Market Returns
Highlights Uncertainty over the duration of lockdowns globally will continue to hamper the estimation of the global demand recovery for commodities. This uncertainty will continue to fuel safe-haven demand for USD for the balance of 2Q20. In addition, markets continue to experience a shortage of USD, which can become acute for EM debtors servicing dollar-denominated debt. The combination of safe-haven demand and a continued dollar shortage will keep the USD well bid, which will, at the margin, suppress commodity demand, compounding the effects of COVID-19-induced demand destruction. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions, which also reduces the level of economic activity and commodity demand. Commodity demand will recover in 2H20. Given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the Communist Party of China (CCP) – base metals and grain prices should recover earlier than other commodities. Oil likely recovers in 3Q20, as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. We remain long gold as a portfolio hedge against continued global policy uncertainty. Feature The short-term path forward for commodity prices will be a function of uncertainty regarding the global economic recovery and its impact on the US dollar, which, at present, remains well bid and is keeping global financial conditions tight. The sharp USD appreciation – mostly vs. EM currencies – is a response to the COVID-19 economic shock, which intensified in March. This significantly tightened global financial conditions (Chart of the Week). EM economies’ capacity to withstand the hit to aggregate demand locally – caused by widespread lockdown measures meant to contain the spread of the virus – has led to capital outflows. EM economies, therefore, are forced to combat a combination of plunging currencies, crumpling domestic and export demand, and increasing financing costs. Low risk appetite globally and diminished liquidity in money and credit markets add to USD demand, and will keep it elevated over the next few months. Chart of the WeekEM Currencies Plunged Vs. The USD Chart 2Commodity-Intensive Industries Are Vulnerable To USD Shocks After that, we expect the dollar will reverse – mostly on the back of massive Fed accommodation to redress these factors – in 2H20. As COVID-19-induced demand destruction abates, this weakening in the USD will propel EM economic growth higher and bolster commodity demand (Chart 2). USD Well Bid On Safe-Haven Demand, Dollar Shortage The dollar could retest its recent highs in the short term. Heightened volatility over the past two months powered a surge in demand for safe havens and highly liquid risk assets globally. We expect this to persist as stringent lockdowns remain in place to combat the COVID-19 pandemic. This will keep economic policy uncertainty elevated. Over the short term, the USD will benefit in this environment. Demand for USD and dollar-denominated assets will remain strong. Indeed, our FX strategists believe the dollar could retest its recent highs (Chart 3).1 Chart 3Global Uncertainty Lifts The US Dollar And Rates Since the Global Financial Crisis (GFC), US dollar movements have been a prime driver of cross-currency basis swaps and can be indicative of risk-taking capacity in capital markets.2 Also, a rising dollar limits the cross-border supply of dollar-denominated loans and increases funding costs. The Fed is monitoring domestic and global liquidity conditions closely, and is fulfilling the role of global USD lender of last resort. Its rapid extension of swap lines to foreign central banks, as well as a temporary repo facility for foreign and international monetary authorities (FIMA), temporarily eased liquidity concerns in some regions (Chart 4). Chart 4Fed Actions Have Eased Global Liquidity Constraints It is too early to presume the dollar liquidity constraints have been wholly contained. However, it is too early to presume the dollar liquidity constraints have been wholly contained. The Fed cannot force foreign central banks to direct these dollars to the sectors in which they are needed in their domestic economies. Besides, not all EMs have access to these swap lines. This means much-needed swap lines are inaccessible to a significant portion of the global financial system. In addition, close to 60% of outstanding foreign exchange swaps/forwards involve non-bank financial and other institutions.3 It is highly likely, therefore, the Fed will have to provide additional liquidity to struggling foreign entities. We believe the Fed is well aware of these constraints on global growth and is addressing the need for additional global USD liquidity. However, as has been the case throughout the post-GFC period, policy action will continue to be uncertain as to its duration and its effectiveness. Combined with expanding fiscal deficits in the US, we believe this extraordinary accommodation by the Fed will considerably increase USD supply this year. Following a volatile 2Q20, we expect the US dollar will face severe downward pressures – assuming lockdown measures are successful in containing the pandemic and are gradually lifted. With interest rates now close to zero in most DM economies, relative balance-sheet dynamics will become important drivers of exchange rates (Chart 5). Ample liquidity globally will propel pro-cyclical currencies up and the combination of fiscal and monetary easing could lead to a debasing of the dollar next year as inflationary pressures intensify. Momentum will start working against the dollar in 2H20. Chart 5Massive QE In The US Will Pressure The USD Downward USD Strength Hinders Global Growth The dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened. The strong dollar remains a headwind to global growth – particularly in EM economies – as it pushes up funding costs and tightens financial conditions. This negative dollar shock adds to the devastating effects of lockdowns, record portfolio outflows, and collapsing commodity prices on EM economies (Chart 6). Since the GFC, the dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened (Chart 7). EM economies’ rising responsiveness to dollar movements is in part explained by their growing share of foreign USD-denominated debt, a larger foreign ownership of their sovereign debt, and increasing integration into global supply chains, in which transactions typically are invoiced in dollars (Chart 8). Chart 6Record Portfolio Outflows From EM Chart 7Brent Prices Are Closely Correlated With EM Currencies Post-GFC Chart 8EM Vulnerability To The USD Increased Since The GFC Elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Thus, elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Interestingly, this relationship is non-linear and asymmetric – i.e. the dollar’s impact on commodity prices is higher in dollar bull markets, and positive dollar changes have a greater impact. For instance, its impact on oil prices is 30% stronger in dollar-appreciation cycles. Large increases in the relative value of the USD – on a monthly, weekly, or daily basis – have a disproportionate negative impact on oil prices compared to large decreases (Chart 9). Hence, sudden rushes to safe and liquid assets in periods of rising global economic uncertainty have a magnified negative effect on commodity prices. This means the recovery in commodity prices will be more gradual. Chart 9Asymmetric Impact Of USD Changes On Commodity Prices Base Metals Could Recover In 2Q20 Gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. The USD strength is keeping commodity demand growth in check. Until uncertainty re the speed of economic recovery dissipates – mainly vis-à-vis EM economies – commodity prices will remain under pressure (Chart 10). Base metals and grain prices could recover earlier than other commodities given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the CCP. Specifically, copper prices could decouple from the USD, following China’s economic growth as it contributes close to 50% of both supply and demand of refined copper (Chart 11). Chart 10USD Strength Will Weigh Down Commodity Prices In 2Q20 Chart 11Metals' Prices Will React To China's Economic Recovery Oil will rebound in 3Q20 as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. China consumes a smaller 14% of world oil demand, which is not sufficient to support a sustainable rally in prices on its own. For 2Q20, the correlation with the USD will intensify and weigh down its price (Chart 12). Lastly, gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. Bottom Line: As the global economy recovers from the COVID-19 pandemic and things get back to normal in 2H20, the USD will weaken and commodity prices will rebound. These two factors will halt the deflationary impulse from the COVID-19 demand shock. On the back of this improvement, we expect inflation expectations to recover throughout 2021 (Chart 13). Chart 12Oil Prices' Correlation With The USD Increases In Contango Chart 13Weaker USD, Rising Commodity Prices Will Revive Inflation Expectations Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Oil price volatility as measured by the Crude Oil ETF Volatility Index (OVX) surged to above 300% earlier this week as WTI futures for May 2020 delivery fell to a low of -$40.40/bbl (Chart 14). Unprecedented negative pricing for the North American benchmark crude oil will accelerate supply destruction and bankruptcies among highly levered, unprofitable E+P companies operating in the principal shale basins, particularly the Permian. We will be looking at the supply-side implications of the massive price volatility, coupled with the first-ever negative pricing for the benchmark crude oil in next week’s publication. We currently expect US production to fall 1.5mm b/d this year. Base Metals: Neutral Front month Singapore Iron Ore Futures continue to perform relatively well, with the 62% Fines contracts hovering around $83/MT. This contract is down 5.3% ytd, after having peaked in January at $92/MT. Chinese steel inventories while elevated, have started to turn the corner since Mid-March when they reached a record 26 Mn MT (Chart 15). Resilience in iron ore and steel reflects favorable fundamentals, as Chinese manufactures starting to get back to business are reviving demand in China, and as supply concerns stemming from reduced mine activity among major mining groups around the world persist. Precious Metals: Neutral We are going long palladium at tonight’s close, following its break below $2,000/oz. We expect the global economy to recover in 2H20 on the back of massive fiscal and monetary stimulus. We expect this will be supportive of consumer spending, particularly automobiles. Palladium is essential to pollution-abatement technology in gasoline-powered cars. While work is being undertaken to rehabilitate South Africa’s derelict power grid, this is at least a five-year effort. In the meantime, rolling backouts will continue to threaten the 73% of global palladium supply produced in South Africa. Ags/Softs: Underweight CBOT corn May futures fell 1.55% on Tuesday, closing at $3.09/bu, the lowest level since 2009. Corn has been under pressure in recent weeks as the COVID-19 pandemic caused large demand destruction for this grain. Initially, this stemmed from a lower ethanol demand. However, concerns over a slowdown in demand for cattle feed has impacted corn demand as meat plants close in North America. Chart 14Crude Oil ETF Volatility Index Surged Over 300% Chart 15Chinese Steel Inventories Have Turned The Corner Footnotes 1 Please see QE And Currencies, published by BCA Research’s Foreign Exchange Strategy April 17, 2020. It is available at fes.bcareserach.com. 2 Please see Avdjiev, Stefan, Wenxin Du, Cathérine Koch, and Hyun Song Shin. 2019. "The Dollar, Bank Leverage, and Deviations from Covered Interest Parity." American Economic Review: Insights, 1 (2): 193-208. 3 Please see Capitulation?, published by BCA Research’s Foreign Exchange Strategy April 3, 2020. It is available at fes.bcareserach.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 2020 Summary of Closed Trades
Highlights Q1/2020 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -40bps during the first quarter of the year – a number that would have been far worse if not for the changes in exposures for duration (increased) and spread product (decreased) made in early March. Winners & Losers: Underperformance was concentrated in sovereign debt, US Treasuries in particular (-94bps), as yields plummeted. This detracted from the outperformance in spread product (+51bps) led by US investment grade corporates (+34bps) and emerging markets (+20bps). Scenario Analysis For The Next Six Months: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Feature Global bond markets were roiled in the first quarter of 2020 by the economic fallout from the COVID-19 pandemic. Government bond yields crashed to all-time lows while volatility reached extremes across both sovereign debt and credit. The quick, coordinated policy response from global monetary and fiscal authorities – which includes unprecedented levels of direct central bank asset purchases, both in terms of size and the breadth across markets and counties - has helped stabilize global credit spreads and risk assets, more generally. The outlook remains highly uncertain, however, with many governments worldwide looking to reopen their collapsed economies, risking the potential resurgence of a virus still lacking effective treatment or a vaccine. We are focusing more on relative value between counties and sectors. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful first quarter of 2020. We also present our updated recommended positioning for the portfolio for the next six months. The main takeaway there is that we are focusing more on relative value between counties and sectors while staying close to benchmark on both overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 1Q1/2020 Performance: Lagging, But It Could Have Been Much Worse As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2020 Model Portfolio Performance Breakdown: A Missed Rally In Sovereigns, Outperformance In Credit The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -0.1%, underperforming the custom benchmark index by -40bps (Chart 1).1 That relative underperformance came from the government bond side of the portfolio, while our spread product allocation outperformed the benchmark. US Treasuries underperformed the most (-91bps) with losses concentrated in the +10 year maturity bucket. (Table 2). After US Treasuries, euro area high-yield corporates were the second worst performer, underperforming the benchmark by -10bps. Outperformance in spread product was driven by US investment grade industrials (+22bps) and EM credit (+20bps). Table 2GFIS Model Bond Portfolio Q1/2020 Overall Return Attribution The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. Our decision to raise overall global duration exposure to neutral at the beginning of March helped shield the portfolio as yields plummeted.2 We followed this by upgrading sovereign debt in the US and Canada, both higher-beta countries, to overweight while moving to an underweight stance on US high-yield debt, euro area investment-grade and high-yield debt, and emerging market (EM) USD-denominated sovereign and corporate debt.3 In an environment of rampant uncertainty, these allocation changes helped prevent catastrophic losses in the model portfolio that had previously been positioned for a pickup in global growth. The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -91bps of underperformance versus our custom benchmark index while the latter outperformed by +51bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q1/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2020 Spread Product Performance Attribution By Sector The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+22bps) Underweight euro area investment grade corporate bonds (+16bps) Underweight EM USD-denominated corporates (+12bps) Overweight US investment grade financials (+10bps) Underweight Japanese government bonds with maturity greater than 10 years (+8bps) Biggest Underperformers Underweight US government bonds with maturity greater than 10 years (-36bps) Underweight US government bonds with maturity of 3-5 years (-17bps) Underweight US government bonds with maturity of 5-7 years (-16bps) Underweight US government bonds with maturity of 1-3 years (-13bps) Underweight US government bonds with maturity of 7-10 years (-12bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2020. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Predictably, government debt performed the best in Q1/2020 as global bond yields fell and monetary authorities raced to support economies and inject liquidity. UK, US, and Canadian government debt delivered the best returns this quarter. While we started the year neutral or underweight those assets, we moved to an overweight allocation in March, which helped salvage some returns. Also worth noting is that Australian government debt, where we have maintained a structural overweight stance, was one of the top performing markets during the first quarter. The deepest losses were sustained in EM USD-denominated sovereign and corporate debt, and euro area high-yield. Although it seems a distant memory at this point, we did start this quarter on an optimistic note and expected spreads on these products to narrow as global growth picked up. However, we were able to shield our portfolio against excessive losses in these products by moving to an underweight stance in March once the severity of the COVID-19 global economic shock become apparent. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the first quarter of the year. The underperformance was concentrated in government bonds, which rallied on the back of the global pandemic. However, the portfolio outperformed the benchmark in spread products, where the combination of massive fiscal/monetary easing and direct central bank asset purchases have brought credit spreads under control. Future Drivers Of Portfolio Returns Typically, in these quarterly performance reviews of our model bond portfolio, we attempt to make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. In the current unprecedented economic and financial market environment, however, we are reluctant to rely on model coefficients and correlations to estimate expected returns. Instead, in this report, we will focus on discussing the logic behind our current model portfolio positioning and how those allocations should expect to contribute to the overall portfolio performance over the next six months. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: Our recommended overweight stance on US spread product that is backstopped by the Fed—US investment grade corporates, Agency CMBS, and Ba-rated high-yield; Our recommended overweight stance on relatively higher-yielding sovereigns like the US and Italy; Our recommended underweight stance on EM USD-denominated corporates and sovereigns, where the specter of defaults and liquidity crunches looms. In terms of specific weightings in the GFIS model bond portfolio, we have moderated our stance on global spread product since our previous review of the portfolio.5 While the monetary liquidity backdrop is highly bullish, with central banks aggressively buying bonds and keeping policy rates at the zero lower bound, it is still unclear if and when economies will be able to successfully reopen and put an end to the COVID-19 recession. We are now recommending only a small relative overweight of two percentage points for spread product versus the benchmark index (Chart 5), leaving room to add more should the news on the virus and global growth take a turn for the better. Chart 5Overall Portfolio Allocation: Slightly Overweight Credit We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has plunged and is signaling bond yields will stay depressed over the next six months (Chart 6). Yet at the same time, yields in most countries have been unable to hit new lows after the panic-driven bond rally in late February and early March, even as global oil prices have collapsed and inflation expectations remain depressed, suggesting that yields already discount a lot of bad news. Chart 6Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low We do not see much value in taking a big directional bet on yields through overall duration exposure at the present time. We also think it is far too early to contemplate reducing duration – even with many global equity and credit markets having rallied sharply off the lows – given the persistent uncertainty over the timing of a recovery in global growth. Thus, we are maintaining a neutral overall portfolio exposure (Chart 7). Chart 7Overall Portfolio Duration: At Benchmark Chart 8Country Allocation: Favor Those With Higher Betas To Global Yields Within the government bond side of the model bond portfolio, we recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and peripheral Europe while maintaining underweights in core Europe and Japan, where yields have relatively little room to fall. That allocation also lines up with the sensitivity of each market to changes in the overall level of global bond yields, i.e. the yield beta (Chart 8). By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields, while still maintaining an overall neutral level of portfolio duration. By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields. Turning to spread product allocations, we recommend focusing more on policymaker responses to the COVID-19 recession rather than the downturn itself. Yes, the earlier widening of global high-yield spreads is forecasting a sharp plunge in global growth and rising unemployment rates (Chart 9, top panel). At the same time, the now double-digit year-over-year growth in global central bank balance sheets - a measure that has led global high-yield bond excess returns by one year in the years after the Global Financial Crisis (bottom panel) – is pointing to a period of improved global corporate bond market performance over the next 6-12 months. Chart 9Global Corporate Performance Should Benefit From Global QE In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. Chart 10Credit Allocation: Buy What The Central Banks Are Buying That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets. That means concentrating spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). We are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed is now allowed to hold in its corporate bond buying program, and euro area investment grade corporate bonds (excluding bank debt) that the ECB is also buying in its increased bond purchase programs. Chart 11Stay Underweight EM Credit One new change we are making this week is upgrading US agency commercial mortgage-backed securities (CMBS) to overweight, funding by a reduction in US agency residential mortgage-backed securities (MBS) to underweight. While the Fed is still buying agency MBS debt in its new QE programs, MBS spreads have already compressed substantially and are now exposed to potential refinancing risk as eligible US homeowners look to take advantage of the recent plunge in US mortgage rates. We prefer to increase the allocation to agency CMBS, which the Fed can now buy within its expanded QE programs and which offer more attractive spreads than agency MBS (middle panel). One part of the spread product universe where we continue to recommend an underweight stance is USD-denominated EM corporate and sovereign debt. The time to buy those markets will be when the US dollar has clearly peaked and global growth has clearly bottomed. Neither of those conditions is in place now, with the price momentum in both the EM currency index and the trade-weighted US dollar still tilted towards a stronger greenback. That backdrop is unlikely to change in the next few months, suggesting a defensive stance on EM credit is still warranted (Chart 11). A defensive stance on EM credit is still warranted. Model bond portfolio yield and tracking error considerations The selective global government bond and credit portfolio we have just outlined does not come without a cost. While we are currently overweight countries with higher-yielding government bonds, our underweight positions on riskier spread product like EM debt and lower-rated US junk bonds bring the yield of our model portfolio down to 1.8%, –15bps below the yield of the model portfolio benchmark index (Chart 12). We feel that is an acceptable level of “negative carry” given the still heightened levels of uncertainty over global growth. This leads us to focus more on relative value between countries and sectors to generate outperformance that we expect to offset the impact of underweighting the highest yielding credit markets. Chart 12Portfolio Yield: Moderately Below Benchmark Chart 13Portfolio Volatility: Currently High, But Expected To Fall Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. However, given our pro-risk positioning in the first two months of 2020, combined with the extreme volatility in markets during the first quarter, the realized portfolio tracking error blew through our self-imposed ceiling of 100bps (Chart 13). We expect this to settle down in the coming months as the recent changes in our positioning start to be reflected in the trailing volatility of our portfolio. Bottom Line: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "What Bond Investors Should Do After The 'Great Correction'", dated March 3 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q1/2020 will have multiple colors in the respective bars in Chart 4. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "2019 GFIS Model Bond Portfolio Performance Review: Praise Credit & Blame Duration", dated January 14, 2020, available at gfis.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
Highlights Portfolio Strategy Our conservative dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – result in an SPX 3,000 fair value target. Relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. An upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all warrant an overweight stance in the S&P software index. Recent Changes Trim the S&P packaged foods index to neutral today, which pushes the S&P consumer staples sector to a benchmark allocation. Boost the S&P software index to overweight today, which lifts the S&P tech sector to a benchmark allocation. Table 1 Feature The SPX jumped to a five-week high last week, on the back of news that the economy will gradually reopen next month. In other news, GILD’s remdesivir drug showed some positive early signs in fighting off the coronavirus, sparking an impressive late-week rally in the SPX. From a macro perspective, flush monetary liquidity and extremely easy fiscal policy remain the dominant market forces. While we remain confident that equities will be higher on a 9-12 month cyclical time horizon, we believe that the easy money since the March 23 lows has already been made and a consolidation phase now looms. Thus, monetizing some of these gains would make sense at the current juncture. Keep in mind that the SPX, junk spreads and the CBOE’s put/call ratio have returned to their respective means since 2018 (horizontal lines denote the historical averages, Chart 1). Tack on the stiff resistance that the S&P 500 will face near the 50-day and 100-week moving averages, and a lateral move is likely in the coming weeks. Meanwhile, in our seminal report “SPX 3,000?” on July 10, 2017 we introduced our SPX dividend discount model (DDM) when we first came up with the SPX 3,000 target.1 It is now custom to update our DDM every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Chart 1Consolidation Mode Chart 2Dividends Rule As a reminder, we have been and remain very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 2). Our 8.2% discount rate mirrors the corporate junk bond yield historical average. This year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. In the spirit of conservatism, we pick the lowest point hit in early April across the different dividend futures expirations. Tables 2 & 3 summarize the results. In the dividend futures derived approach, SPX fair value is close to 2,110. Granted, such dividend contractions for two years running (33% in 2020 and 14% in 2021, Table 2) are extreme and highly unlikely. Moreover, dividend futures have since rebounded violently. However, we stick with them to derive our worst case SPX value. Table 2SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Our own dividend growth estimates result in an SPX 3,000 fair value target (Table 3). While our assumptions are not as dire as the nadir in dividend futures, they are slightly more conservative than the GFC experience. As a reminder, in the aftermath of the GFC dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively (please click here if you would like to receive our DDM and insert your own assumptions). Table 3SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Building up on this analysis, we want to identify sectors that are at risk of a dividend cut, and thus pose the greatest threat to our SPX dividend projections. Table 4 shows the 2019 sectorial dividends, profits, and the payout ratio along with indebtedness. While during the Great Recession financials cut their handsome dividends, the current recession is not a financial crisis and we doubt the financials sector will cut their dividends, at least not as aggressively as in the GFC (Table 5). Table 4S&P 500 GICS1 Sector Dividend Analysis Table 5The GFC S&P 500 GICS1 Sector Dividend Experience Energy is a clear standout, but neither XOM nor CVX will forego their dividend aristocrat status (minimum 25 consecutive years of rising dividends) and chop their dividends. In other words, these Oil Majors will do everything in their power including raising debt to ever so modestly increase their dividends and maintain their aristocrat status. Thus, $24bn of energy sector related dividends are safe or 55% of the overall energy sector’s dividend. Keep in mind that the energy sector increased their dividends in the GFC (Tables 4 & 5). Industrials (GE is no longer a big dividend payer), materials, real estate and select consumer discretionary are sore spots, but not large enough to undermine the SPX (Table 4). Tech, health care and consumer staples are in excellent shape and judging by JNJ’s and COST’s recent dividend hikes, these sectors that enjoy mostly pristine balance sheets may even increase their payouts as they did during the GFC (Tables 4 & 5). While utilities and telecom services are debt saddled, their defensive stature and stable cash flow streams along with their history of steady dividend payments also do not pose a real threat to the SPX’s dividend (Tables 4 & 5). This leaves financials as the key sector to monitor for a possible large inflicted wound to the SPX dividend. In the most adverse scenario where the Fed instructs banks to eliminate their dividends, as the BoE and the ECB recently did in Europe, then the SPX dividend will contract, but only by 15%, ceteris paribus. This is because last year the tech sector had the highest dividend weight in the SPX and also because the financials sector’s dividend weight has fallen from 30% in 2007 to 15% in 2019 (Tables 4 & 5). Netting it all out, we are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. However, given that the easy SPX gains from the March 23, 2020 lows – when we turned cyclically bullish2 – have been made, opportunistic/nimble investors could monetize at least a part of these massive one-month returns. As aforementioned the SPX may face resistance near the 50-day moving average where it attempts to consolidate its recent gains. This week we are downgrading a defensive group to neutral and boosting a deep cyclical group to an above benchmark allocation. Turning Stale Following up from last week’s report, we heed the message from our research to be wary of staples stocks at the depth of the recession and downgrade the S&P packaged foods index to neutral. This move also pushes the S&P consumer staples sector down to a benchmark allocation from previously overweight. While this defensive index had been severely bruised from the accounting scandal at Kraft/Heinz, it has really flexed its safe haven muscles year-to-date. We use this opportunity to trim exposure down to neutral as we deem that this relative advance has run out of steam, despite the once in a lifetime jump in a number of key demand indicators. Chart 3 shows that food & beverage store retail sales now garner 17% of total retail sales a percentage last hit in the early 1990s. Impressively, not only did industry sales rise in absolute terms, but also overall retail sales suffered a severe setback accentuating last month’s spike. Similarly, food output hit a high mark last month, outpacing overall industrial production that came to a standstill. Food products resource utilization also soared, outpacing overall capacity utilization by 10% (bottom panel, Chart 3). As a result, relative share price momentum came close to accelerating by triple digits on a short-term rate of change basis (Chart 4). While such euphoria is warranted, we reckon that most if not all the good news is already reflected in prices, especially given the early signs of a possible reopening of the US economy some time next month. Importantly, sell side analyst optimism has climbed to a similar height observed in late-2015/early-2016 when industry 12-month forward EPS were slated to outshine the broad market by over 10% (bottom panel, Chart 4). Chart 3Demand Boost… Chart 4…Is Already Baked In Worrisomely, despite the rising demand profile, operating margins have been drifting lower over the past decade and a further profit margin squeeze remains a high probability outcome (Chart 5). Finally, on the food export front, the rising US dollar is warning that volumes will remain in check in coming quarters (greenback shown inverted, middle panel, Chart 6). All of this is reflected in valuations that have returned to the 25-year mean with packaged food manufacturers now trading at a 9% forward P/E premium to the broad market (bottom panel, Chart 6). Chart 5Margin Trouble Chart 6Past Expiry Date In sum, relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. Bottom Line: Trim the S&P packaged foods index to neutral, today for a loss of 20% since inception. This downgrade also pushes the S&P consumer staples sector to neutral for a loss of 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PACK – MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, GIS, HSY, HRL, K, LW. Boost Software To Overweight We recently monetized over 50% relative gains in our overweight in the S&P software index, but today we are compelled to lift this heavyweight tech sub-index back to an overweight stance. One key reason for our renewed bullishness is that for the second time in the past 15 months, software stocks managed to eke out relative gains when the broad market fell peak-to-trough 20% and 35% in late-2018 and in Q1/2020, respectively (Chart 7). This resilience on the way down confirms both the defensive stature of this services tech subgroup and simultaneously our long held belief that when growth is scarce investors will flock to secular growth stocks. Chart 7Recession Proof As a result and following up from our recent data processing upgrade, another defensive services tech group, we are compelled to augment exposure to the S&P software index to overweight. Last week we showed that the tech sector (along with financials and consumer discretionary) best the broad market from the recessionary troughs onward, signaling that the key software sub group will likely lead the recovery.3 Software investment is on a multi decade upward trajectory and is slated to rise further in coming quarters as overall spending takes the back seat, but defensive software capex remains resilient (Chart 8). Not only do corporate executives upgrade software in downturns as these upgrades yield near instantaneous return on investment and are immediately productivity enhancing, but also the push to cloud-based services will only accelerate during the ongoing recession (bottom panel, Chart 8). Tack on that the global coronavirus social distancing measures are also boosting demand for remote working services specifically, and software sales will continue to grind higher (Chart 9). Chart 8Capex Market Share Gains Chart 9Rising Demand Buoys Sales Meanwhile, industry M&A remains robust and both the number of deals are still rising at a brisk rate and the premia paid remain near historically high levels (Chart 10). Contrary to a slew of corporations that have announced dividend cuts and equity buyback suspensions, pristine software balance sheets underscore that shareholder friendly activities will remain in place, if not accelerate, during the current recession (bottom panel, Chart 10). Chart 10What’s Not To Like? Chart 11Model Says Buy Our macro-based software EPS growth model does an excellent job in capturing all these moving forces and it is signaling that industry profits will continue to expand at a healthy pace for the rest of the year, in marked contrast to the broad market’s expected profit contraction (Chart 11). Adding it all up, an upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all bode well for an earnings-led outperformance phase in the S&P software index. Bottom Line: Boost the S&P software index to overweight, today. This upgrade also lifts the S&P tech sector to neutral for a loss of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights The May-June WTI spread settled earlier in the week at a $7.29/bbl contango, the widest level since February 2009 during the GFC. This reflects an extraordinarily tight storage market in the US Gulf and Midcontinent. WTI for May delivery breached $20/bbl Wednesday, touching a 18-year low (Chart of the Week). Output cuts starting in May agreed by OPEC 2.0 over the weekend will remove 6.1mm b/d on average for May-December vs. 1Q20 levels. Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y. We raised our estimate of COVID-19-induced demand destruction in 2Q20 to 14.6mm b/d from 12.1mm b/d. We expect demand to fall ~ 8mm b/d in 2020 vs. our previous estimate of 4mm b/d, as global fiscal and monetary stimulus revives growth in 2H20. We expect 2021 demand to rise 7.7mm b/d, averaging 100.6mm b/d. In our updated forecast, Brent is expected to average $39/bbl – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Our Brent forecast for 2021 remains ~ $65/bbl. WTI will trade $2-$4/bbl lower. Feature April is the cruellest month … - T.S. Eliot, The Waste Land1 Global oil logistical capacity will be tested in extremis this month, as cargoes laden with oil arrive in ports that have no need for ready supply and few storage options to hold the crude until its needed. This is filling traditional global storage, inland pipelines and ships, which, as typically occurs in extremis, are used as floating storage (Chart 2). Chart of the WeekCrude Oil In Extremis Chart 2Floating Storage Volumes Soar As Terminals and Pipelines Fill The most extreme testing of global logistics likely will occur in this cruel month, to borrow once again from the laureate, as markets are forced to absorb the production surge from OPEC 2.0 – mostly from KSA and its allies. Repeated excursions to and through $10/bbl in physical markets, as already have been registered in Canada and US shale basins, can be expected this month (Chart 3). Indeed, we expect price pressures to reduce US oil ouput – mostly in the shales – by 1.5mm b/d or more.2 Beginning in May, OPEC 2.0 will begin cutting production, with its putative leaders – KSA and Russia – accounting for 1.3mm b/d and 2.1mm b/d, respectively, of the coalition’s total pledged cuts of 7.6mm b/d vs. 1Q20 production levels. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to 9.7mm b/d for May-June, and 7.7mm b/d for 2H20).3 Chart 3Cash Markets Pressing /bbl While the official OPEC communique notes the coalition also will implement a 6mm b/d cut from January 2021 to April 2022, we doubt this will be necessary. The coalition meets again in June, and KSA’s Energy Minister, Prince Abdulaziz bin Salman, said the Kingdom is prepared to increase its cuts if needed.4 Based on historical experience, we expect KSA to over-deliver on cuts, and for Russia to gradually meet its pledged volumes. We are haircutting other states’ production cuts based on historical observation, and are projecting cuts of ~ 75% for 2020 and 70% for 2021 compliance (Table 1). Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y on average. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Lowering Our Demand Forecast The COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008. Our estimate of COVID-19-induced demand destruction in 2Q20 is now 14.6mm b/d, up from 12.1mm b/d. For all of 2020, we expect demand to fall 7.9mm b/d in our base case vs. our previous estimate of 4mm b/d. These estimates are highly conditional on the trajectory of the containment of the COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global real GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008 (Chart 4). Nonetheless, we believe the massive global fiscal and monetary stimulus now being deployed will restore growth beginning in 2H20 and carrying through to expect 2021 demand to rise 7.7mm b/d, and to average 100.6mm b/d (Chart 5). Chart 4COVID-19 Real GDP Hits Dwarf 2009 GFC Recession Chart 5Massive Stimulus Will Revive Demand We assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. While our demand expectations are slightly weaker, in our modeling we see supply being curtailed sufficiently to produce a physical deficit beginning in 3Q20 (Chart 6). Our supply-demand trajectory projects a peak in OECD storage of 3.7 billion barrels in May, after which inventories fall sharply (Chart 7). Indeed, we assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. Chart 6Oil Supply-Demand Balances Point To Physical Deficit By 4Q20 Chart 7Inventories Spike, Then Draw Sharply Two-Way Price Risk Our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. In our updated forecast, we see Brent averaging $39/bbl this year – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Next year, our expectation remains ~ $65/bbl. WTI will trade $2-$4/bbl lower (Chart 8). As noted above, our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. However, as the pandemic spreads deeper into less-developed EM economies without robust public-health infrastructures, or social security systems providing a basic income in the event of job loss due to recessions the risk of widespread infection rises significantly.5 Chart 8Stronger Price Recovery Expected No amount of fiscal or monetary stimulus will allow an economy to weather such a storm. This is a clear and present danger to the global recovery and to a recovery in commodities generally, oil in particular. Investment Implications Our expectation for prices is reflected in Chart 8, premised, again, on COVID-19 being contained and fiscal and monetary stimulus reviving global growth. We are retaining our long exposure to the market, expecting the supply and demand policies set in motion will be effective. However, there is no way of accurately assessing the likelihood of an uncontained pandemic hitting EM markets, and, from there, re-entering other markets that presumably have dealt with the coronavirus. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com Commodities Round-Up Energy: Overweight Global oil inventories will be filled rapidly in 2Q20 as major economies remain in lockdowns. High-cost Canadian oil sand producers will be severely hit as their output is landlocked, distant from key demand centers, and facing storage and pipeline infrastructure constraints. More than 500k b/d of production will be shut-in in April and May as crude-by-rail collapses, local and US refinery runs are reduced, and Alberta’s limited inventory moves closer to its maximum capacity – estimated at ~ 90mm bbls (Chart 9). Separately, a €20/MT stop to our EUA futures recommendation was triggered on April 14, 2020, leaving us with a 14.2% gain. Base Metals: Neutral China’s iron ore imports fell to 85.9mm MT in March, a decline 0.6% y/y, after growing 1.5% in January and February. This came as steel mills arranged maintenance or slowed production to deal with record-high inventories after the COVID-19 pandemic curtailed construction and industrial activities. However, in the long run the outlook for iron ore and steel appears to be improving. Mysteel data for China indicates utilization rates at blast furnaces have been rising for four weeks and are now at ~ 79%. Chinese Steel exports also picked up in March, up 2.4% from a year earlier, but are now facing new anti-dumping duties on stainless steel in the EU. Precious Metals: Neutral Gold continues to trade above $1700/oz – reaching its highest level since October 2012 – supported by easing fiscal and monetary policy in the US and fear of a prolonged economic slowdown. A lower US dollar – the DXY index fell back below 100 last week – and depressed real rates supported gold’s move higher (Chart 10). Dollar debasement risks and negative real rates increase gold’s attractiveness as a safe asset. Ags/Softs: Underweight China’s March soybean imports came in at 4.28mm MT y/y, the lowest level since February 2015. Rains in Brazil delayed that country’s exports to China. The fall also reflects a 6% contraction in soymeal (i.e., the “crush”) consumed by livestock – as the African Swine Fever slashed China’s pig herd by more than 40% and shortages forced operations to grind to a halt. Similarly, meat suppliers in the US and Canada are closing plants temporarily due to COVID-19 cases among employees. As a result, Chicago soybean futures traded 0.8% lower on Tuesday. Chart 9Limited Storage Capacity In Alberta Chart 10Lower US Rates And Dollar Support Gold Footnotes 1 The Waste Land, by T.S. Eliot, originally was published in 1922 in The Criterion, which was founded and edited by Eliot. 2 The Texas Railroad Commission held day-long hearings April 14 to consider returning to its historic roll as an oil-production regulator on Tuesday. As we went to press no ruling on the petition to revive pro-rationing was delivered. The Oklahoma Corporation Commission will hold similar hearings next month. Please see Texas and Oklahoma weigh production quotas for oil published by washingtonpost.com April 13, 2020. 3 Please see The 10th (Extraordinary) OPEC and non-OPEC Ministerial Meeting concludes, posted by OPEC April 12, 2020. 4 Please see Saudi energy minister leaves door open for more cuts in June, published by worldoil.com April 13, 2020. 5 Please see National governments have gone big. The IMF and World Bank need to do the same. This op-ed by Gordon Brown and Larry Summers, published by washingtonpost.com April 14, 2020, lays out some of the issues that elevate downside risk to a COVID-19 recovery. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades
Dear Client, I will be discussing the economic and financial implications of the pandemic with my colleague Caroline Miller this Friday, March 27 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). I hope you will be able to join us for this webcast. Next week, we will send you a special report prepared by BCA’s Chief Economist Martin Barnes. Martin will provide his perspective on the current crisis, focusing on some of the longer-run implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The world is in the midst of a deep recession. Growth should recover in the third quarter as the measures taken to compensate for the initial slow response to the crisis are relaxed and existing measures are better calibrated to reduce economic distress. Continued monetary support and unprecedented fiscal stimulus should help drive the recovery once businesses reopen and workers return to their jobs. Investors should maintain a modest overweight to global equities. US stocks will lag their foreign peers over the next 12 months. The US dollar has peaked. A weaker dollar should help lift commodity prices and the more cyclical sectors of the stock market. High-yield credit spreads will narrow over the next 12 months, but we prefer investment-grade credit on a risk-reward basis. Investors are understating the potential long-term inflationary consequences of all the stimulus that has been unleashed on the global economy. Buy TIPS and gold. I. Macroeconomic Outlook The global economy is now in recession. The recession has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus. Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On a sequential annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history. Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus. Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending. A One-Two Punch The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would. This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash. All this reduces aggregate demand. On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home (Chart 1). Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally. Chart 1US: Who Can Work From Home And Who Cannot? Think of this as a Great Depression-style demand shock combined with a category five hurricane supply shock. The fact that both of these shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse (Chart 2). During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing. This time is different. Chart 2The Service Sector Accounts For A Big Chunk Of GDP And Has Been Very Hard Hit The Shape Of The Recovery: L, U, or V? Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. What will the recovery look like? From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP. Chart 3 shows three scenarios: 1) An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend; 2) A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year; and 3) A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend. Chart 3Profile Of The Recovery: L, U, or V? We had previously thought that the recovery from the pandemic would be V-shaped. Compared to the sluggish recovery following the Great Recession, that is likely still true. However, at this point, we would prefer to characterize the probable recovery as being more U-shaped in nature. This is mainly because the measures necessary to contain the virus may end up having to remain in place, in one form or another, for the next few years. Why Not L? Given the likelihood that containment measures will continue to weigh on economic activity, how can an L-shaped “recovery” be avoided? While such a dire outcome cannot be ruled out, there are three reasons to think “U” is more likely than “L”. Reason #1: We Will Learn From Experience It is almost certain that we will figure out how to fine-tune containment measures to reduce the economic burden without increasing the number of lives lost. There are still many questions that remain unanswered. For example: Are restaurants where family members sit together really more dangerous than bars or conferences where strangers are milling about talking to one another? How dangerous is air travel? Modern airplanes have hospital-grade filtration systems that recirculate all the air in the cabin every three minutes. Might this explain why there has only been a handful of flight attendants that have tested positive for the virus? How contagious are children, who often may not present any symptoms at all? Which drugs might slow the spread of the disease or perhaps even cure it? To what extent would widespread mask-wearing help? Yes, a mask may not prevent you from catching the virus, but if there is major social stigma associated with being unmasked in public, then people who have the virus and may not know it will be less of a threat to others. One study estimates that the virus could be completely eradicated if 80% of people always wore masks.1 With time, we will learn the answers to these questions. We will also be able to stockpile masks, ventilators, respirators, and test kits – all of which are currently in short supply – to better combat the virus. Reason #2: We Are NowOvercompensating For Lost Time Second, most countries are currently at the stage where they are trying not just to bring down the basic reproduction number for the virus to 1, but to drive it down to well below 1. There is merit in doing so. If you can reduce the reproduction number to say, 0.5, meaning that 100 people with the virus will pass it on to only 50 other people, then the number of new infections will fall rapidly over time. This is what China was finally able to achieve. A recent study documented that China succeeded in bringing down the reproduction number in Wuhan from 3.86 to 0.32 once all the containment measures had been implemented (Chart 4).2 Chart 4Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak The critical point is that once you reduce the number of new infections to a sufficiently low level, you can then relax the containment measures by just enough so that the reproduction number rises back to 1. At that point, the number of new infections at any given point in time will be constant. One can see this point by imagining a bicycle coasting down a mountain road. Ideally, the rider should apply uniform pressure on the brakes at the outset of the descent to prevent the bicycle from accelerating too quickly. However, if the rider is too slow to apply the brakes and ends up going too fast, he or she will then need to overcompensate by pressing hard on the brakes to slow the bike down before easing off the brakes a bit. Most of the world is currently in the same predicament as the cyclist who failed to squeeze the brakes early on. We are overcompensating to get the infection rate down. However, once the infection rate has fallen by enough, we can ease off the most economically onerous measures, allowing GDP to slowly recover. Reason #3: Containment Measure Will Be Eased As More People Acquire Immunity Much of the popular discussion of the epidemiology of COVID-19 has failed to distinguish between the basic reproduction number, R0, and the effective reproduction number, Re. The former measures the average number of people a carrier of the virus will infect in an entirely susceptible population, whereas the latter measures the average number of people who will be infected after some fraction of the population acquires immunity either by surviving the disease or getting vaccinated. Mathematically, Re = R0*(1-P), where P is the proportion of the population which has acquired immunity. For example, suppose P=0.5, meaning that half the population has acquired immunity. In this case, the average number of people a carrier will infect will be only half as high as when no one has immunity. As we discuss below, there is considerable uncertainty about how fast P will increase over time, including whether it could spike upwards if a vaccine becomes widely available. Still, any increase in P will make it more difficult for the virus to propagate. Over time, this will permit policymakers to raise R0 at an accelerating rate towards the level it would naturally be in the absence of any containment measures (Chart 5). Such a strategy would allow economic activity to increase without raising Re; that is to say, without triggering an explosion in the number of new cases. Chart 5Populations Acquiring Immunity Is Key The Virus Endgame How long will it take to dismantle all the containment measures completely? This partly depends on what medical breakthroughs occur and what measures are needed to “flatten the curve” of new infections (Chart 6). Right now, most countries are trying to drive down the number of new infections to very low levels in the hopes that either a vaccine will be invented or new treatment options will become available. Chart 6Flattening The Curve We are not medical experts and will not offer an opinion on how likely a breakthrough may be. What we would say is that combating the virus has become a modern-day Manhattan project. If the project succeeds, a V-shaped recovery could still ensue. What if the virus evades the best efforts of scientists to eradicate it? In that case, the only way for life to return to some semblance of normalcy is for the population to acquire herd immunity. How many people would need to be infected? In the context of the foregoing discussion, this is equivalent to asking how high P needs to rise for Re to fall below 1. The equation above tells us this must correspond to the value of P for which R0 (1-P) <1. Solving for P yields P > 1-1/R0. In the absence of social distancing and other containment measures, most estimates of R0 for COVID-19 place it between 1.5 and 4. This implies that between one-third (1-1/1.5) to three-quarters (1-1/4) of the population would need to be infected for herd immunity to set in. Even if one allows for the likelihood that significantly more resources will be marshalled to allow hospitals to service a greater number of patients, we estimate that it would take 2-to-3 years to reach that point.3 To be clear, the virus’ ability to spread will decline even before herd immunity is achieved. An increase in the share of the population who survived and became naturally inoculated against the virus would allow policymakers to relax containment measures, perhaps to such an extent that eventually only the simplest of actions such as increased hand-washing and widespread mask-wearing would be enough to prevent hospitals from being overwhelmed. This underscores our baseline expectation of a U-shaped economic recovery. Second-Round Effects Suppose the global economy starts to recover in the third quarter of this year as the measures taken to compensate for the initial slow response to the crisis are relaxed, existing measures are better calibrated to reduce economic distress, and more younger and healthier people acquire natural immunity to the virus, thus reducing the vulnerability of the old and frail. Does that mean we are out of the woods? Not necessarily! We still have to worry about the second-round economic effects. Even if the virus is contained, there is a risk that the economy will be so scarred by the initial drop in output that it will fail to recover. A vicious circle could emerge where falling spending leads to higher unemployment, leading to even less spending. In the current environment, the tendency for unemployment to rise may be initially mitigated by the decision of a few large companies with ample financial resources to pay their workers even if they are confined to their homes. This would result in a decline in labor productivity rather than higher unemployment. That said, given the severity of the shock and the fact that many of the hardest-hit firms are in the labor-intensive service sector, a sharp rise in joblessness is still inevitable, particularly in countries with flexible labor markets such as the US. Chart 7Worries Over Job Security Abound Today’s spike in US initial unemployment claims is testament to that point (Chart 7). In fact, the true increase in the unemployment rate will probably be greater than what is implied by the claims data because many state websites did not have the bandwidth to handle the slew of applications. In addition, under existing rules, the self-employed and those working in the “gig economy” do not qualify for unemployment benefits (this has been rectified in the bill now making its way to the White House). The Role Of Policy Could we really end up in a world where the virus is contained, and people are ready and able to work, only to find that there are no jobs available? While such a sorry outcome cannot be dismissed, we would bet against it. This outcome would only arise if there is insufficient demand throughout the economy when it reopens. Unlike in 2008/09 when there was a lot of moralizing about how this or that group deserved to be punished for their reckless behavior, no one in their right mind today would argue that the workers losing their jobs and the companies facing bankruptcy somehow had it coming. What can policymakers realistically do? On the monetary side, policy rates are already close to zero in most developed economies. A number of emerging markets still have scope to cut rates, but even there, many find themselves not far from the zero bound (Chart 8). Chart 8DM Rates At The Zero Bound, With EM Rates Approaching Chart 9A Mad Scramble For Cash That said, cutting interest rates right now is not the only, and probably not the most important, way for central banks to stimulate their economies. The global economy is facing a cash shortage. Companies are tapping credit lines at a time when banks would normally be looking to increase their own cash reserves. The mad scramble for cash has caused libor, repo, and commercial paper spreads to surge (Chart 9). And not just any cash. As the world’s reserve currency, the dollar is increasingly in short supply (Chart 10). This explains why cross-currency basis spreads have soared and why the DXY index has jumped to the highest level in 17 years. Chart 10Dollars Are In Short Supply Flood The Zone Chart 11US Mortgage Spreads Have Spiked The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency mortgage-backed securities (MBS) since relaunching its QE program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields (Chart 11). The Fed has also dusted off the alphabet soup of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses. In order to ease overseas funding pressures, the Fed has opened up swap lines with a number of central banks. We expect these lines to be expanded to more countries if the situation necessitates it. The Coming Mar-A-Lago Accord? We also think that there is at least a 50-50 chance that we could see coordinated currency interventions designed to drive down the value of the US dollar. Federal Reserve, Treasury, and IMF guidelines all permit currency intervention to counter “disorderly market conditions.” While a weaker dollar would erode the export competitiveness of some countries, this would be more than offset by the palliative effects of additional dollar liquidity stemming from US purchases of foreign securities, as well as the relief that overseas dollar borrowers would receive from dollar depreciation. Thus, on balance, a weaker dollar would result in an easing of global financial conditions. Liquidity Versus Solvency Risk Some might complain that the actions of the Fed and other central banks go well beyond their mandates. They might argue that it is one thing to provide liquidity to the financial system; it is quite another to socialize credit risk. We think these arguments are largely red herrings. For one thing, concern about credit risk can be addressed by having governments backstop central banks for any losses they incur. Moreover, there is no clear distinction between liquidity and solvency risk during a financial crisis. The former can very easily morph into the latter. For example, consider the case of Italy. Would you buy more Italian bonds if the yield rises? That depends on two competing considerations. On the one hand, a higher yield makes the bond cheaper. On the other hand, a higher yield may make it more difficult for the government to service its debt obligations, which raises the risk of default. If the second consideration outweighs the first, your inclination may be to sell the bond. To the extent that your selling causes yields to rise further, that could lead to another wave of selling. As Chart 12 illustrates, this means that there may be multiple equilibria in fixed-income markets. It is absolutely the job of central banks to try to steer the economy towards the good ”low yield” equilibrium rather than the bad “default” equilibrium. Chart 12Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort In this light, ECB president Christine Lagarde’s statement on March 12th that “we are not here to close spreads” – coming on the heels of a spike in Italian bond yields and a 13% drop in euro area stocks the prior day – was one of the most negligent things a central banker has ever said. To her credit, she has since walked back her comments. The ECB has also launched the Pandemic Emergency Purchase Programme (PEPP), a EUR 750bn asset-purchase program, which gives the central bank considerable flexibility over the timing, composition, and geographic makeup of purchases. Further actions, including upsizing the PEPP, creating a “conditionality-lite” version of the ESM program, and perhaps even issuing Eurobonds, are possible. All this should help Italy. Accordingly, BCA’s global fixed-income team upgraded Italian government bonds to overweight this week. Using Fiscal Policy To Align Financial Time With Economic Time While central banks will play an important role in mitigating the crisis, most of the economic burden will fall on fiscal policy. How much fiscal support is necessary and what should it consist of? To get a sense of what is optimal, it is useful to distinguish between the concept of financial time and economic time. Financial time and economic time usually beat at the same pace. Most of the time, people have financial obligations – rent, mortgage payments, spending on necessities – that they match with the income earned from work. Likewise, companies have expenses that they match with the revenue that they derive from various economic activities. No one worries when economic time and financial time deviate in predictable ways. For example, GDP collapses around 5pm on Monday only to recover at 9am on Tuesday. The fact that many western Europeans take most of August off for vacation is also not a problem, since everyone expects this. The problem occurs when economic time and financial time deviate in unpredictable ways. That is the case at present. Today, economic time has ground to a halt as businesses shutter their doors and workers confine themselves to their homes. Yet, financial time continues to march on. This implies that in the near term, the correct course of action is for governments to transfer money to households and firms to allow them to service their financial obligations. One simple way of achieving this is through wage subsidies, where the government pays companies most of the wage bill of their employees who, through no fault of their own, are unable to work. Note that this strategy does not boost GDP. By definition, an idle worker is one who does not contribute to economic output. What this strategy does do is alleviate needless hardship, while creating pent-up demand for when businesses start to open their doors again. Once the virus is contained, traditional fiscal stimulus that boosts aggregate demand will be appropriate. How much money are we talking about? In the case of the US, suppose that annualized growth is -5% in Q1, -25% in Q2, and +10% in Q3 and Q4, respectively. That would leave the level of real GDP down 4% on the year compared to 2019. Assuming trend GDP growth of 2%, that implies an annual shortfall of income (consisting of wages and lost profits) that the government would have to cover amounting to 6% of GDP. The $2 trillion stimulus bill amounts to 10% of GDP, although not all of that will be spent during the next 12 months and about a quarter of the amount is in the form of loans and loan guarantees. Still, on size, we would give it an “A”. On composition, we would give it a “B”, as it lacks sufficient funding for state and local governments to cover the likely decline in the tax revenues that they will experience. This could result in layoffs of first responders, teachers, etc. Given that the US was running a fiscal deficit going into the crisis, all this additional stimulus could easily push the budget deficit to over 15% of GDP. While this is a huge number, keep in mind that in a world where interest rates are below the trend growth rate of the economy, a government can permanently increase its budget deficit by any amount it wants while still achieving a stable debt-to-GDP ratio over the long haul.4 Today, we are not even talking about a permanent increase in the deficit, but a temporary increase that could last a few years at most. If we end up in a depression, don’t blame the virus; blame politicians. Fortunately, given that the political incentives are aligned towards fiscal easing rather than austerity, our guess is that a depression will be averted. Appendix A summarizes the monetary and fiscal measures that have already been taken in the major economies. II. Investment Strategy As anyone who has ever watched a horror movie knows, the scariest part of the film is the one before the monster is revealed to the audience. No matter how good the makeup or set design, our imaginations can always conjure up something much more frightening than Hollywood can invent. Right now, we are fighting an invisible enemy that is ravaging the world. Victory is in sight. The number of new infections has peaked in China and South Korea. I mentioned during last week’s webcast that we should watch Italy very carefully. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control. While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past five days (Chart 13). Chart 13A Peak In The Number Of New COVID-19 Cases In Italy Would Send An Encouraging Signal Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. However, as we spelled out in this report, there are good reasons to think that these measures will not need to be as severe as the ones currently in place. As such, it is likely that global growth will begin to rebound in the third quarter of this year. Equities: A Modest Overweight Is Warranted We turned more cautious on the near-term outlook for global equities earlier this year, but upgraded our recommendation on the morning of February 28th after the MSCI All-Country World Index fell by 12% over the prior week. While stocks did rally by 7% during the following three trading days, they subsequently plunged to multi-year lows. In retrospect, we should have paid more attention to our own warnings in our earlier report titled “Markets Too Complacent About The Coronavirus.” 5 For now, we would recommend a modest overweight to stocks on both a 3-month and 12-month horizon. Monetary and fiscal easing and the prospect of a peak in the number of new cases in Italy could continue to support stocks in the near term, while a rebound in growth starting this summer should pave the way for a recovery in corporate earnings over a 12-month horizon. Chart 14US Equity Valuations Are Not Yet At Bombed-Out Levels Of course, when it comes to financial markets, one should always be prepared to adjust one’s conviction level if prices either rise or fall significantly. We mentioned two weeks ago that we would move to a high-conviction overweight if the S&P 500 fell below 2250. While the index did briefly fall below this level, it has since bounced back to about 2630. At its current level, the S&P 500 is trading at 15.3-times forward earnings (Chart 14). While this is not particularly expensive, it is still well above the trough of 10.5-times forward earnings reached in 2011 during the height of the euro crisis. And keep in mind that current earnings estimates are based on the stale assumption that S&P 500 companies will earn $172 over the next four quarters, down only 3% from the peak earnings estimate of $177 reached in February. With this in mind, we are introducing a lower and upper bound for global equity prices at which we will adjust our view. To keep things simple, we will focus on the S&P 500, which accounts for over half of global stock market capitalization. If the S&P 500 falls below (and stays below) 2250, we would recommend a high-conviction overweight to global stocks. If the index rises above 2750, we would recommend a neutral equity allocation. Anything between 2250 and 2750 would justify the current stance of modest overweight. Going forward, we will adjust this range as events warrant it. Our full slate of views can be found in the table at the end of this report. Sector And Regional Equity Allocation: Favor Cyclicals and Non-US Over A 12-Month Horizon Not surprisingly, defensive equity sectors outperformed cyclicals both in the US and abroad during this month’s selloff. Financials also underperformed on heightened worries about rising defaults and the adverse effect on net interest margins from flatter yield curves (Chart 15). Chart 15Cyclicals And Financials Underperformed On The Way Down Chart 16Non-US Stocks Are Cheaper Even After Adjusting For Differences In Sector Weights Cyclicals and financials have outperformed the broader market over the past few days as risk sentiment has improved. They are likely to continue outperforming over a 12-month horizon as global growth eventually recovers and yield curves steepen modestly. To the extent that cyclicals and financials are overrepresented in stock market indices outside the US, this will give non-US equities the edge. Stocks outside the US also benefit from more favorable valuations. Even after adjusting for differences in sector weights, non-US stocks are quite a bit cheaper than their US peers as judged by price-to-earnings, price-to-book, and other valuation measures (Chart 16). The US Dollar Has Probably Peaked Another factor that should help cyclical stocks later this year is the direction of the US dollar. The greenback has been buffeted by two major forces this year (Chart 17). Chart 17The Dollar Has Been Facing Crosscurrents Chart 18USD Is A Countercyclical Currency Between February 19 and March 9, the dollar weakened as US bond yields fell more than yields abroad. This eliminated some of the yield advantage that had been supporting the dollar last year. Starting around the second week of March, however, global financial stresses escalated. Money began to flow into the safe-haven Treasury market. Global growth prospects also deteriorated sharply. As a countercyclical currency, this helped the dollar (Chart 18). Looking out, interest rate differentials are unlikely to return anywhere close to where they were at the start of this year, given that the Fed will probably keep rates near zero at least until the middle of 2021. Meanwhile, aggressive central bank liquidity injections should reduce financial stress, while a rebound in global growth will allow capital to start flowing back towards riskier foreign markets. This should result in a weaker dollar. Once Growth Bottoms, So Will Commodities Chart 19Low Prices Force US Shale Cutbacks The combination of a weaker dollar, a rebound in global growth starting this summer, and increased infrastructure stimulus spending in China should help lift resource prices. This will also buoy currencies such as the AUD, CAD, and NOK in the developed market space, and RUB, CLP, ZAR, and IDR, in the EM space. Oil prices have tumbled on the back of the sudden stop in global economic activity and the breakdown of the agreement between OPEC and Russia to restrain crude production. BCA’s commodity strategists expect the Saudis and Russians to come to an agreement to reduce output, as neither side has an incentive to pursue a prolonged price war. They see Brent prices averaging $36/barrel in 2020 and $55/barrel in 2021. However, prices are not likely to go much higher than $60/barrel because that would take them well above the current breakeven cost for shale producers, eliciting a strong supply response (Chart 19). Spread Product: Favor IG Over HY A rebound in oil prices from today’s ultra-depressed levels should help the bonds of energy companies, which are overrepresented in high-yield indices. This, together with stronger global growth and improving risk sentiment, should allow HY spreads to narrow over a 12-month horizon. Chart 20High-Yield Credit Is Pricing In Only A Moderate Recession Nevertheless, we think investment grade currently offers a better risk-reward profile. While HY spreads have jumped to more than 1000 basis points in the US, they are still nowhere close to 2008 peak levels of almost 2000 basis points. Like the equity market, high-yield credit is pricing in only a modest recession, with a default rate on par with the 2001 downturn (Chart 20). Moreover, central banks around the world are racing to protect high-quality borrowers from default. The Fed’s announcement that it will effectively backstop the investment-grade corporate bond market could be a game changer in this regard. Unfortunately for HY credit, the moral hazard consequences of bailing out companies that investors knew were risky when they first bought the bonds are too great for policymakers to bear. Government Bonds: Deflation Today, Inflation Tomorrow? As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary impulse will be exacerbated by rising unemployment. Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be deflationary. On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. This could be particularly true in the US, where our geopolitical team now expects Joe Biden to win the presidential election. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy. Our hunch is that the more inflationary scenario will unfold over the next 2-to-3 years. Interestingly, that is not the market’s opinion. For example, the 5-year US TIPS breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take. Finally, a word on gold. Just as during the Global Financial Crisis, gold failed to be an attractive hedge against financial risk during the recent stock market selloff – bullion dropped by 15% from $1704/oz to $1451/oz, before rebounding back to $1640/oz over the past few days as risk sentiment improved. Nevertheless, gold remains a good hedge against long-term inflation risk. And with the US dollar likely to weaken over the next 12 months, gold prices should move up even if near-term inflationary pressures remain contained. As such, we are upgrading our outlook on the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Appendix A Appendix A Table 1Central Banks Still Had Some Options When Crisis Hit Appendix A Table 2Massive Stimulus In Response To Pandemic Footnotes 1 Jing Yan, Suvajyoti Guha, Prasanna Hariharan, and Matthew Myers, “Modeling the Effectiveness of Respiratory Protective Devices in Reducing Influenza Outbreak,” U.S. National Library of Medicine, (39:3), March 2019. 2 Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. 3 This calculation assumes that 5% of infected people need ICU care and each spends an average of 2 weeks in the ICU. It also assumes that hospitals are able to expand their capacity by 30 additional ICU beds per 100,000 people per year to treat COVID-19. 4 Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, available at gis.bcarearch.com. 5 Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020, available at gis.bcaresearch.com. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights Portfolio Strategy We have identified 20 reasons to start buying equities. We highlight positive catalysts that should underpin the equity market as the pandemic progresses. Investors with higher risk tolerance should continue to layer in slowly and put cash to work with a cyclical 9-12 month time horizon. Consumer staples in general and hypermarkets and household products in particular are defensive areas where we are comfortable to deploy fresh longer-term oriented capital. Recent Changes Erratic trading compelled us to close out all our high-conviction calls for the year last Friday, booking handsome gains for our portfolio.1 Table 1 Feature Equities oscillated violently last week and remain mostly rudderless (Chart 1). While the relentless COVID-19 news bombardment kept on feeding the bears, on the flip side monumental monetary easing and fiscal packages the world over emboldened the bulls. This tug of war is far from over, but it is becoming crystal clear that both monetary and fiscal authorities will throw the proverbial kitchen sink at it until the hemorrhaging stops. Last week we showed that it takes a median two full years for the SPX to make fresh all-time highs following a bear market.2 This week we highlight the median and mean profile of the bear market recoveries since WWII (Chart 2). Crudely put, if history at least rhymes the SPX will not make any fresh all-time highs until early 2022. Chart 1Rudderless Chart 2Profile Of A Bear As a reminder, our equity market roadmap for the next few months is a drawn out consolidation phase leaving investors ample time to shift portfolios and put cash to work. This bottoming roadmap is something akin to the 1987, 2011, 2015/16 or early-2018 episodes.3 We cannot rule out further downside to equities. Moreover, we can neither time the tops nor the bottoms. However, the same way we were cautioning investors not to chase this market higher – as we were not willing to risk 100-200 points of SPX upside for a potential 1000 point drawdown – we are now compelled to nibble on the way down. Turning over to volatility, the VIX hit 85.47 intraday last week and clocked its highest close since the history of the data. Its sibling the VXO (volatility on the OEX or S&P 100) that predated the VIX hit an intraday high of 172.79 on Tuesday, following Black Monday, October 20, 1987, and clearly warns that if another crash takes root the VIX will explode higher.4 Importantly, vol at 85 translates into a 25% move in the SPX, in either direction, in the next 30 days. Chart 3 shows that actual SPX realized volatility jumped to 103 last week, trumping the VIX’s spike. Historically, when realized volatility trumps the VIX, it is time to sell the VIX; the opposite is also true. Given that we still do not expect a repeat of the GFC, or a depression, we recommend investors with higher risk tolerance start to deploy long-term oriented capital in the equity market. Chart 3Realized Versus Implied Vol Below are 20 reasons to start buying equities. We highlight positive catalysts that should underpin the equity market as the pandemic progresses. We are already in recession. Markets trough in recessions and historically offer enticing risk/reward return profiles. China’s manufacturing PMI and other hard data fell below the GFC lows. As a general rule of thumb investors should buy stocks when the global PMI is well below 50 (Chart 4). Cupboards are bare. A drawdown in inventories is usually followed by a jump in production. That is one of the reasons to be bullish staples. As for durables, pent-up demand due to delayed purchases will eventually be violently unleashed, especially given zero rates. Consumers will benefit from the oil market carnage and the super low mortgage refinancing rates. The Fed cut rates to zero, did QE5, and brought back the alphabet soup of programs like CPFF, PDCF and MMLF from the GFC, more will likely follow (Chart 5). Chart 4Time To Buy Chart 5The Fed Put The DXY has gone from 95 on March 9 to 103 on Friday. King dollar will soon have to reverse course and provide some much-needed relief globally as the Fed’s US dollar swap lines aim to alleviate the shortage of US dollars (Chart 6). Keep in mind what Dr. Bernanke told Scott Pelley in a 60 Minutes interview with regard to money creation: “PELLEY: Is that tax money that the Fed is spending? BERNANKE: It's not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed (emphasis ours). So it's much more akin to printing money than it is to borrowing.”5 Other global Central Banks are cutting rates and doing QE. Beyond Christine Lagarde’s recent €750bn bazooka, the ECB has the OMT ready from previous crises. Already last week the ECB intervened in Italian BTPs via Banca d’Italia. Germany has hinted that it would not be opposed to a “Covid-bond” A mega US fiscal package looms near the $1tn mark.6 The recession-related automatic stabilizers and government spending will soar. China’s fiscal response will likely be as large as in late 2008 (as a reminder in Q4/2008 the Chinese fiscal spending announcement equated “to 12.5% of China’s GDP in 2008, to be spent over 27 months”7). Germany and a slew of other countries have already pledged fiscal spending. Spain has announced a 20% of GDP package. Countries will bid-up the size of the bailout. IMF announced a $1tn bailout package. Nibbling at stocks when the VIX is at 85 makes sense versus when the VIX is at 12 (Chart 7). Chart 6Greenback Falls And Rates Rise When The Fed Does QE Chart 7Compelling Entry Point The yield curve slope is steepening (Chart 8). Chart 8The Yield Curve Always Leads Stocks The 10-year real Treasury yield hit a low of -50bps that indicator has also priced in recession (Chart 7). Chart 9Recession Nearly Fully Priced In Equity market internals have fully priced recession, small caps and weak balance sheet stocks in particular (Chart 9). Sentiment is washed out as per our Capitulation, Sentiment and Complacency-Anxiety Indicators (Chart 9). Bernie Sanders has lost his bid to become the nominee of the Democratic Party. Buffett will either bailout a company or two or buyout a company he likes. Jamie Dimon and/or other prominent CEOs (insiders) will start buying their own company stock. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus. Nevertheless, there are some risks we are closely monitoring. First, if we are offside and this turns into a GFC, another big down-leg will ensue. One reason for this would be a Spanish Flu parallel where the second wave of deaths trounced the first wave. In that case, the GDP contraction will be longer-lived and SPX EPS will suffer a long-lasting setback. Second, a credit crunch can cause a credit event, which is a big risk as we have been highlighting recently. Counter party as well as bank insolvency risks will also come into play. Third, non-financial non tech corporate net debt-to-EBITDA is at all-time highs according to company reported data and non-financial corporate debt as a percent of GDP is at all-time highs according to national accounts (Chart 10). Finally, while lower rates are helpful in the long run, a long era of low rates in Japan and more recently the euro area have not helped equities in the longer-term. The NIKKEI 225 is still down 58% from the December 1989 all-time highs and the MSCI Eurozone index is down 46% from the March 2000 all-time highs (Chart 11). Chart 10Risk: Too Much Indebtedness Chart 11Japan And The Euro Area Are Scary ZIRP Parallels Netting it all out, following a nine-month cyclical period of being in the bearish camp, we are now selectively nibbling on stocks with a 9-12 month time horizon, as we deem the potential positive catalysts will overwhelm the few risks that we are closely monitoring. This week we reiterate our overweight stance in the second largest defensive sector – the S&P consumer staples index – and two of its key sub-components. Continue To Favor Defensive Staples… Consumer staples stocks have caught on fire lately as investors have been seeking refuge in defensive equities during the current “risk off” phase. Behind health care (15.6% of the SPX weight), their safe haven siblings, staples are the second largest defensive sector comprising 8.5% of the S&P 500, and we reiterate our overweight stance in this sector. Historically, staples equities thrive in recessions and in deflationary/disinflationary environments. The reason is the allure of their stable cash flows especially in times of duress when growth is really hard to come by, a staples company growing revenues 5%/annum is sought after aggressively. Currently, relative share prices have troughed near the GFC bottom, and are probing to break out of the one standard deviation below the historical time trend mean (Chart 12), offering a compelling entry point to deploy new capital. Chart 12Bouncing Last week’s jump in unemployment insurance claims to 281,000 is a small precursor of things to come as more parts of the US get locked down (middle panel, Chart 13). This recessionary backdrop, coupled with the surging VIX, which will take months to die down to 20 near the historical average, and investors hiding in Treasurys all argue that it pays to stay with defensive staples stocks (top & bottom panels, Chart 13). Two of our preferred vehicles to continue to explore an overweight in the consumer staples sector are via above benchmark allocation in both hypermarkets and household products stocks. Chart 13Sticks With Staples …Stick With Hypermarkets… Last summer, following our recession thought experiment report8 we upgraded the S&P hypermarkets index to overweight preparing our portfolio for the inevitable recession.9 Since then, hypermarket stocks have bested the SPX by over 36%. While a consolidation phase looms that will allow hypermarkets to build a base before vaulting higher, today we are instituting a rolling 10% stop from the highs in order to protect handsome gains for our portfolio. The savings rate more than trebled from the GFC lows as the once in a generation Great Recession scared consumers. The savings rate has remained elevated ever since and is primed to rise further in the current recession as consumers tighten their purse strings. Historically, relative share prices and the savings rate have been positively correlated as even wealthier consumers opt for rock bottom selling price points. The current message is to expect a durable bidding up phase of hypermarket equities (Chart 14). Chart 14When The Going Gets Tough, Buy Hypermarkets The soaring greenback is underpinning these pricing strategies from Big Box retailers as it keeps import prices in deflation, allowing retailers to pass these on to the consumer (fourth & bottom panels, Chart 15). The recent drubbing in oil prices is an added catalyst to boost hypermarket equities as lower prices at the pump will translate into more cash in consumers’ wallets (top panel, Chart 15). Keep in mind that WMT is the number one grocery store in the US with near 25% market share – COST is also a large mover of US groceries – thus the coronavirus pandemic will not deal a blow to their demand profile. Chart 15Defense Is… The 10-year Treasury yield recently melted to 0.31%, fully discounting ZIRP, QE5 and recession. Last week’s Philly Fed survey made for grim reading, a harbinger of acute economic pain in the weeks to come. Tack on the 40% jump in weekly unemployment insurance claims, and things are falling into place for additional gains in relative share prices (Chart 16). Finally, overall tighter financial conditions and the more than doubling in the junk spread also corroborate that the path of least resistance remains higher for hypermarket equities (second & middle panels, Chart 15). Bottom Line: We reiterate our overweight stance in the S&P hypermarkets index. Today, we are also instituting a risk management metric in order to protect profits: we are implementing a rolling 10% stop from the highs in order to protect gains. The ticker symbols for the stocks in this index are: BLBG: S5HYPC – WMT, COST. Chart 16…The Best Offense …And Overweight Household Products Household products stocks have recently bounced off of long-term support and have sling shot higher (Chart 17). While we continue to recommend an above benchmark allocation of this safe haven index, we are also obliged to initiate a 5% rolling stop in order to protect our recent explosive gains. We reckon that the COVID-19 experience will scar consumers and alter behaviors with long lasting effects. We doubt this sanitization craze will completely subside following the passing of the pandemic. Our sense is that use of disinfectants and cleaning products in general will experience a parallel shift higher in the demand curve. Chart 17Held The Line Therefore, consumer outlays on household products will continue to gain share from the overall spending pie and underpin relative share prices (top panel, Chart 18). US household products exports are another important source of demand for the industry. Exports recently ticked higher and the coronavirus pandemic underscores that US manufacturers that are held in high regard abroad especially sanitation household products will struggle to meet export demand (bottom panel, Chart 18). Domestically, overall grocery store level wholesale selling prices are expanding smartly paving the way for a similar trajectory for household products pricing power (second panel, Chart 18). Importantly, given the recent consumer behavior, shortages all but assure that non-durable goods factories will be humming at a time when almost all other industries will grind to a halt (third panel, Chart 18). Moreover, household products are part of consumer goods that have a fairly inelastic demand profile and really shine during recessions. The recent collapse of the Philly Fed survey heralds a durable outperformance phase for household products equities (Chart 18). While relative valuations appear expensive, relative forward EPS and revenues are slated to trail the market in the coming 12 months. If our thesis pans out then household products stocks will grow into their pricey valuations as profits will overwhelm (Chart 19). Chart 18Demand Driven Advance In fact, our macro based S&P household products sale per share growth model does an excellent job in capturing all these drivers and signals that top line growth will continue to accelerate for the rest of the year (Chart 20). Chart 19Low Bar To Surpass Chart 20Macro Model Says Buy Bottom Line: Stick with the S&P household products index, but institute a 5% rolling stop from the highs in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5HOPRX – PG, CL, KMB, CLX, CHD. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Daily Report, “Closing Out All High-Conviction Calls” dated March 20, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com. 4 http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index/vix-historical-data 5 https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 6 Please see BCA US Equity Strategy Daily Report, “Don’t Be A Hero” dated March 11, 2020, available at uses.bcaresearch.com. 7 https://www.oecd.org/gov/budgeting/Public%20Governance%20Issues%20in%20China.pdf 8 Please see BCA US Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 9 Please see BCA US Equity Strategy Weekly Report, “Divorced From Reality” dated July 15, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights As the global economy moves toward shut-down, the Kingdom of Saudi Arabia (KSA) and Russia will be forced to end their market-share war and focus on shoring up their economies and tending to their populations’ welfare. Governments worldwide are rolling out fiscal- and monetary-policy responses to the COVID-19 pandemic. They also are imposing seldom-seen freedom-of-movement and -gathering restrictions on their populations to contain the spread of the virus. A surge in bankruptcies among US shale-oil companies is expected as demand and supply shocks push Brent and WTI below producers’ breakeven prices. In our base case, benchmark prices are pushed toward $20/bbl this year, which will keep volatility elevated. Prices recover in 4Q20 and 2021, as the pandemic recedes, and economies respond to fiscal and monetary stimulus. We have reduced our oil-price forecasts in the wake of the deterioration in fundamentals, expecting Brent to average $36/bbl in 2020, and $55/bbl in 2021. WTI will trade ~ $3-$4/bbl lower. COVID-19 is transitory. Therefore price risk is to the upside in 2021, given the global stimulus being deployed. Feature Brent and WTI prices are down 61.4% and 66.6% since the start of the year (Chart of the Week), taking front-month futures to their lowest levels since 2002. Oil markets are in a fundamental disequilibrium – the expected global supply curve is moving further to the right with each passing day, as the KSA and Russia market-share rhetoric escalates. Global demand curves are moving further to the left on an hourly basis, as governments worldwide impose freedom-of-movement restrictions and lock-downs to contain the spread of COVID-19 seen only during times of war and natural devastation. These effects combine to swell inventories globally, as rising supply fails to be absorbed by demand. The collapse in crude oil prices since the beginning of this year is lifting volatility to levels not seen since the Gulf War of 1990-91. Chart of the WeekBenchmark Crude Prices Collapse Toward Cash Costs Chart 2Oil-Price Volatility Surges To Wartime Levels Prices, as can be expected under such circumstances, are plunging toward cash costs – i.e., the level at which only operating costs are covered – which are below $20/bbl. The collapse in crude oil prices since the beginning of this year is lifting volatility to levels not seen since the Gulf War of 1990-91 launched by the US and its allies following Iraq’s invasion of Kuwait (Chart 2). As inventories rise, the supply of storage globally falls, and prices are forced below cash costs to drive surplus crude oil production from the market. The rapid evolution from backwardation (prompt prices exceed deferred prices) to steep contango (prompt prices at a discount) in the benchmark crudes is how markets signal the supply of storage is falling (Chart 3). Chart 3Markets' Violent Move From Backwardation To Contango Chart 4Storage Constraints Drive Price Volatility This strain on global inventory capacity will keep volatility elevated: As physical constraints on storage intensify, only price can adjust to clear the market, which results in massive price moves as markets respond in real time to supply-demand imbalance (Chart 4). Shales Lead US Output Lower At this point, massive increases in supply are not required to keep benchmark oil prices below $30/bbl. Markets are seeing and anticipating a sharp contraction in demand in the near term, with storage building as consumers “shelter in place” around the world. Production is set to increase in April, in the midst of a global exogenous shock to demand. As these fundamentals are worked into prices volatility will remain high. In our updated forecasts, our base case assumes KSA and its allies, and Russia raise production by 1.3mm b/d in 2Q20 and 3Q20. KSA's and Russia's output increase to ~ 11mm b/d and 11.7mm b/d, respectively. We expect the reality of low prices and a slowing world economy to force these states back to the negotiating table in 2H20, with production cuts being realized in 4Q20 and 2021 (see below). With less capital made available to shale drillers, production growth in the shales literally is forced to slow. While KSA’s and Russia’s budgets almost surely will bear enormous strain in such an environment, we believe it is the US shales that take the hardest hit over the short run, if KSA and Russia maintain their avowed production intensions. The growth in US shale output – Russia’s presumed target – is expected to slow sharply this year under current circumstances, increasing at a rate of just 650k b/d over 2019’s level. Next year, we expect shale production in the US to fall ~ 1.3mm b/d to 7.7mm b/d. Part of this is driven by the on-going reluctance of capital markets to fund shale drillers and hydrocarbon-based energy companies generally, which can be seen in the blowout in high-yield bond spreads dominated by shale issuers (Chart 5). With less capital made available to shale drillers, production growth in the shales literally is forced to slow. Chart 5Low Price Force US Shale Cutbacks With funding limited and domestic oil prices well below breakevens – and cash costs – more shale-oil producers will be pushed into bankruptcy or into sharp slowdowns in drilling activity (Charts 6A and 6B). These constraints will force total US output to contract by 1.3mm b/d next year, based on our modeling. This will take US lower 48 output this year and next to 10.5mm b/d and 9.2mm b/d, respectively (Chart 7). Chart 6ALow Prices Force US Shale CutbacksChart 6BLow Price Force US Shale Cutbacks Capital markets will not tolerate unprofitable production. When the dust settles next year, US shale-oil output is expected to take the biggest supply hit globally, based on our current assumptions and modeling results. Worthwhile remembering, however, shale-oil production is highly likely to emerge a leaner more efficient sector, as they did in the OPEC-led market-share war of 2014-16.1 Also worthwhile remembering, for shale operators, is capital markets will not tolerate unprofitable production. So, net, a stronger, more disciplined shale-oil producer cohort emerges from the wreckage of the COVID-19 demand shock coupled with the KSA-Russia market-share war of 2020. Chart 7US Shale Contraction Leads US Output Lower In 2021 Demand Uncertainty Is Huge We are modeling a shock that reduces global demand – a highly unusual occurrence – by 150k b/d this year versus 2019 levels (Table 1). Most of this shock occurs in 1H20, where a large EM contraction originating in China set the pace. We expect China’s demand to begin recovering in 2Q20. The demand contraction moves into OECD states in 2Q20, which are expected to follow a similar trajectory in demand shedding seen elsewhere (Chart 8). In 2H20, we expect global demand to begin recovering, and, barring another outbreak of COVID-19 (or another novel coronavirus) next winter, for global demand growth to re-accelerate to ~ 1.7mm b/d in 2021. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) The uncertainty around our demand modeling is large. Expectations from the large data providers are all over the map: The EIA expects demand to grow 360k b/d this year, while the IEA and OPEC expect -90k and 60k b/d. In addition, some banks and forecasters make a case for demand falling by 1mm b/d or more in 2020, a scenario we do not expect. Sorting through the evolution of demand this year – i.e., tracking the recovery from China and EM through to DM – will be difficult, particularly as Western states go into lock-down mode and the global economy remains moribund. This makes our forecasts for supply-demand balances and prices highly tentative, and subject to revision. Chart 8Demand Shock + Market-Share War = Imbalance Market-Share War: What Is It Good For? As we argue above, the US shale-oil producers will, for a variety of reasons, be forced by capital and trading markets to retrench, and to cut production sharply. They lost favor with markets prior to the breakdown of OPEC 2.0, and this will not change. At this point, it is unlikely KSA and Russia can alter this evolution by increasing or decreasing production – investors already have shown they have little interest in funding their further growth and development. The KSA-Russia market-share war reinforces investors’ predispositions, and decidedly accelerates this retrenchment by the shale producers. As the global economy moves toward shut-down, KSA and Russia will be forced to turn their attention to shoring up their economies and tending to their populations’ welfare. The strain of a global shut-down will absorb governments’ resources worldwide, and self-inflicted wounds – which, at this point, a market-share war amounts to – will only make domestic conditions worse in KSA, Russia and their respective allies. The income elasticity of supply for these producers is such that small adjustments – positive or negative – on the supply side have profound effects on oil producers’ revenues (Table 2). Both KSA and Russia are aware of this. Russia burns through its $150 billion national wealth fund in ~ three years in a market-share war, while KSA burns through ~ 10% of its foreign reserves, when export prices fall $30/bbl and Russia's exports rise 200k b/d and KSA's rise 2mm b/d.2 In a world where demand destruction is accelerating revenue losses, and storage limitations threaten to collapse oil prices below cash costs, production management – even if that means extending the 1Q20 cuts of 1.7mm b/d for the balance of 2020 – is necessary to avoid larger, longer-term economic damage (Chart 9). Table 2Market-Share War Vs. Revenue Chart 9Global Inventories Could Surge We believe the leadership in both of these states have sufficient reason to return to the negotiating table to figure out a way to re-start their production-management accord, if only to preserve funds to cover imports while global demand recovers. It may take a month or two of unchecked production to make this point clear, however, so volatility can be expected to remain elevated. These fundamental and political assessments compel us to reduce our oil-price forecasts in the wake of the deterioration in fundamentals, expecting Brent to average ~ $36/bbl in 2020, and $55/bbl in 2021. WTI will trade ~ $3-$4/bbl lower. Price risk is to the upside in 2021, given the global fiscal and monetary stimulus being deployed. Bottom Line: The confluence of a true global demand shock and a market-share war on the supply side has pushed benchmark crude oil prices close to cash costs for many producers. The damage to states highly dependent on oil revenues is just now becoming apparent. We expect KSA and Russia to return to the negotiating table, to hammer out a production-management accord that allows them to control as much of the economic damage to their economies as is possible. Capital markets already are imposing a harsh discipline on US shales – Russia’s presumptive target in the market-share war. The consequences of the COVID-19 vis-a-vis demand destruction are of far greater moment for KSA and Russia than their market-share war. They need to shore up their economies and get in the best possible position to benefit from a global economic rebound, not destroy themselves seeking a Pyrrhic victory that devastates both of them. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Chinese refiner Sinochem International Oil (Singapore) turned down an offer of crude-oil cargoes for May-June deliver from Russian oil company Rosneft PJSC, which is under US sanctions, according to Bloomberg. Sinochem refuses cargoes from Iran, Syria, Venezuela, and Kurdistan, which also are under sanction or are commercially aligned with sanctioned entities. Base Metals: Neutral The downward trend in base metal prices remains, as the spread of the coronavirus intensifies outside of China, and governments worldwide impose freedom-of-movement restrictions on their populations to contain further spread. Persistent US dollar strength – supported by inflows to safe assets amid the elevated global economic uncertainty – pressures EM economies’ base metal demand. As a result, the LME index is down 18% YTD, reaching its 2016 lows. We were stopped out of our long LMEX recommendation on March 17, 2020 for a 12% loss. Precious Metals: Neutral Gold and silver are caught up in a global selloff of assets that have performed well over the past year as safe havens, as market participants raise cash for liquidity reasons or margin calls. We are waiting for an opportunity to go long gold again after being stopped out earlier in the sell-off. Silver will recover with industrial-commodity demand, which we expect to occur in 4Q20, when the COVID-19 threat recedes, and consumers worldwide are responding to the globally fiscal and monetary stimulus being rolled out now. We are staying on the sidelines for now, as volatility is extremely high for metals (Chart 10). Ags/Softs: Underweight CBOT May Corn futures were down 3% Tuesday, reaching 18-month lows, driving mostly by high USD levels, which make US exports less competitive. Supplies from South America, where a large harvest is ongoing in Argentina and Brazil, are taking market share. Furthermore, according to a report from the University of Illinois, lower gasoline consumption resulting from the COVID-19 pandemic will reduce the amount of corn needed for ethanol production; demand could fall 120mm to 170mm bushels. Soybeans and wheat futures ended the day slightly higher on the back of bargain buying, after falling to multi-month lows on Monday. USD strength remains a headwind on ags, encouraging production ex-US at the margin and contributing to stifling demand for US exports (Chart 11). Chart 10Gold Is Experiencing Extremely High Volatility Chart 11USD Strength Remains A Headwind On AGS Footnotes 1 Please see How Long Will The Oil-Price Rout Last?, a Special Report we published March 9, 2020, which discussed US bankruptcy law and the re-cycling of assets. 2 Please see Russia's Supply Shock To Oil Markets and Russia Regrets Market-Share War?, which we published March 6 and March 12, 2020, for additional discussion. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades