Emerging Markets

Highlights Base metals appear to be pricing the impact of the Chinese 2019-nCoV coronavirus in line with the 2003 SARS outbreak. We expect an earlier peak in reported (ex-Hubei) cases than is currently discounted by markets, implying Asian economies – and base metals – will recover sooner than expected, perhaps by end-February. We estimate the marginal impact of 2019-nCoV on global oil demand implied by the recent sell-off translates to a loss of ~ 800k b/d over February-July 2020. This leads us to expect OPEC 2.0’s technical committee will recommend additional cuts of 500k b/d for 2Q-4Q20 to the full coalition, following their meetings in Vienna. This would be bullish, if Asian economies recover as quickly as we expect. Safe-haven assets – chiefly gold and the USD – rallied but do not signal an exodus from risky assets. After breaching $1,580/oz last week, gold traded lower, while the broad trade-weighted USD index rallied 1%, mildly reversing a decline begun at the end of 2019. Risky-asset markets are anticipating monetary accommodation by systemically important central banks will remain in place this year; fiscal stimulus in China and EM economies is likely. This remains supportive of commodity demand. Feature Our view differs from the markets’, which makes us relatively more bullish base metals prices. There is a tight relationship between Asian economic activity and base metals prices, which provides a window on how markets currently expect the 2019-nCoV outbreak will impact aggregate demand in Asia (Chart of the Week). Our view differs from the markets’, which makes us relatively more bullish base metals prices. Chief among the assumptions driving our view is our expectation markets will stage a recovery once the number of 2019-nCoV cases peaks outside the epicenter of the outbreak in Wuhan, a city of 11mm people in Hubei Province, which remains locked down per Chinese containment efforts.1 This is our House view, as well. Alert: The peak in cases ex-Wuhan could come sooner than expected. Our colleagues at BCA’s China Investment Strategy (CIS) note, “New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February.”2 Chart of the WeekBase Metals Prices Lead Changes in Asian Economies This will be important for base metals demand. China accounts for ~ 50% of global supply and demand for refined base metals (Chart 2). These markets are exquisitely attuned to the decisions of Chinese policymakers, so much so that they resemble a vertically integrated system: Policymakers allocate and direct credit to industries and projects – creating a demand signal – and the supply side, which includes numerous state-owned enterprises, responds. What cannot be consumed domestically is exported to neighboring economies. Chart 2China Dominates Base Metals This largely explains why base metals are so entwined with Chinese economic activity, and with Asian activity generally. Our research indicates base-metals prices lead our Asia Economic Diffusion index, reflecting the information-processing capacity of these markets vis-à-vis the evolution of the regional economies.3 This is one reason we use base-metals markets as information sources in conjunction with our proprietary models and indicators. At present, it appears base metals markets are pricing in a recovery trajectory similar to what was seen during the 2003 SARS episode. Chart 3Markets Price Metals Hit Similar To SARS At present, it appears base metals markets are pricing in a recovery trajectory similar to what was seen during the 2003 SARS episode (Chart 3), when the LMEX fell 9% from February to April, then fully recovered by year end (Chart 4). Also noteworthy is the fact that most commodity markets were processing this information and reflecting it in their own trajectories, as seen in the path taken by our proprietary Global Commodity Factor (Chart 4, bottom panel). Chart 4Once SARS Infection Peaked, Base Metals Recovered Quickly The market call from our CIS colleagues implies base metals – summarized by the LMEX – will begin to rally this month as the odds of a peak in 2019-nCoV cases outside Hubei increases. We expect this rally will be aided by increased fiscal stimulus in China (e.g., infrastructure and construction spending), and monetary stimulus (Chart 5), which will renew the lift in manufacturing that appeared toward the end of 2019 (Chart 6).4 Chart 5Higher China Policy Stimulus Expected Chart 6Early 2019-nCoV Peak Would Revive China's Growth Oil Marches To A Different Drummer Oil markets primarily are pricing to expectations of a deep hit to crude oil demand, driven by 2019-nCoV’s impact on China’s consumption.5 Based on our modeling, we estimate the marginal impact of 2019-nCoV on global oil demand priced into WTI and Brent prices earlier in the week translates to a loss of ~ 800k b/d over February-July 2020. This leads us to expect OPEC 2.0’s technical committee will recommend additional cuts of 500k b/d for 2Q-4Q20, following meetings in Vienna this week. These cuts would be in addition to the 1.7mm b/d cuts agreed by the coalition at its November 2019 meeting, for the January to March 2020 period. OPEC’s (the old cartel) crude oil production in January fell 640k b/d from December levels to 28.35mm b/d, as the additional cuts of 1.7mm b/d agreed in November kicked in, according to Reuters. Additionally, Gulf Cooperation Council (GCC) member states over-complied on their cuts. Output from Libya also is down by ~ 1mm b/d since last month. Importantly, the latest OPEC output levels are ~ 1.3mm b/d below average 2019 production, which Platts estimates at 29.66mm b/d – the lowest output since 2011. We will be updating our balances and price forecasts in two weeks, which will reflect these data more fully. This will allow us to include more information on the demand destruction in China, the evolution of 2019-nCoV, and OPEC 2.0 supply decisions. Additional production cuts by OPEC 2.0 as demand recovers – along with the likely acceleration of the slow-down in US shale-oil production following the recent oil price rout and continued parsimony in capital markets – also would allow backwardation to return to the oil forward curves. Although China’s share of global oil demand amounts to ~ 14% – far less than its share of base metals’ supply and demand – the fact that more than 70% of its 10.2mm b/d of imports comes from OPEC 2.0 is focusing the coalition on the need to restrain supply (Chart 7).6 If, as discussed above, 2019-nCoV cases peak sooner than expected, Asia’s economies likely will recover sooner than expected, which will rally oil prices sooner than expected. Additional production cuts by OPEC 2.0 as demand recovers – along with the likely acceleration of the slow-down in US shale-oil production following the recent oil price rout and continued parsimony in capital markets – also would allow backwardation to return to the oil forward curves (Chart 8). Chart 7China's Share Of Global Oil Demand Chart 8An Early Peak In 2019-nCoV Cases Would Restore Backwardation To Oil Based on this assessment, we are getting long 4Q20 WTI vs. Short 4Q21 WTI at tonight’s close, in expectation of a return to backwardation. Bottom Line: Base metals markets could rally sharply if, as we expect, 2019-nCoV cases peak sooner than expected outside the epicenter of Wuhan. This also will lift oil demand in China and Asia. Lastly, it will restore backwardation in the benchmark crude oil curves – Brent and WTI – which is why we are going long 4Q20 WTI vs. short 4Q21 WTI at tonight’s close. Commodities Round-Up Energy: Overweight Uncertainty around the potential impact of the new coronavirus in China pushed WTI prices down to $49.6/bbl as of Tuesday’s close, a 22% drop since the onset of the outbreak. Oil speculators are rapidly exiting the market; non-commercial long WTI positions fell to 564k from 626k on January 7, 2020. On the supply side, OPEC’s oil production dropped to 28.4mm b/d in January, according to Bloomberg, in line with Reuters estimate. This partly reflects the collapse in Libya’s oil production following the closure of its main export terminals by forces loyal to General Khalifa Haftar. Production there was estimated at 204k b/d – the lowest level since the uprising against Muammar Qaddafi in 2011 – vs. an average of 1.1mm b/d in 2019. Base Metals: Neutral China’s net export of steel products declined throughout 2019 amid strong production growth and range-bound inventories. This suggests steel consumption in China remained buoyant, supported by strong new property starts and infrastructure investments (Chart 9). Our commodity-demand indicators suggest most metals’ fundamentals turned constructive in late 2019. However, the coronavirus outbreak will delay the rebound in prices we expected. Over the medium term, we continue to expect prices to pick up, fueled by accommodative monetary policy, and stronger-than-expected monetary and fiscal stimulus in China to offset the negative effect of the 2019-nCoV. Precious Metals: Neutral Fears of wider contagion of the coronavirus are keeping gold above $1,550/oz despite the rise in the US dollar powered by upbeat US manufacturing data. Over the long term, periods of elevated uncertainty are associated with rising households’ precautionary demand for savings as future income becomes increasingly uncertain. This pushes up asset prices as total savings increase, and specifically safer assets, such as gold, until uncertainty abates. This high savings rate acted as a floor to gold prices in the aftermath of the global financial crisis and is currently a crucial contributor to its elevated price (Chart 10). Ags/Softs:  Underweight Abating fears of a pandemic spread of the 2019-nCoV lifted CBOT March corn futures to $3.8225/bu on Tuesday, reversing some of the damage done by disappointing export reports from the USDA and favorable crop conditions in South America supporting expectations for a large corn harvest there. Strong sales of soybeans to Egypt and favorable export inspections helped beans reverse last week's negative trend. USD strength on the back of the 2019-nCoV, particularly against the Brazilian real, remains a headwind to bean prices. Chart 9China's Steel Consumption Remained Buoyant In 2019 Chart 10Uncertainty Drives Demand For Safe Havens     Footnotes 1     It is important to note this is a highly speculative call, and that even the public-health experts are groping for understanding on the trajectory of 2019-nCoV at this point. It is possible the virus is not contained and extinguished as SARS was in 2003, but becomes a recurrent feature of the flu season globally. Please see Experts envision two scenarios if the new coronavirus isn’t contained, published by Stat February 4, 2020. Stat is a life sciences and medical news service produced by Boston Globe Media. 2     Please see Recovery, Temporarily Interrupted, published by BCA Research’s China Investment Strategy February 5, 2020. It is available at cis.bcaresearch.com. 3    Our Asia Economic Diffusion index was developed by BCA Research’s Global Investment Strategy team. The “information” we refer to here is the actual buying and selling of base metals, and contracting for services related to the economic activity accompanying a revival in manufacturing, infrastructure buildouts and construction that drives that demand. This will show up in various measures of economic activity, among them BCA’s Asia Economic Diffusion index and different gauges used by the IMF and World Bank. In other words, base metals prices lead the Asia Economic Diffusion index based on our analysis of Granger causality. This is valuable because the metals price in real time. In earlier research, we showed that, among commodity markets, base metals prices – via copper prices, the LMEX, and the IMF’s metals index – can be used to confirm the signals from our econometric indicators and models of EM and global economic activity. Please see World Bank Lowers Growth Forecast; Commodity Demand Will Pick Up, published January 16, 2020, and Godot … Trade Deal … Wait For It … Base Metals Are Primed For A Rally, published November 28, 2019, by BCA Research’s Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 4    Iron ore and steel prices also will revive on the back of this economic recovery; we will be looking into this next week. 5    Earlier this week, Bloomberg reported the initial hit to oil demand in China amounted to 3mm b/d – the largest such hit since the Global Financial Crisis. This represented ~ 20% of daily Chinese oil demand. 6    We discuss China’s position in the global oil market – and, importantly, in the global air-transportation markets – in last week’s publication, Expect OPEC 2.0 To Cut Supply In Response to Demand Shock. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked   Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them.  At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates   Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering   Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure.  Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak   Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming   Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear clients, Over the next couple of weeks, we will be further analyzing China’s coronavirus outbreak, its economic impact, and the likely policy response, as well as the attendant investment recommendations. We will also examine any sector-related or regional themes that stem from the outbreak. Stay tuned. Jing Sima, China Strategist Highlights The peak in the number of new cases outside of the crisis epicenter will be more market-relevant than the total number of infections. New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February. It will take longer for the service sector to recover, implying a larger hit to the economy compared with the SARS episode given that services have grown in importance. This will force Chinese policymakers to set their financial deleveraging agenda aside for the rest of the calendar year. We maintain an overweight stance on Chinese stocks both tactically and cyclically, based on our view that the outbreak will soon be contained outside of Hubei province and that China’s budding economic recovery will be delayed, but not prevented, by the crisis. Feature The coronavirus (2019-nCoV) outbreak in China has sparked a selloff in risk assets around the globe. China’s A-share equity market, after an extended Chinese New Year market closure, was in a free fall when it reopened on February 3. In the offshore market, the MSCI China Index has declined by 9% from its most recent high on January 13, 2020 (Chart 1).  When attempting to forecast a turning point in bearish investor sentiment stemming from the outbreak, it is important to note that during the 2003 SARS epidemic, both global and Chinese equity markets rebounded when the number of new cases peaked in Hong Kong SAR and globally (Chart 2).  Chart 1Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chart 2Markets Bottomed As Total SARS Infections Peaked We maintain our long stance both tactically and cyclically on Chinese stocks, based on the following assessments: In the next three months, the panic brought on by 2019-nCoV will abate before the total number of new cases peaks, as investors focus on the turning point in the outbreak outside of the epicenter (Hubei province). Beyond the next three months, the outbreak will likely delay China’s economic recovery. However, this means that Chinese policymakers will not likely reduce the scale of their stimulative efforts this year. The Market Correction May Be Short-Lived Since the onset of the 2019-nCoV outbreak, many studies have attempted to predict the speed and magnitude of the spread of the virus. Using a mathematical model called Susceptible-Exposed-Infected-Recovered (SEIR), The Lancet,1 The University of Hong Kong,2 and Johns Hopkins CSSE3 all drew a conclusion that a peak in the current episode is likely to occur between late April and early May. The number of cases outside of the crisis epicenter will likely drive financial market sentiment. While we think this conclusion may be true for the total number of new cases, the total count will be less relevant to investors during this episode than during the 2003 SARS outbreak. Instead, it will be more useful to break down the total infection count into two sets of data: the number of new cases within the city of Wuhan and Hubei Province (the epicenter of the outbreak), and the number of new cases outside of Hubei. The latter is more likely to be the primary driver of short-term outbreak-related market sentiment. While Hubei is experiencing an acceleration in the daily rate of new cases, the number of new cases across the rest of China seems to be flattening off of late (Chart 3). We think that the number of cases outside of Hubei will peak earlier than within the epicenter. This is in contrast to the 2003 SARS outbreak when the peak of new cases in the rest of China and globally lagged the epicenter Hong Kong SAR by a month (Chart 4). Chart 3Number Of 2019-nCoV New Cases Flattening Outside The Epicenter Chart 4SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter There are two reasons for the difference between the 2003 SARS peak and projections for the 2019-nCoV outbreak: Timely cutoff of virus mobility outside of epicenter: The world responded quickly to contain the virus. During the 2003 SARS episode, Chinese authorities responded with protective measures only after the outbreak had already peaked in the epicenter. This time the Chinese government intervened at an early stage of the outbreak with forceful and in some cases extreme actions, including a near-complete lockdown of Wuhan (the crisis epicenter) and restrictions on inter- and intra-city traffic in other major metropolitan areas. Foreign governments in North America, Europe, and Southeast Asia took unprecedented measures to ban or limit air traffic to/from China. Furthermore, with timely and sufficient medical care, the fatality rate outside of the epicenter has been much lower4 – a significantly underreported fact. Mishandling of the crisis within the epicenter: Within Hubei province, particularly the city of Wuhan where the virus originated, the number of infections will likely continue climbing in the next two to even three months. The abovementioned studies suggest the number of cases in the epicenter is five to seven times higher than the official count. Local hospitals are experiencing severe shortages of medical supplies, meaning that people with mild-to-medium symptoms have reportedly been turned away. These patients are not included in the official statistics as confirmed or suspect cases. The discrepancy in reporting means these cases will be confirmed and recorded at a much later date. Without quarantine and treatment, these patients may continue to transmit the virus to others within the epicenter. This will have a tragic human cost, but it will hold few consequences for financial markets. The corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Bottom Line: Market sentiment will rebound following the peak in new 2019-nCoV cases outside the epicenter of Wuhan/Hubei. We think the peak may come as early as mid to late-February, which suggests the corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Economic Recovery In Sight Beyond the near-term, our view on China’s likely policy response and the economy’s fundamentals support a positive outlook for Chinese stocks over the next 6 to 12 months. In absolute dollar terms, the scale of the economic impact from the 2019-nCoV outbreak will likely be larger than the SARS episode in 2003. Unlike with SARS, when disruptions were mild and limited to the travel and retail sectors, the extreme measures China took in response to the coronavirus outbreak have essentially placed Chinese economic activity on hold. Chart 5Service Sector Now A Larger Part Of China's Economy Compared With 2003 China’s service sector is also likely to be more affected than manufacturing, because the outbreak coincided with the Chinese New Year holiday when services are normally in high demand. In addition, the service sector accounts for a much larger share of the Chinese economy than in 2003 (Chart 5). Therefore, the reduction in services output will have a comparatively bigger economic impact. However, as we think the 2019-nCoV outbreak outside of the epicenter will likely peak in February, the majority of nationwide manufacturing activity should resume no later than the last week of February. Chinese authorities have already signaled they will speed up government-led infrastructure investment as early as March. Chart 6Service Sector Took Longer To Recover After SARS Outbreak The service sector will take longer to recover. Following the 2003 SARS outbreak, the recovery in the service sector lagged the manufacturing and primary sectors by one quarter (Chart 6). This will likely delay the bottoming of the aggregate Chinese economy. We project a bottom in China’s economy towards the end of the second quarter of 2020. A delay in economic recovery will force Chinese policymakers to put aside their financial deleveraging agenda, and focus on economic growth for the year. 2020 marks the final year for policymakers to accomplish their goal to double GDP from 2010. This means policymakers will likely augment the amount of stimulus in order to stabilize the economy and avoid falling short of their growth target. Bottom Line: Business activities should resume in late February, with a bottoming in the economy towards the end of the second quarter of 2020. Monetary Support Already Lining Up The Chinese economy is on a structurally slowing trend, but is in an early stage of cyclically recovering from last year (Chart 7). This is in contrast with 2003 during the SARS outbreak when China’s economic growth was structurally accelerating, but the monetary environment was in a tightening cycle and industrial profit growth was downshifting (Chart 8). Chart 7Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chart 8...And Is In An Expansionary Monetary Cycle   As the performance of Chinese onshore stocks reflects domestic policy, Chinese A-shares, after briefly rebounded when the 2003 SARS outbreak peaked, underperformed the global benchmark during much of the 2004-2006 period when monetary policy tightened (Chart 9). Contrasting with 2003, we expect the PBoC to maintain a more accommodative monetary stance throughout 2020 (Chart 10): the PBoC cut the open market operation interest rates by 10bps on February 3. We expect this move to lead to a 5bps LPR and MLF rate cut in March. Moreover, the chance that the PBoC will cut the bank reserve requirement ratio (RRR) in Q2 is also increasing. Chart 9Chinese Onshore Equity Market Largely Driven By Domestic Policy Chart 10Easy Monetary Stance Is Here To Stay Bottom Line: Monetary policy will become more accommodative this year. Investment Conclusions Chinese stocks just went on sale, but the sale likely will not last long. Chart 11Chinese Stocks Are Priced At An Even Deeper Discount Over the next 0-3 months, Chinese equities will likely rebound as soon as the peak in the number of new cases outside of Wuhan/Hubei occurs. We believe the peak will happen within the next two weeks, and manufacturing activities in the majority of Chinese cities will resume following the peak in the outbreak. Depressed valuations in Chinese stocks compared with the global benchmark and the expectation of a rebound in Chinese economic activity should provide a good buying opportunity for global investors (Chart 11). In short, Chinese stocks just went on sale, but the sale likely won’t last long. Over a cyclical time horizon, we had previously predicted that China’s authorities may reduce the scale of the stimulus in the second half of this year as the economy starts to recover in Q1. The 2019-nCoV outbreak will alter the leadership’s policy trajectory and extend pro-growth support through 2020, and both the central and regional governments have announced a slew of policies in supporting businesses, particularly for the private sector. Our expectation that the viral outbreak will not derail China’s economic recovery suggests that corporate earnings will also rebound over a 6-12 month time horizon. One risk that we will be monitoring over the coming several months is the potential for firm- or sector-specific effects on earnings. The nationwide city lockdowns are certain to reduce or halt the flow of cash to businesses, and it is unclear whether this will have any disproportionate effects on corporate earnings relative to what we expect will occur for the economy beyond Q1. However, for now, our assumption is that the trend in earnings growth is likely to match that of the economy more generally unless evidence to the contrary presents itself. This supports an overweight position in Chinese stocks compared with their global peers over the coming 6-12 months.   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1    “Nowcasting and forecasting the potential domestic and international spread of the 2019-nCoV outbreak originating in Wuhan, China: a modelling study”, The Lancet, January 31, 2020. 2   “Real-time nowcast on the likely extent of the Wuhan coronavirus outbreak, and forecasts domestic and international spread”, Hong Kong University, January 27, 2020 3   “Modeling the Spreading Risk of 2019-nCoV”, John Hopkins Center For Systems Science And Engineering, January 31, 2020. 4   As of February 3, 2020, the fatality rate of 2019-nCoV outside of Hubei stands at 0.2%, compared with a 3% fatality rate in Hubei province and 5.5% in Wuhan, according to the World Health Organization (WHO). Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Growth Fears: Efforts to contain the China coronavirus outbreak risk creating the outcome that investors feared most in 2019 from the US-China trade war – weaker global growth and a severe disruption to supply chains worldwide. Monetary Policy Responses: Global bond yields have plunged as investors have piled into safe haven assets and priced in additional monetary easing from major central banks. Some of that decline in yields, however, may be a repricing of future rate hike probabilities with central banks like the Fed and ECB rethinking their inflation mandates and how to achieve them. Duration Strategy: Maintain a moderate below-benchmark cyclical (6-12 months) stance on overall interest rate duration in global fixed income portfolios. Yields now discount a significant hit to global economic growth from China. This outcome is far from certain, especially if China delivers more aggressive fiscal and monetary policy easing to mitigate the deflationary effects of the public health crisis. Feature Chart of the WeekBond Yields Have "Gone Viral" Global bond yields have declined sharply over the past two weeks, as investors have tried to process the potential implications of the China coronavirus outbreak. Scenes of empty streets in Chinese cities under quarantine look like something out of a Hollywood science fiction movie. Fears of a “zombie apocalypse” scenario plunging the global economy into recession are proliferating among doomsayers. The viral outbreak is interrupting global growth just as it is starting to show signs of recovery from the manufacturing slump of 2019 (Chart of the Week). Global bond yields had been slowly rising alongside that economic improvement, and risk premia in equity and credit markets had begun to narrow in earnest. Against that backdrop with markets priced for perfection, a massive public health crisis in the most marginal driver of global growth, China, was a potent trigger for a correction in risk assets. The story is obviously very fluid, with the number of infected continuing to grow in China and more cases being discovered across the world. At least 50 million Chinese citizens are now under quarantine, across several major cities. More countries are instituting travel bans to and from China, and important global companies like Apple are shuttering their China operations until further notice. The ultimate hit to global growth is yet to be determined, but measures being taken to slow the spread of the coronavirus will clearly have an impact on global trade, supply chain management and, thus, economic growth. This risks a repeat of the May-August period last year, when markets were pricing in the potential negative effects of US-China trade tariffs on global growth, triggering a major decline in global bond yields. A big driver of that bond rally last year was a shift towards expectations of easier global monetary policy. Those were largely realized as central banks cut rates while global growth was actually slowing. Bond yields now discount another round of rate cuts, most importantly from the US Federal Reserve, despite no formal indication (yet) that policymakers are looking to deliver more easing. The risk now is that investors will become too pessimistic, setting up a swing of the pendulum in the opposite direction if the hit to global growth from the virus is less than feared. On that note, a significant Chinese economic growth slowdown now appears fully priced into global bond yields. The risk now is that investors will become too pessimistic, setting up a swing of the pendulum in the opposite direction if the hit to global growth from the virus is less than feared. On that note, a significant Chinese economic growth slowdown now appears fully priced into global bond yields, as we discuss later in this Weekly Report. Breaking Down The Latest Decline In Global Bond Yields The decline in government bond yields in the developed markets (DM) has been sharpest since Chinese authorities confirmed human-to-human transmission of the coronavirus on Monday, January 20. That appears to be the date when investors began to take the outbreak much more seriously. Growth-sensitive assets like emerging market (EM) equities, copper and oil prices peaked on Friday, January 17, while measures of volatility like the US VIX index and US high-yield credit spreads troughed (Chart 2). The price of safe haven assets like gold and the Japanese yen have also increased since that “pre-virus peak” on January 17, as have bond volatility measures like the US MOVE index or European swaption volatility (Chart 3). Importantly, the increases in rates volatility have been smaller to date compared to mid-2019, when the “convexity” trade triggered an insatiable demand for duration that drove longer-maturity global bond yields sharply lower. Chart 2A Pullback In Growth-Sensitive Assets Chart 3A Mild Bid For Safe Havens Compared To 2019 A breakdown of the decline in the benchmark 10-year government bond yields in the major DM countries (US, Germany, Japan, the UK, Canada and Australia) since that “pre-virus peak” is shown in Table 1. Table 1Global Bond Yield Changes Since January 17, 2020 The biggest declines were in the US (-33bps), Canada (-29bps) and Australia (-23bps) where central bank monetary policy expectations also saw the largest shift. Our 12-month discounters, which measure the change in short-term interest rates over a one-year horizon priced into Overnight Index Swap (OIS) curves, have fallen by -30bps in the US, -26bps in Canada and -22bps in Australia – indicating that markets had fully priced in a rate cutting response to the coronavirus outbreak from the Fed, Bank of Canada and Reserve Bank of Australia. Bond yields have fallen to a lesser extent in Germany (-19bps), the UK (-11bps) and Japan (-7bps), but with very modest declines in our 12-month discounters for those three countries were policy interest rates are close to, or below, 0%. Therefore, the decline global yields over the past two weeks can, on the surface, be attributed to expectations of easier monetary policy in response to the potential hit to growth, and tightening of financial conditions as risk assets sell off, from the coronavirus (Chart 4). Chart 4Falling Yields Reflect Expectations Of More Rate Cuts In 2020... Chart 5...But Also Expectations Of Lower Rates For Longer Yet when looking at our estimates of the term premium for all six countries, the decline in the nominal 10-year yields is almost equal to the reduction in the term premium. On the surface, this would be consistent with the idea that the fall in yields is due to risk aversion driving up the demand for the safety of government bonds – and can hence be unwound if the news were to turn less gloomy on the spread of the coronavirus. Yet interest rates further out the yield curve have also fallen by similar amounts in all countries shown, when looking at 1-year interest rates, 5-years forward (the bottom row of Table 1). That decline in longer-dated forwards does correlate strongly with lower inflation expectations as measured by 10-year CPI swap rates (Chart 5). This suggests an alternative explanation for the recent fall in global bond yields that is not related to worries over the coronavirus: bond markets increasingly believe that policy interest rates will be lower for a lot longer. An alternative explanation for the recent fall in global bond yields that is not related to worries over the coronavirus: bond markets increasingly believe that policy interest rates will be lower for a lot longer. With the Fed and ECB now openly discussing changing their monetary policy frameworks to manage achievement of their statutory inflation targets more proactively, the hurdle for contemplating any interest rate hikes in the future is now much higher. Thus, central banks are giving forward guidance to the markets that rates will be lower. That is a message that would also be consistent with the decline in the term premium, to the extent that the premium is compensation for the future volatility of short-term interest rates. When looking at all the components, the message from the most recent decline in global bond yields may be more complex than simple virus-driven risk aversion. Our Duration Indicator continues to improve alongside rebounding global economic sentiment, signaling cyclical upward pressure on yields (Chart 7) – assuming, of course, that the hit to Chinese growth from the coronavirus outbreak is no worse than currently discounted in financial asset prices. In the case of US Treasuries, the bond rally also has a cyclical component, with yields now down to levels more consistent with the softer pace of growth indicated by the ISM Manufacturing index and the recent softening trend in US data surprises (Chart 6). Yet with US monetary policy and financial conditions still highly accommodative, the odds still favor some improvement in the current trend-like pace for US GDP growth that will, eventually, begin to put moderate upward pressure on Treasury yields again. Chart 6Low UST Yields Are Not Just A coronavirus Story Chart 7Global Yields Were Due For A Corrective Pullback A similar message is given when we look at global bond yields, more generally. Our Duration Indicator continues to improve alongside rebounding global economic sentiment, signaling cyclical upward pressure on yields (Chart 7) – assuming, of course, that the hit to Chinese growth from the coronavirus outbreak is no worse than currently discounted in financial asset prices. Bottom Line: Efforts to contain the China coronavirus outbreak risk creating the outcome that investors feared most in 2019 from the US-China trade war – weaker Chinese growth and a severe disruption to global supply chains. Global bond yields have plunged as investors have piled into safe haven assets and priced in additional monetary easing from major central banks. Some of that decline in yields, however, may be a repricing of future rate hike probabilities with central banks like the Fed and ECB rethinking their inflation mandates and how to achieve them. How Much China Weakness Is Priced Into Global Bond Yields? The China coronavirus outbreak, and the response to contain it, represents a potentially severe hit to Chinese – and global – economic growth. A lot of comparisons have been made to the 2003 SARS outbreak to try and find a comparable past event. However, as our colleagues at BCA Research Emerging Markets Strategy have noted, China’s economy is so much larger now, rendering comparisons of the economic impact from SARS to that of the coronavirus far less meaningful.1 For example, China’s GDP at purchasing power parity accounts for 19.3% of world GDP compared to 8.3% in 2002 before the SARS outbreak occurred. China’s share of the global consumption of various industrial metals has surged, as well, from between 10-20% in 2002 to 50-60% today. A simple alternative way to measure the impact of any virus-driven slowing of Chinese economic growth would be to calculate the reduction in full-year 2020 GDP growth relative to consensus forecasts. In this sense, the comparison is made to current expectations rather than to a past episode – an approach that should be far more relevant for predicting the response of financial asset prices today. For example, the Bloomberg consensus expectation for Chinese nominal GDP growth for all of 2020 is currently 7.2%. Using that rate and the level of nominal GDP from 2019, we can calculate an expected level for nominal GDP for 2020. We can then make some simplifying assumptions for the impact on full-year growth from an extended period of lost output from the quarantines, government-ordered factory shutdowns and extended holidays, travel bans, etc. Assuming that one full month of expected nominal GDP growth is lost (i.e. 1/12th of the expected increase in the level of nominal China GDP), the full-year growth rate falls to 6.6% Assuming that two full months of expected nominal GDP growth are lost, the full year growth rate falls to 6.0% Global bond yields now reflect a considerable slowdown of Chinese economic activity from the coronavirus, representing between 1-2 months of expected full-year 2020 nominal GDP growth that will be lost.  The last time that Chinese nominal GDP growth fell to a sub-7% pace was back in 2015 (Chart 8). The Caixin manufacturing PMI reached a low of 47.2 then, 3.9 points below the current level of 51.1. The level of global bond yields, using our “Major Countries” GDP-weighted aggregate, was at 0.72% - similar to today’s level. Global growth ex-China was also at similarly subdued levels in 2015 (i.e. the US ISM manufacturing index was below 50). Chart 8Global Yields Already Priced For A 2015-Type Slowdown In China Chart 9New Stimulus Measures In China Are Inevitable We conclude from this admittedly simple analysis that global bond yields now reflect a considerable slowdown of Chinese economic activity from the coronavirus, representing between 1-2 months of expected full-year 2020 nominal GDP growth that will be lost. The final impact on China economic growth in 2020 will likely be less than that full hit, as Chinese policymakers will surely look to ease monetary and fiscal policy to offset the hit to the economy (Chart 9). While BCA’s China strategists do not currently expect the same magnitude of policy responses as was seen in 2015/16, there will likely be enough to at least partially offset the hit to growth from containing the virus. In terms of timing, the critical point for financial markets – and bond yields – will be when the growth rate of new coronavirus cases peaks. During the 2003 SARS episode, global equity markets bottomed when that number of new cases peaked, which we believe to be a useful template for timing a potential turning point in the “fear narrative” (Chart 10). The number of new coronavirus infections continues to rise, however, suggesting that risk assets and bond yields will likely remain subdued in the near term. Chart 10Markets Bottomed In 2003 When The SARS Infection Rate Peaked When that turn does happen, any potential increase in global bond yields will be driven more by unwinding the declines in real yields and term premia of the past two weeks shown earlier in this report in Table 1. Chart 11Only A Pause In The Cyclical Upturn In Yields? That suggests a potential rise in the 10-year US Treasury yield of as much as 30bps, and a 23bps increase in the 10-year German bund yield. An additional increase of 5-10bps for both markets could come from higher inflation expectations, although that would likely need to be accompanied by a sizeable rebound in the price of oil and other industrial commodities. We are not seeing signs in our most favored leading indicators – like our global LEI diffusion index or the global ZEW index – suggesting that the next cyclical move in yields will be lower. We acknowledge that the recent fall in yields has gone against our expectations of a moderate grind higher global bond yields in 2020. However, we are not seeing signs in our most favored leading indicators – like our global LEI diffusion index or the global ZEW index – suggesting that the next cyclical move in yields will be lower (Chart 11). We will monitor those indicators in the coming months for any signs of a serious hit to global growth from the coronavirus outbreak. Bottom Line: Maintain a moderate below-benchmark cyclical (6-12 months) stance on overall interest rate duration in global fixed income portfolios. Yields now discount a significant hit to global economic growth from China. This outcome is far from certain, especially if China delivers more aggressive fiscal and monetary policy easing to mitigate the deflationary effects of the public health crisis.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Emerging Markets Strategy Weekly Report, "Coronavirus Versus SARS: Mind The Economic Differences", dated January 30, 2020, available at ems.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

  Feature Everyone’s asset-allocation plans for the year have been disrupted by the novel coronavirus (2019-nCoV). Our view is that, while the virus is serious and will hurt the Chinese and global economy in the short term, it does not change the 12-month structural outlook for financial markets. Once the epidemic is under control (which it is not yet), there will be an excellent buying opportunity for risk assets and for the most affected asset classes. Many commentators have pointed to the lessons from SARS in 2003. Markets bottomed around the time that new cases of the disease peaked (Chart 1). But there are risks with such a simplistic comparison. The US invasion of Iraq happened at the same time – between 19 March and 1 May 2003 – with arguably a bigger impact on global markets. The Chinese economy was much less significant: China represented only 4% of global nominal GDP in 2003 (versus 17% now), 7% of global car sales (35% now), and 10-20% of commodity demand (50-60%). And it is still unclear how similar 2019-nCoV is to SARS: it appears to be spreading more rapidly (Chart 2) but (so far, at least) is less deadly, with a mortality rate of about 2%, compared to 10% for SARS. Recommended Allocation Chart 1The Lesson From Sars Chart 2But Is Novel Coronavirus Different?     Nonetheless, the basic theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. With the number of deaths still growing, however, that is not yet the case. Our advice to investors would be not to sell at this point. The hedges we have in our portfolio (overweight cash and gold) should help to cushion any further downside. But, within a few weeks, assets such as EM equities, airline stocks, commodities, or the Australian dollar should look very attractive again (Chart 3). For the next few months, economic data, particularly from China, will be hard to interpret. In 2003, Chinese GDP was reduced by 1.1% because of SARS, according to estimates by the Brookings Institute.1 The global economy is likely to be more heavily impacted this time, given today’s closely integrated supply chains. On the other hand, most academic research shows that consumption and production lost during an epidemic are later made up. Additionally, the Chinese government is likely to respond with easier fiscal and monetary policy. Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. The data over the past few weeks supports this. In Asia, in particular, PMIs for the major emerging economies are back above 50 (Chart 4). Europe’s rebound has lagged a little but, in the key German economy, indicators of business and investor sentiment have bottomed. Demand in the auto sector, crucial for Europe and Japan, is clearly starting to recover. Data in Europe and EM have generally surprised to the upside recently (Chart 5). Chart 3Some Assets May Soon Look Attractive   Chart 4Asian And European Data Picking Up Chart 5Positive Surprises The theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. To a degree, the new virus gave investors an excuse to take profits in some over-bought markets. The US equity market, in particular, looked expensive at the start of the year, with a forward PE of 19x. But we would dismiss the common view that investors had become too optimistic. The bull-bear ratio is not elevated (Chart 6), with only 37% of US individual investors at the start of January believing that the stock market would go up over the next six months, not particularly high by historical standards – it has fallen now to 32%. Last year, investors took money out of equity funds, despite strong returns from stocks. In the past – for example 2012 and 2016 – when this happened, it was followed by further gains for equities, as investors belatedly bought into the rally (Chart 7).   Chart 6Retail Investors Aren't So Bullish... Chart 7...Indeed, They Have Been Selling Stocks     On a 12-month investment horizon, therefore, we remain overweight risk assets such as equities and credit, albeit with some hedges. The upside to global growth remains underestimated: the economists’ consensus is for only 1.8% GDP growth in the US and 1.0% in the euro area this year. A combination of accelerating global growth and central banks that will stay dovish should allow equities to outperform bonds over the next 12 months (Chart 8). Chart 8If PMIs Pick Up, Equities Will Outperform   Chart 9First Signs Of US Equity Underperformance? Equities:  In December, we moved underweight US equities and recommended shifting into more cyclical markets: overweight the euro zone, and neutral on EM, the UK, and Australia. Before the outbreak of 2019-nCoV, this had worked in EM, but less well in Europe (Chart 9). Once the effects of the virus have cleared, we still believe this allocation will outperform as the global manufacturing cycle picks up. But we have a couple of concerns. (1) The recent US/China trade deal will require China to increase imports from the US by a highly unrealistic 83% year-on-year in 2020 (Chart 10). Our China strategists don’t expect this target to be fully met, but think any increase will come from substitution.2 This would hurt exporters in Europe and Asia. (2) The outperformance of euro area equities is very much determined by how banks fare. The headwinds against them continue: the ECB recently decreed that six major banks fall below required capital ratios; loan growth to corporates in the euro area has fallen to 3.2% year-on-year. Much, though, depends on the yield curve (Chart 11). If it steepens, as a result of stronger growth this year, as we expect, bank stocks should outperform, especially since they remain very cheap (the average price/book ratio of euro area banks is currently only 0.65).   Chart 10China’s Import Targets Are Unrealistic Chart 11Bank Performance Depends On The Yield Curve Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. Fixed Income: Government bond yields have fallen in recent weeks as investors sought cover, with the US Treasury 10-year yield dropping to 1.55%. While it may test last September’s low of 1.46%, we do not see much further room for global yields to fall. They tend to be highly correlated with manufacturing PMIs, which we expect to rise over the next 12 months (Chart 12). Also, we see the Fed staying on hold this year, not cutting rates twice, as the market is now pricing in. This mildly hawkish surprise should push up rates (Chart 13). We continue to prefer credit over government bonds. Our global fixed-income strategists consider that, from a valuation standpoint, US high yield, and UK investment grade and high yield are the most attractive (Chart 14).3 Chart 12Rates Move In Line With PMIs Chart 13What If The Fed Doesn't Cut Rates? Chart 14US Junk Looks Most Attractive Currencies:  Defensive currencies such as the yen, Swiss franc, and US dollar have benefitted from the recent risk-off move. We see this as temporary. Once investors refocus on growth, the US dollar should start to depreciate again (the DXY index did fall by 3% between September and early January). The dollar is a counter-cyclical currency. It is 15% overvalued relative to PPP (Chart 15). It is also very momentum-driven – and, since December, momentum has pointed to depreciation and continues to do so (Chart 16).  Chart 15Dollar Is 15% Overvalued... Chart 16...And Momentum Has Moved Against USD Commodities: Industrial metals prices had started to pick up over the past few months, reflecting the stabilization of Chinese growth (Chart 17). How they fare from now will depend on: (1) how sharply Chinese growth slows as a result of 2019nCoV, and (2) how much stimulus the Chinese government rolls out to offset this. Given the degree of decline in some commodity prices (zinc down by 16% since mid-January, and copper by 9%, for example), there should be an attractive buying opportunity in these assets over coming weeks. Gold has proved to be a handy hedge against geopolitical risks (Iran) and unexpected tail risks (the coronavirus), rising by 4% year-to-date. We continue to believe it has a useful place in investors’ portfolios as a diversifier and hedge, particularly in a world of very low interest rates where cash is unattractive (Chart 18). The oil price has been hit by the disruption to air travel in January, but supply remains tight (and OPEC is likely to cut supply further in response to the demand shock).4 As long as economic growth picks up later this year, we see the crude oil price recovering over the coming months. Chart 17Metals Reflect Chinese Growth Chart 18Gold Attractive With Bond Yields So Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1  Please see Globalization and Disease: The Case Of SARS, Jong-Wha Lee and Warwick J. McKibbin, Brookings Discussion Paper No. 156, available at https://www.brookings.edu/wp-content/uploads/2016/06/20040203-1.pdf 2 Please see China Investment Strategy Weekly Report “Managing Expectations,” dated 22 January 2020, available at cis.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report “How To Find Value In Corporate Bonds,” dated 21 January 2020, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report “Expect OPEC 2.0 To Cut Supply In Response to Demand Shock,” dated 30 January 2020, available at ces.bcaresearch.com GAA Asset Allocation