Countries Are Not Overall, investors can draw the following conclusions from Charts II-1 – II-3 and Table II-1: When measured as the total of above- and below-the-line measures, nearly all large developed market countries have responded with sizeable measures. Emerging market economies are the clear laggards. Excluding below-the-line measures and using our approach, Australia, the US, China, Germany, Japan, and Canada appear to be spending the most relative to the size of their economies. While Japan’s “headline” fiscal number was inflated by including previously-announced spending, it is still decently-sized after adjustment. Outside of Germany, the rest of Europe appears to be providing a middling or poor above-the-line fiscal response. The UK appears to be providing between 4-5% of GDP as a fiscal impulse, whereas the fiscal response in Italy, Spain, and France looks more like that of emerging markets than of advanced economies. Measuring The Stimulus Against The Shock Despite the substantial amount of new information over the past six weeks concerning the evolution of the pandemic and the attendant policy response, it remains extremely difficult to judge what the balance between shock and stimulus will be and what that means for the profile of growth. Nonetheless, below we present a framework that investors can use to approach the question, and that can be updated as new information emerges concerning the impact of the shutdowns and the extent of the response. Our approach involves analyzing four specific questions: What is the size of the initial shock? What are the likely second-round effects on growth? What is the likely multiplier on fiscal spending? Will the composition of fiscal spending alter its effectiveness? The Size Of The Initial Shock Chart II-4 presents the OECD’s estimates of the initial impact of partial or complete shutdowns on economic activity in several countries. The OECD first used a sectoral approach to estimating the impact on activity while lockdowns are in effect, assuming a 100% shutdown for manufacturing of transportation equipment and other personal services, a 50% decline in activity for construction and professional services, and a 75% decline for retail trade, wholesale trade, hotels, restaurants, and air travel. Chart II-4 illustrates the total impact of this approach for key developed and emerging economies. Chart II-4Annual GDP Will Be 1.5%-2.5% Lower For Each Month Lockdowns Are In Effect The OECD’s approach provides a credible estimate of the impact of aggressive containment policies, and implies that annual real GDP is likely to be 1.5-2.5% lower for major countries for each month that lockdown policies are in effect. This implies that output in major economies is likely to fall 3.5% - 6% for the year from the initial shock alone, assuming an aggressive 10-week lockdown followed by a complete return to normal. Estimating Potential Second Round Effects Chart II-5 presents projections from the Bank for International Settlements on the spillover and spillback potential of a 5% initial shock to the level of global GDP from the COVID-19 pandemic (equivalent to a 20% impact on an annualized basis). Chart II-5Additional Lockdown Events Are A Greater Risk Than First Wave After-Effects The chart shows that the cumulative impact of the initial shock rises to 7-8% by the end of this year for the US, euro area, and emerging markets, and 6% for other advanced economies. These estimates account for both domestic second round effects of the initial shock, as well as the reverberating impact of the shock on global trade. Chart II-5 also shows the devastating effect that a second wave of COVID-19 emerging in the second half of the year would have after including spillover and spillback effects, assuming that only partial lockdowns would be required. In this scenario, the level of GDP would be 10-12% lower at the end of the year depending on the region, suggesting that investors should be more concerned about the possibility of additional lockdown events than they should be about the after-effects of the first wave of infections (more on this below). Will Fiscal Multipliers Be High Or Low? When examining the academic literature on fiscal multipliers, the first impression is that multipliers are likely to be extremely large in the current environment. Tables II-2 and II-3 present a range of academic multiplier estimates aggregated by the IMF, categorized by the stage of the business cycle and whether the zero lower bound is in effect. Table II-2Fiscal Multipliers Are Much Larger During Recessions Than Expansions Table II-3Models Suggest The Multiplier Is Quite High At The Zero Lower Bound The tables tell a clear story: multipliers are typically meaningfully larger during recessions than during expansions, and extremely large when the zero lower bound (ZLB) is in effect. However, there are at least two reasons to expect that the fiscal multiplier during this crisis will not be as large as Tables II-2 and II-3 suggest. First, it is obviously the case that the multiplier will be low while full or even partial lockdowns are in effect, as consumers will not have the ability to fully act in response to stimulative measures. This will be partially offset by a burst of spending once lockdowns are removed, but the empirical multiplier estimates during recessions shown in Table II-2 have not been measured during a period when constraints to spending have been in effect, and we suspect that this will have at least somewhat of a dampening effect on the efficacy of fiscal spending relative to previous recessions (even once regulations concerning store closures are removed). Second, Table II-3 likely overestimates the multiplier at the ZLB. These estimates have been based on models rather than empirical analysis, and appear to be in reference to the prevention of large subsequent declines in output following an initial shock. The modeled finding of a large multiplier at the ZLB occurs because increased deficit spending will not lead to higher policy rates in a scenario where the neutral rate has fallen below zero. But it seems difficult to believe that the fiscal multiplier during ZLB episodes, defined as the impact of fiscal spending on the path of output relative to the initial shock (not relative to a counterfactual additional shock), is larger than the highest empirical estimates of the multiplier during recessions. The only circumstance in which we can envision this being the case is an environment where long-term bond yields are capped and remain at zero, alongside short-term interest rates, as the economy improves. The IMF has provided a simple rule of thumb approach to estimating the fiscal multiplier for a given country. The IMF’s approach involves first estimating the multiplier under normal circumstances based on a series of key structural characteristics that have been shown to influence the economy’s response to fiscal shocks. Then, the “normal” multiplier is adjusted higher or lower depending on the stage of the business cycle, and whether monetary policy is constrained by the ZLB. For the US, the IMF’s approach suggests that a multiplier range of 1.1 – 1.6 is reasonable, assuming the highest cyclical adjustment but no ZLB adjustment (see Box II-1 for a description of the calculation). Given the unprecedented nature of this crisis, we are inclined to use the low end of this range (1.1) as a conservative assumption when judging whether fiscal responses to the crisis are sufficient. For investors, this means that governments should be aiming, at a minimum, for fiscal packages that are roughly 90% of the size of the expected shock of their economies, using our US fiscal multiplier assumption as a guide. Box II-1 The “Bucket” Approach To Estimating Fiscal Multipliers The IMF “bucket” approach to estimating fiscal multiplier involves determining the multiplier that is likely to apply to a given country during “normal” circumstances, based on a set of structural characteristics associated with larger multipliers. This “normal” multiplier is then adjusted based on the following formula: M = MNT * (1+Cycle) * (1+Mon) Where M is the final multiplier estimate, MNT is the “normal times” multiplier derived from structural characteristics, Cycle is the cyclical factor ranging from −0.4 to +0.6, and Mon is the monetary policy stance factor ranging from 0 to 0.3. The Cycle factor is higher the more a country’s output gap is negative, and the Mon factor is higher the closer the economy is to the zero lower bound. Table II-B1 applies the IMF’s approach to the US, using the same structural score as the IMF presented in the note that described the approach. The table highlights that the approach suggests a US fiscal multiplier range of 1.1 – 1.6 given the maximum cycle adjustment proscribed by the rule, which we feel is reasonable given the unprecedented rise in US unemployment. We make no adjustment to the range for the zero lower bound. Table II-B1A Multiplier Estimate Of 1.1 – 1.6 Seems Reasonable For The US The Composition Of The Response: Helping Or Hurting? The last of our four questions deals with the issue of composition and whether the form of a country’s fiscal response is likely to alter its effectiveness. We implicitly addressed the first element of composition, whether measures are above-the-line or below-the-line, by comparing Charts II-1 - II-3 on pages 28-31. Our view is that above-the-line measures are far more important than below-the-line measures, as the former provides direct income and liquidity support. Below-the-line measures are also important, as they are likely to help reduce business failure and household bankruptcies. The fiscal multiplier on these measures has to be above zero, but it is likely to be much lower than that of an above-the-line response. The second element of composition concerns the appropriate distribution of aid among households, businesses, and local governments. On this particular question, it remains extremely challenging to analyze the issue on a global basis, owing to a frequent lack of an explicit breakdown of fiscal measures by recipient. Chart II-6Much Of The US Fiscal Response Is Going To Households And Small Businesses For now, we limit our distributional analysis to the US, and hope to expand our approach to other countries in future research. Chart II-6 presents a breakdown of the US fiscal response by recipient, which informs the following observations. Households: Chart II-6 highlights that US households will receive approximately $600 billion as part of the CARES Act, roughly half of which will occur through direct payments (i.e. “stimulus checks”) and another 40% from expanded unemployment benefits. In cases where the federal household response has been criticized by members of the public as inadequate, it has often been compared to income support programs of other countries. The Canada Emergency Response Benefit (“CERB”) is a good example of a program that seems, at first blush, to be superior: it provides $2,000 CAD in direct payments to individuals for a 4 week period, for up to 16 weeks (i.e. a maximum of $8,000 CAD), which seems better than a $1,200 USD stimulus check. However, Table II-4 highlights that this comparison is mostly spurious. First, the CERB is not universal, in that it is only available to those who have stopped or will stop working due to COVID-19. At a projected cost of $35 billion CAD, the CERB program represents 1.5% of Canadian GDP. By comparison, $600 billion USD in overall household support represents 2.75% of US GDP; this number drops to 1.75% when only considering support to those who have lost their jobs, but this is still higher as a share of the economy than in Canada. Moreover, there is little question that Congress is prepared to pass more stimulus for additional weeks of required assistance. The discrepancy between the perception and reality of US household sector support appears to be rooted in the speed of payments. Speed is the one area where Canada’s household sector response appears to have legitimately outperformed the US; CERB payments are received by applicants within three business days for those registered for electronic payment, and in some cases they are received the following day. By contrast, it has taken some time for US States to start paying out the additional $600 USD per week in expanded unemployment benefits, but as of the middle of last week nearly all states had started making these payments. Table II-4US Household Relief Is Just As Generous As Seemingly Better Programs Firms: On April 16th the Small Business Administration announced that the Paycheck Protection Program (“PPP”) had expended its initial budget of $350 billion. While additional funds of $320 billion have subsequently been approved (plus $60 billion in small business emergency loans and grants), the run on PPP funds was, to some investors, an implicit sign that the CARES Act was inadequately structured. However, the fact that the initial funds ran out in mid-April simply reflects the reality that social distancing measures had been in place for 3-4 weeks by the time that the program began taking applications. Table II-5 highlights that $350 billion was large enough to replace nearly 90% of lost small business income for one month, assuming that overall small business revenue has fallen by 50% and that small businesses account for 44% of total GDP. The Table also shows that a combined total of $730 billion is enough to replace almost 80% of lost small business income for 10 weeks, given these assumptions. With loan forgiveness at least partially tied to small businesses retaining employees on payroll for an 8-week period, the PPP is also essentially an indirect form of household income support. Table II-5Help For Small Businesses Will Replace A Significant Amount Of Lost Income Chart II-7Persistent State & Local Austerity Must Be Avoided This Time State & Local Governments: The magnitude of support for state & local (S&L) governments appears to be the least-well designed element of the US fiscal response. The CARES Act provides for $170 billion in support to S&L, which at first blush seems large as it is approximately 25% of S&L current receipts in Q4 2019 (i.e. it stands to cover a 25% loss in revenue for one quarter). However, this does not account for the significant reported increase in S&L costs to combat the pandemic, nor does it provide S&L governments with any revenue certainty beyond June 30th when most of the assistance from CARES must be spent. Unlike households or firms, who also face significant uncertainty, nearly all US states are subject to balanced budget requirements, which prevent them from spending more than they collect in revenue. When faced even with projected revenue losses in the second half of this year and into 2021, states are likely to aggressively and immediately cut costs in order to avoid budgetary shortfalls. Chart II-7 highlights that S&L austerity was a significant element of the persistent drag on real GDP growth from overall government expenditure and investment in the first 3-4 years of the post-GFC economic expansion. A repeat of this episode would significantly raise the odds of an “L-type” recession (and thus should certainly be avoided). This is why Congress is moving to pass larger state and local aid. Our Geopolitical Strategy team argues that neither President Trump nor Senate Majority Leader Mitch McConnell will prevent the additional financial assistance that US states will require, despite their rhetoric about states going bankrupt.3 A near-term, temporary standoff may occur, but Washington will almost certainly act to provide at least additional short-term funding if state employment starts to fall due to budget pressure. So while we recognize that the state & local component of the US fiscal response is currently lacking, it does not seem likely to represent a serious threat to an eventual economic recovery in the US. Putting It All Together: Will It Be Enough? Chart II-8 reproduces Chart II-3 with an assumed fiscal multiplier of 1.1, and with shaded regions denoting the likely initial and total impact on GDP from aggressive containment measures (based on the OECD and BIS’ estimates). Based on our analysis of the US fiscal response, we make no adjustments for the composition of the measures beyond defining the fiscal response on a narrow basis (i.e. excluding loans, guarantees, and non-specified revenue deferrals). The chart highlights that the narrowly-defined fiscal response of three key economies driving global demand, the US, China, and Germany, is either at the upper end or above the total impact range. Thus, for now, we tentatively conclude that the fiscal response that has or will happen appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event, especially since Chart II-8 explicitly excludes below-the-line measures. However, there are two important caveats to this conclusion. First, Chart II-8 makes it clear that measures in France, Italy, and Spain are still lacking and must be stepped up. Italy and France have provided a substantial below-the-line response, but it is far from clear that a debt-based response or one that only temporarily improves access to cash for households and businesses will be enough to prevent a prolonged fallout from the sudden stop in economic activity and income. Chart II-8Several Important Countries Seem To Be Doing Enough, But More Is Needed In Europe Ex-Germany Second, our analysis suggests that the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year or if these measures remain in place at half-strength for many months. This underscores how sensitive the adequacy of announced fiscal measures are to the amount of time economies remain under full or partial lockdown. As such, it is crucial for investors to have some sense of when advanced economies may be able to sustainably end aggressive containment measures. When Can The Lockdowns Sustainably End? Several countries and US states have already announced some reductions in their restrictions, but the question of how comprehensive these measures can be without risking a second period of prolonged stay-at-home orders looms large. Table II-6 presents two different methods of estimating sustainable lockdown end dates for several advanced economies. First, we use the “70-day rule” that appears to have succeeded in ending the outbreak in Wuhan, calculated from the first day that either school or work closures took effect in each country.4 Second, using a linear trend from the peak 5-day moving average of confirmed cases and fatalities, we calculate when confirmed cases and fatalities may reach zero. Table II-6By Re-Opening Soon, The US May Be Risking A Damaging Second Wave The table highlights that these methods generally prescribe a reopening date of May 31st or earlier, with a few exceptions. The UK’s confirmed case count and fatality trends are still too shallow to suggest an end of May re-opening, as is the case in Canada. In the case of Sweden, no projections can truly be made based on the 70-day rule because closures never formally occurred. But the most problematic point highlighted in Table II-6 is that US newly confirmed cases are only currently projected to fall to zero as of February 2021. Chart II-9 highlights that while new cases per capita in New York state are much higher than in the rest of the country, they are declining whereas they have yet to clearly peak elsewhere. Cross-country case comparisons can be problematic due to differences in testing, but with several US states having already begun the gradual re-opening process, this underscores that US policymakers may be allowing a dangerous rise in the odds of a secondary infection wave. Chart II-9No Clear Downtrend Yet Outside Of New York State Investment Conclusions Our core conclusion that an “L-shaped” global recession is likely to be avoided is generally bullish for equities on a 12-month horizon. However, uncertainty remains extremely elevated, and the recent rise in stock prices in the US (and globally) has been at least partially based on the expectation that lockdowns will sustainably end soon, which at least in the case of the US appears to be a premature conclusion given the current lack of large-scale virus testing capacity. As such, we are less optimistic towards risky assets tactically, and would recommend a neutral stance over a 0-3 month horizon. As noted above, our cross-country comparison of narrowly-defined fiscal measures suggested that euro area countries (excluding Germany) will likely have to do more in order to prevent a long period of below-trend growth. In the case of highly-indebted countries like Italy, this raises the additional question of whether a significantly increased debt-to-GDP ratio stemming from an aggressive fiscal impulse will cause another euro area sovereign debt crisis similar to what occurred from 2010-2014. Chart II-10Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Government debts are sustainable as long as interest rates remain below economic growth, and from this vantage point Italy should spend as much as needed in order to ensure that nominal growth remains above current long-term government bond yields. Chart II-10 highlights that, despite a widening spread versus German bunds, Italian 10-year yields are much lower today than they were during the worst of the euro area crisis, meaning that the debt sustainability hurdle is technically lower. However, we have also noted in previous reports that high-debt countries often face multiple government debt equilibria; if global investors become fearful that that high-debt countries may not be able to repay their obligations without defaulting or devaluing, then a self-fulfilling prophecy will occur via sharply higher interest rates (Chart II-11). Chart II-11Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort Chart II-12Italy's Structural Budget Balance Has Improved For now, we view the risk of a renewed Italian debt crisis from significantly increased spending related to COVID-19 as minimal, and it is certainly lower than the status quo as the latter risks causing a sharp gap between nominal growth and bond yields like what occurred from 2010 – 2014. First, Chart II-12 highlights that Italy has succeeded in somewhat reducing its structural balance, which averaged -4% for many years prior to the euro area crisis. Assuming an adequate global response to the crisis and that economic recovery ensues, it is not clear why global bond investors would be concerned that Italian structural deficits would persistently widen. Second, the ECB is purchasing Italian government bonds as part of its new Pandemic Emergency Purchase Program, which will help cap the level of Italian yields. Chart II-13Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Third, Chart II-13 shows what will occur to Italy’s government debt service ratio (general government net interest payments as a percent of GDP) in a scenario where Italy’s gross debt to GDP rises a full 20 percentage points and the ratio of net interest payments to debt remains unchanged. The chart shows that while debt service will rise, it will still be lower than at any point prior to 2015. So not only should Italy spend significantly more to combat the severely damaging nature of the pandemic, we would expect that Italian spreads would fall, not rise, in such an outcome. Jonathan LaBerge, CFA Vice President Special Reports Footnotes 1  Skeptical economists call Japan’s largest-ever stimulus package ‘puffed-up’, Keita Nakamura, The Japan Times, April 8, 2020. 2  Please note that Chart II-3 differs somewhat from a chart that has been frequently shown by our Geopolitical Strategy service. Both charts are accurate; they simply employ different definitions of the fiscal response to the pandemic. 3 Indeed, McConnell has already walked back his comments that states should consider bankruptcy. President Trump is constrained by the election, as are Senate Republicans, and the House Democrats control the purse strings. Hence more state and local funding is forthcoming. At best for the Republicans, there may be provisions to ensure it goes to the COVID-19 crisis rather than states’ unfunded pension obligations. See Geopolitical Strategy, “Drowning In Oil (GeoRisk Update),” April 24, 2020, www.bcaresearch.com. 4 School and work closure dates have been sources from the Oxford COVID-19 Government Response Tracker.