Estados Unidos

Informe especial

Dear Client, This week, I provided an update through a webcast on the economic and financial market outlook in the era of the COVID-19 outbreak. You can access the webcast here. In lieu of our regular report this week, we are sending you a Special Report from my colleague Jonathan LaBerge. Jonathan shows why the most widely cited estimate of the US neutral rate of interest, the Laubach & Williams estimate of “R-star”, is very likely wrong and that the true neutral rate may be higher than many investors believe. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. I hope you find the report insightful. Please note that next week we will be publishing our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to the only available real time estimate of the real neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even once economic recovery takes hold unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). This report revisits the “LW” R-star estimate in detail, and demonstrates why the estimation is almost certainly wrong, at least over the past two decades. We also outline an inferential approach that investors can use to monitor where the neutral rate is in real time and whether it is rising or falling. The core conclusion for investors is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, investors should avoid dogmatic medium-to-longer term views about yields as they may rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. Feature Over the past several weeks financial markets have moved rapidly to price in a global recession stemming from the COVID-19 outbreak. As financial market participants began to turn to policy makers for support, eyes focused first on the Federal Reserve, and then fiscal authorities. Earlier this week, the ECB joined the party and announced aggressive further measures of its own. When responding to the Fed’s return to the lower bound and its other recent monetary policy decisions, many market participants have expressed the view that the Fed is largely impotent to deal with a global pandemic. There are three elements to this view. The first is that interest rate cuts are ill equipped to stimulate domestic demand if quarantine measures or other forms of “social distancing” are in effect. The second element is that the Fed has only been capable of delivering a fraction of the reduction in interest rates compared to what has occurred in response to previous contractions. The third aspect of this view is that because the neutral rate of interest is so much lower now than it was in the past, Fed rate cuts will not be as stimulative as they were before. Chart 1Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate While we at least partly agree with the first and second elements of this view, we feel strongly that the third is flawed. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013,1 and have gravitated to the only available real time estimate of the neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. This time series, which is regularly updated by the New York Fed,2 suggests that the real fed funds rate reached neutral territory in the first quarter of 2019 (Chart 1). With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even beyond the near term unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). In this Special Report we revisit the “LW” R-star estimate in detail, and demonstrate why the estimation is almost certainly wrong, at least over the past two decades. Our analysis does not reveal a precise alternative estimate of the neutral rate, although we do provide some inferential perspective on how investors may be able to monitor where the neutral rate is in real time and whether it is rising or falling. However, the core insight emanating from our report, particularly for US fixed income investors, is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once economic activity recovers. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise may be larger than many investors currently expect. Demystifying The LW R-star Estimate The LW estimate of the neutral rate of interest has gained credibility for three reasons. First, as noted above, the evolution of the series fits with the secular stagnation narrative re-popularized by Larry Summers. Second, the series is essentially sponsored by the Federal Reserve even if it is not officially part of the Fed’s forecasting framework, as its two creators are long-time Fed employees (Thomas Laubach is a director of the Fed’s Board of Governors, and John Williams is the current President of the New York Fed). But, in our view, there is a third important reason that global investors have accepted the LW R-star estimate of the neutral rate of interest: the methodology used to generate the estimate is extremely technically complex, and thus is difficult for most investors to penetrate. Much of the technical complexity of the LW estimate is centered around the use of a statistical procedure called a Kalman filter (“KF”). Simply described, the KF is an algorithm that tries to estimate an unobservable variable based on 1) an idea of how the unobservable variable might relate to an observable variable (the “measurement equation”), and 2) an idea of how the unobservable variable might change through time (the “transition equation”). Through a repeated process of simulating the unobserved variable based on a set of assumptions, the KF is able to compare predicted results to actual results on an observation-by-observation basis, and use that information to generate ever more reliable future estimates of the unobserved variable (Chart 2). Chart 2A Very Simplified Overview Of The Kalman Filter Algorithm We acknowledge that a full technical treatment of the Kalman Filter as it relates to the LW estimate of the neutral rate of interest is beyond the scope of this report, and we provide a more technical overview in Box 1. But what emerges from a detailed analysis of the model is that the Kalman Filter jointly estimates R-star, potential GDP growth, potential GDP, and the variable “z”, the determinants of R-star that are not explained by potential GDP growth. As we will highlight in the next section, this joint estimation of these four variables is a crucial aspect of the model, because a valid estimate of R-star necessitates a valid estimate of the remaining variables. Box 1 A Technical Overview Of The Laubach & Williams R-star Model Debunking The LW R-star Estimate Before criticizing the LW estimate of the neutral rate of interest, it is important for us to note that we have the utmost respect for the Federal Reserve and its research methods. We fully acknowledge that the LW R-star estimation is rooted in solid economic theory, and we have identified no technical errors in the setup of the LW model. Nevertheless, valid analytical efforts sometimes lead to problematic real-world results, and there are two key reasons to believe that the Kalman filter in the LW model is almost certainly misspecifying R-star, at least in terms of its estimate over the past two decades. The first reason relates to the sensitivity of the model to the interval of estimation (the period over which R-star is estimated). Chart 3 presents the range of quarterly estimates of R-star since 2005, along with the difference between the high and low end of the range in the second panel. The chart shows that while previous estimates of R-star have generally been stable for values ranging between the early-1980s and 2006/2007, pre-1980 estimates have varied quite substantially and we have seen material revisions to the estimates over the past decade. Q1 2018 serves as an excellent example: in that quarter R-star was estimated to be 0.14%; today, the Q1 2018 R-star estimate sits at 0.92%. Chart 3Since 2005, There Has Been Some Instability In The LW R-star Estimates   However, Table 1 and Chart 4 highlight the real instability of the Kalman filter estimation by demonstrating the effect of varying the starting point of the model (please see Box 2 for a brief description of how our estimation of R-star using the LW approach differs slightly from the original procedure). Laubach & Williams originally estimated R-star beginning in Q1 1961; Table 1 shows what happens to today’s estimate of R-star simply by incrementally varying the starting point of the model from Q1 1958 to Q4 1979. Table 1Alternative Current LW Estimates Of R-star By Model Starting Point Chart 4Alternative Starting Points Produce Wildly Different Estimates Of R-star Today Box 2 The Laubach & Williams R-star Model With Simplified Inflation Expectations The table highlights that the model fails to even generate a result in a majority of the cases (only 39 out of 88 of the model runs were error-free). In addition, Chart 4 shows that of the successful estimates of R-star using the LW procedure and alternate starting dates of the model, the estimate of R-star today varies from -2% (in one case) to +2%. Excluding the one extremely negative outlier results in an effective estimate range of 0% to 2%, but the key point for investors is that this range is massive and underscores that the original model’s estimate of R-star today is heavily and unduly influenced by the interval of estimation. Investors should also note that of all of the alternative estimates of R-star today shown in Chart 4, the estimate using the original interval is very much on the low end of the distribution. The second (and most important) reason to believe that the LW estimate is misspecifying R-star is that the output gap estimate generated by the model is almost certainly invalid, at least over the past two decades. Chart 5 presents the LW output gap estimate alongside an average of the CBO, OECD, and IMF estimates of the gap; panel 1 shows the official current LW output gap estimate, whereas panel 2 shows the range of output gap estimates that are generated using the different estimation intervals highlighted in Table 1 and Chart 4. Given that the Kalman filter in the LW model jointly determines R-star and the output gap (by way of estimating potential output via estimating potential GDP growth) and that these estimates are dependent on each other, Chart 5 highlights that in order to believe the LW R-star estimate investors must believe three things: That the US economy was chronically below potential in the late-1990s when the unemployment rate was below 5%, real GDP growth averaged nearly 5%, and the equity market was booming, That output exceeded potential in 2004/2005 by a magnitude not seen since the late-1970s / early-1980s despite an average unemployment rate, That the 2008/2009 US recession was not particularly noteworthy in terms of its deviation from potential output, and that the economy had returned to potential output by 2010/2011 when the unemployment rate was in the range of 8-9%. Chart 5The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades While we do not believe any of these three statements, the third is especially unlikely. Chart 6 highlights that the economic expansion from 2009 – 2020 was the weakest on record in the post-war era in terms of average annual real per capita GDP growth. To us, this is a clear symptom of a chronic deficiency in aggregate demand, and that it is essentially unreasonable to argue that the economy was operating at full employment prior to 2014/2015. This means that the Kalman filter is generating incorrect and unreliable estimates of the output gap, which means in turn that the filter’s estimation of R-star is almost assuredly wrong. Chart 6The US Economy Was Definitely Not At Full Employment In 2010 How Can Investors Tell What The Neutral Rate Is? An Inferential Approach Table 2 presents the sensitivity of the original Q1 1961 LW estimate of R-star to a series of counterfactual scenarios for inflation, real GDP growth, nominal interest rates, and import and oil prices since mid-2009. While these scenarios do not in any way improve the validity of the LW R-star estimate, they do help clarify the theoretical basis of the model and they help reveal how investors may infer whether the neutral rate of interest is higher or lower than prevailing market rates, and whether it is rising or falling. Table 2 highlights that today’s estimate of R-star using the original LW approach is mostly sensitive to our counterfactual scenarios for growth and interest rates, but not inflation or oil prices. Shifting down import price growth also has a meaningful effect on R-star, but since core import price growth has been particularly weak over the past several years (Chart 7), it seems unreasonable to suggest that they have been abnormally high and thus “explain” a low R-star estimate today. Table 2Sensitivity Of Current LW R-star Estimate To Counterfactual Scenarios (2009 - Present) Chart 7Core Import Price Growth Has Been Weak On Average During This Expansion Table 2 essentially highlights that the entire question of the neutral rate of interest over the past decade, and the core contradiction that led to the re-emergence of the secular stagnation thesis, can effectively be boiled down to the following simple question: “Why hasn’t US economic growth been stronger this cycle, given that interest rates have been so low?” Based on the (hopefully uncontroversial) view that interest rates influence economic activity and that economic activity influences inflation, we propose the following checklist for investors to ask themselves in order to not only determine the answer to this important question, but to help identify whether R-star in any given country is likely higher or lower than existing policy rates at any given point in time. Are interest rates above or below the prevailing level of economic growth? Are interest rates rising or falling, and how intensely? Are there identifiable non-monetary shocks (positive or negative) that appear to be influencing economic activity? Is private sector credit growth keeping pace with economic growth? Are debt service burdens in the economy high or low? The first question reflects the most basic view of R-star, which is that the real neutral rate of interest should be equal to, or at least closely related to, the potential growth rate of the economy, ceteris paribus. Questions 2 through 5 attempt to determine whether ceteris paribus holds. In terms of how the answers to these questions relate to identifying the neutral rate, consider two economies, “Economy A” and “Economy B” (Chart 8). Economy A has broadly stable or slightly rising interest rates that are well below prevailing rates of economic growth (questions 1 & 2), no obvious beneficial shocks to domestic demand from fiscal policy or other factors (question 3), and strong private sector credit growth that is perhaps above or strongly above the current pace of GDP growth (question 4). Chart 8''Economy A'', Versus ''Economy B'' Inferentially, it would seem that interest rates in this hypothetical economy are below R-star today. Question 5 is in our list because the more that active private sector leveraging occurs (thus pushing up debt burdens), the more that we would expect R-star in the future to fall. This is because debt payments as a share of income cannot rise forever, and we would expect that the capacity of economy A’s central bank to raise interest rates in the future are negatively related to economy A’s private sector debt service burden today. Now, imagine another economy (“Economy B”) with interest rates well below average rates of economic growth, an interest rate trend that is flat-to-down, no identifiable non-monetary policy shocks that are restricting aggregate demand, persistently sluggish credit growth, and high private sector debt service burdens in the past. If economy B is growing (even sluggishly) and not in the middle of a recession, it would seem that prevailing interest rates are below R-star, but not significantly so. In this scenario it would seem reasonable to conclude that R-star in economy B has fallen non-trivially below its potential growth rate, and that interest rate increases are likely to move monetary policy into restrictive territory earlier than otherwise would be the case. Is The United States “Economy B”? From the perspective of some investors, our description of economy B above perfectly captures the experience of the US over the past decade: an extremely low Fed funds rate, sluggish to weak growth and inflation, all the result of a huge build-up in leverage and debt service burdens during the last economic cycle. We do not doubt that R-star fell in the US for some period of time during the global financial crisis and in the early phase of the economic recovery. But we doubt that it is as low today as the secular stagnation narrative would imply, in large part because it ignores several important aspects concerning questions 2 through 5 noted above. Chart 9Fiscal Austerity Has Been A Serious Non- Monetary Shock To Aggregate Demand Non-monetary shocks to the US and global economies: Over the past 12 years, there have been at least five deeply impactful non-monetary shocks to both the US and global economies that have contributed to the disconnect between growth and interest rates: 1) a prolonged period of US household deleveraging from 2008-2014, 2) the euro area sovereign debt crisis, 3) fiscal austerity in the US, UK, and euro area from 2010 – 2012/2014 (Chart 9), 4) the US dollar / oil price shock of 2014, and 5) the recent trade war between the US and China. Several of these shocks have been policy-driven, and in the case of austerity the negative consequences of that policy has led to a lasting change in thinking among fiscal authorities (outside of Japan) that is unlikely to reverse in the near-future. Private sector credit growth: Chart 10 highlights the extent of household deleveraging noted above by showing the growth in total household liabilities over the past decade alongside income growth. Panel 2 shows the leveraging trend of firms, as represented by the nonfinancial corporate sector debt-to-GDP ratio. Chart 10 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it is now growing again and has largely closed the gap with income growth. The second point is that the nonfinancial corporate sector has clearly leveraged itself over the course of the expansion, arguing that interest rates have not in any way been restrictive for businesses. While it is true that firms have largely leveraged themselves to buy back stock instead of significantly increasing capital expenditures, in our view this reflects the fact that US consumer demand was impaired for several years due to deleveraging. We doubt that firms would have altered their capital structures to this degree if they did not view interest rates as extremely low. Chart 10Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Debt service burdens: Chart 11 highlights that US household debt service burdens were at very elevated levels prior to the financial crisis, suggesting that the neutral rate did fall for some time following the recession. But today, the debt burden facing households is the lowest it has been in the past 40 years due to both rate reductions and deleveraging, arguing against the view that household debt levels will structurally weigh on interest rates in the years to come. Chart 12 shows that the picture is different for nonfinancial corporations, as the substantial leveraging noted above has indeed raised debt service burdens for firms. However, the nonfinancial corporate sector debt service ratio remains 400 basis points below early-2000 levels when excess corporate sector liabilities had a clear impact on the economy, suggesting that the Fed’s capacity to raise interest rates still exists following the onset of economic recovery if corporate sector credit growth does not rise sharply relative to GDP over the coming 6-12 months. Chart 11The Debt Burden Facing US Households Is At A Record Low Chart 12Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise The intensity of recent interest rate changes: Finally, many investors have pointed to sluggish housing activity over the past three years as evidence of a low neutral rate. However, Chart 13 highlights that the rise in the 30-year US mortgage rate from late-2016 to late-2018 was one of the largest two-year changes in US history, and Chart 14 shows that the growth in household mortgage credit did not fall below its trend during this period until Q4 2018, when the US stock market fell 20% from its high in response to the economic consequences of the US/China trade war. Chart 14 also shows that mortgage credit growth responded sharply to a recent reduction in interest rates. All in all, Charts 13 & 14 cast doubt on the notion that the level of mortgage rates over the past three years reached restrictive territory. Chart 13Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Chart 14A Record Rise In Mortgage Rates Did Not Crack The Housing Market Investment Conclusions In the face of a global pandemic and an attendant global recession this year, the idea of eventual Fed rate hikes and the notion that the US economy will be able to tolerate them likely seems preposterous to many investors. We agree that over the coming 6-12 months US Treasury yields are unlikely to rise; even at current levels of the 10-year Treasury yield, we are reluctant to call a trough. Chart 15US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade However, Chart 15 highlights that over a long-term time horizon, the bond market is now essentially priced for a repeat of the ten-year path of the Fed funds rate following the global financial crisis. While some investors will view this as a reasonable expectation in the face of what they see as a persistent and unexplainable gap between growth and interest rates over the past decade, we think this gap is explainable and we highly doubt that a pandemic with minimal mortality risk to the working age population and the young will cause the US economy to be afflicted with active consumer deleveraging lasting 4 to 6-years, substantial and wide-ranging fiscal austerity, persistently rising trade tariffs, and sharply lower oil prices. So while we agree that the US economy will be substantially cyclically affected by COVID-19, US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise following the upcoming recession may be larger than many investors currently believe.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1    "IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer," Washington DC, November 8, 2013. 2    "Measuring the Natural Rate of Interest," Federal Reserve Bank of New York. Global Investment Strategy View Matrix

In our 20+ years in the equity markets we have rarely seen such erratic moves on a daily basis across sectors and subindustries. While our portfolio has withstood the recent tremor, our confidence has taken the back seat with regard to our high-conviction calls for the year initiated in the December 2, 2019 report.1 Therefore we are closing out all high-conviction trades, both overweights and underweights, for a combined relative net gain of 27% (and average gain of 3.4%) since inception. In more detail, our underweight in homebuilders, preference of large caps to small caps and underweight in semi cap names have netted us 43%, 26%, and 6% in gains, respectively (see Charts 1& 2below). On the flip side, the overweight in banks and machinery and underweight in utilities have shaved off 25%, 13% and 12%, respectively (see Charts 1&2 below). Table 1 summarizes all our profits and losses. Further, from a portfolio management perspective we are instituting a rolling 10% stop from the highs on two extremely volatile cyclical positions in order to protect gains: our overweight in the S&P homebuilders index is up 51% since the October 2019 inception, and our large cap over small cap preference is up 45% since the May 2018 inception. Bottom Line: We are moving to the sidelines on the high-conviction calls for the year and are closing out all eight positions for a net gain of 27% (and average gain of 3.4%), since inception. Stay tuned. Chart 1 Chart 2   1     Please see BCA US Equity Strategy Weekly Report, “2020 Key Views: High-Conviction Calls” dated December 2, 2019, available at uses.bcaresearch.com.  

Informe especial

Highlights The global pandemic is quickening the decline in globalization. Democracies can manage the virus, but it will be painful. European integration just got a major boost from Germany’s fiscal turn. Stay long the German consumer relative to the exporter. The US and UK are shifting to a “big government” approach for the first time in forty years. Go long TIPS versus equivalent-maturity nominal Treasuries. The US-China cold war is back on, after a fleeting hiatus. Stay short CNY-USD. Stay strategically long gold but go tactically long Brent crude oil relative to gold. Feature The global pandemic blindsided us this year, but it is catalyzing the past decade’s worth of Geopolitical Strategy’s themes. This week’s report is dedicated to our founder and consulting editor, Marko Papic, who spearheaded the following themes, which should be considered in light of this month’s extraordinary developments: The Apex Of Globalization: Borders are closing and the US is quarreling with both Europe and China over vulnerabilities in its medical supply chain. European Integration: Germany is embracing expansive fiscal policy and is softening its line on euro bonds. The End of Anglo-Saxon Laissez-Faire: Senate Republicans in the US are considering “helicopter money” – deficit-financed cash handouts to the public. US-China Conflict: Pandemic, recession, and the US election are combining to make a dangerous geopolitical cocktail. In this report we discuss how the coronavirus crisis is supercharging these themes, making them salient for investors in the near term. New themes will also develop from the crucible of this pandemic and global recession. Households Can’t Spend Helicopter Money Under Quarantine The global financial meltdown continues despite massive monetary and fiscal stimulus by governments across the world (Chart 1). The reason is intuitive: putting cash in people’s hands offers little solace if people are in quarantine or self-isolation and can’t spend it. Stimulus is essential and necessary to defray the costs of a collapsing economy, but doesn’t give any certainty regarding the depth and duration of the recession or the outlook for corporate earnings. Government health policy, rather than fiscal or monetary policy, will provide the critical signals in the near term. Once the market is satisfied that the West is capable of managing the pandemic, then the unprecedented stimulus has the potential to supercharge the rebound. The most important measure is still the number of new daily cases of the novel coronavirus across the world (Chart 2). Once this number peaks and descends, investors will believe the global pandemic is getting under control. It will herald a moment when consumers can emerge from their hovels and begin spending again. Chart 1Monetary/Fiscal Stimulus Not Enough To Calm Markets Chart 2Keep Watching New Daily Cases Of COVID-19 It is critical to see this number fall in Italy, proving that even in cases of government failure, the contagion will eventually calm down (Chart 3). This is essential because it is possible that an Italian-sized crisis could develop in the US or another European country, especially given that unlike Iran, these countries have large elderly populations highly susceptible to the virus. Financial markets are susceptible to more panic until the US and EU show the virus is under control. At the same time the other western democracies still need to prove they are capable of delaying and mitigating the virus now that they are fully mobilized. They should be able to – social distancing works. The province of Lodi, Italy offers an example of successful non-pharmaceutical measures (isolation). It enacted stricter policies earlier than its neighbors and succeeded in turning down the number of daily new cases (Chart 4).1 But it may also be testing less than its wealthier neighbor Bergamo, where the military has recently been deployed to remove corpses. Chart 3Market Needs Italy Contagion To Subside Chart 4Lodi Suggests Social Distancing Works More stringent measures, including lockdowns, are necessary in “hot zones” where the outbreak gets out of control. It is typical of democracies to mobilize slowly, in war or other crises. Italy brought the crisis home for the G7 nations, jolting them into unified action under Mario Draghi’s debt-crisis slogan of “whatever it takes.” Borders are now closed, schools and gatherings are canceled, policy and military forces are deploying, and emergency production of supplies is under way. Populations are responding to their leaders. Self-preservation is a powerful motivator once the danger is clearly demonstrated. Still, in the near term, Spain, Germany, France, the UK, and the United States have painful battles to fight to ensure they do not become the next Italy, with an overloaded medical system leading to a vicious spiral of infections and deaths (Chart 5). Chart 5Painful Battles Ahead For US And EU Until financial markets verify that current measures are working, they are susceptible to panics and selling. In the United States, testing kits were delayed by more than a month because the Center for Disease Control bungled the process and failed to adopt the successful World Health Organization protocol. Some materials for testing kits are still missing. Many states will not begin testing en masse for another two weeks. This means that big spikes in new cases will occur not only now but in subsequent weeks as testing exposes more infections. Over the next month there are numerous such trigger points for markets to panic and give away whatever gains they may have made from previous attempts at a rally. Pure geopolitical risks, outlined below, reinforce this reasoning. Volatility will continue to be the dominant theme. Governments must demonstrate successes in health crisis management before monetary and fiscal measures can have their full effect. There is no amount of stimulus that can compensate for the collapse of consumer spending in advanced consumer societies (Chart 6), so consumers’ health must be put on a better trajectory first. Thus in place of economic and financial data streams, we are watching our Health Policy Checklist (Table 1) to determine if policy measures can provide reassurance to the economy and financial markets. Chart 6No Stimulus Can Offset Collapse Of Consumer Table 1Markets Need To See Health Policy Succeeding Bottom Line: For financial markets to regain confidence durably, governments must show they can manage the outbreak. This can be done but the worst is yet to come and markets will not be able to recover sustainably over the next month or two during that process. There is more upside for the US dollar and more downside for global equities ahead. The Great Fiscal Blowout Global central banks were not entirely out of options when this crisis hit – the Fed has cut rates to zero, increased asset purchases, and extended US dollar swap lines, while central banks already at the zero bound, like the ECB, have still been able to expand asset purchases radically (Table 2). Table 2Central Banks Still Had Some Options When Crisis Hit Chart 7ECB Still The Lender Of Last Resort The ECB’s new 750 billion euro Pandemic Emergency Purchase Program (PEPP) has led to a marked improvement in peripheral bond spreads which were blowing out, guaranteeing that the lender of last resort function remains in place even in the face of a collapse of the Italian economy that will require a massive fiscal response in the future (Chart 7). Nevertheless with rates so low, and government bond yields and yield curves heavily suppressed, investors do not have faith in monetary policy to make a drastic change to the macro backdrop for developed market economies. Fiscal policy was the missing piece. It has remained restrained due to government concerns about excessive public debt. Now the “fiscal turn” in policy has arrived with the pandemic and massive stimulus responses (Table 3). Table 3Massive Stimulus In Response To Pandemic The Anglo-Saxon world had already rejected budgetary “austerity” in 2016 with Brexit and Trump. Few Republicans dare oppose spending measures to combat a pandemic and deep recession after having voted to slash corporate taxes at the height of the business cycle in 2017.2 The Trump administration is currently vying with the Democratic leadership to see who can propose a bigger third and fourth phase to the current spending plans – $750 billion versus $1.2 trillion? Both presidential candidates are proposing $1 trillion-plus infrastructure plans that are not yet being put to Congress to consider. The Trump administration agrees with its chief Republican enemy, Mitt Romney, as well as former Obama administration adviser Jason Furman, in proposing direct cash handouts to households (“helicopter money”). The size of the US stimulus is at 7% of GDP and rising, larger than in 2008- 10. In the UK, the Conservative Party has changed fiscal course since the EU referendum. Prime Minister Boris Johnson's government had proposed an “infrastructure revolution” and the most expansive British budget in decades – and that was before the virus outbreak. Robert Chote, the head of the Office for Budget Responsibility, captured the zeitgeist by saying, “Now is not a time to be squeamish about public sector debt. We ran during the Second World War budget deficits in excess of 20% of GDP five years on the trot and that was the right thing to do.”3 Now Germany and the EU are joining the ranks of the fiscally accommodative – and in a way that will have lasting effects beyond the virus crisis. Chart 8Coalition Loosened Belt Amid Succession Crisis On March 13 Germany pulled out a fiscal “bazooka” of government support. Finance Minister Olaf Scholz announced that the state bank, KfW, will be able to lend 550bn euros to any business, great or small, suffering amid the pandemic. KfW’s lending capacity was increased from 12% to 15% of GDP. But Scholz, of the SPD, and Economy Minister Peter Altmaier, of the CDU, both insist that there is “no upward limit.” This shift in German policy was the next logical step in a policy evolution that began with the European sovereign debt crisis and took several strides over the past year. The German public, battered by the Syrian refugee crisis, China’s slowdown, and the trade war, voted against the traditional ruling parties, the Christian Democratic Union (CDU) and the Social Democratic Party (SPD). Smaller parties have been stealing their votes, namely the Greens but also (less so) the right-wing populist Alternative for Germany (Chart 8). This competition has thrown the traditional parties into crisis, as it is entirely unclear how they will fare in the federal election in 2021 when long-ruling Chancellor Angela Merkel passes the baton to her as yet unknown successor. To counteract this trend, the ruling coalition began loosening its belt last year with a small stimulus package. But a true game changer always required a crisis or impetus – and the coronavirus has provided that. Germany’s shift is ultimately rooted in geopolitical constraints: Germany is a net beneficiary of the European single market and stands to suffer both economically and strategically if it breaks apart. Integration requires not only the ECB as lender of last resort but also, ultimately, fiscal transfers to keep weaker, less productive peripheral economies from abandoning the euro and devaluing their national currencies. When Germany loosens its belt, it gives license to the rest of Europe to do the same: The European Commission was obviously going to be extremely permissive toward deficits, but it has now made this explicit. Spain announced a massive 20% of GDP stimulus package, half of which is new spending, and is now rolling back the austere structural reforms of 2012. Italy is devastated by the health crisis and is rolling out new spending measures. The right-wing, big spending populist Matteo Salvini is waiting in the wings, having clashed with Brussels over deficits repeatedly in 2018-19 only to see Brussels now coming around to the need for more fiscal action. In addition to spending more, Germany is also sounding more supportive toward the idea of issuing emergency “pandemic bonds” and “euro bonds,” opening the door for a new source of EMU-wide financing. True, the crisis will bring out the self-interest of the various EU member states. For example, Germany initially imposed a cap on medical exports so that critical items would be reserved for Germans, while Italy would be deprived of badly needed supplies. But European Commission President Ursula von der Leyen promptly put a stop to this, declaring, “We are all Italians now.” Fiscal policy is now a tailwind instead of a headwind. Von der Leyen is representative of the German ruling elite, but her position is in line with the median German voter, who approves of the European project and an ever closer union. Chart 9DM Budget Deficits Set To Widen Separately, it should be pointed that Japan is also going to loosen fiscal policy further. Prime Minister Shinzo Abe was supposed to have already done this according to his reflationary economic policy. His decision to hike the consumer tax in 2014-15 and 2019, despite global manufacturing recessions, ran against the aim of whipping the country’s deflationary mindset. While Abe’s term will end in 2021, Abenomics will continue and evolve by a different name. His successor is much more likely now to follow through with the “second arrow” of Abenomics, government spending. Across the developed markets budget deficits are set to widen and public debt to rise, enabled by low interest rates, surging output gaps, and radical policy shifts that were long in coming (Chart 9). Bottom Line: Ultra-dovish fiscal policy is now complementing ultra-dovish monetary policy throughout the West. This was clear in the US and UK, but now Europe has joined in. Germany’s “bazooka” is the culmination of a policy evolution that began with the European debt crisis. This is an essential step to ensuring that Germany rebalances its economy and that Europe sticks together during and after the pandemic. Europe still faces enormous challenges, but now fiscal policy is a tailwind instead of a headwind. US-China: The Cold War Is Back On US-China tensions are heating back up and could provide the source of another crisis event that exacerbates the “risk off” mode in global financial markets. The underlying strategic conflict never went away – it is rooted in China’s rising geopolitical power relative to the United States. The “phase one” trade deal agreed last fall was a manifestly short-term, superficial deal meant to staunch the bleeding in China’s manufacturing sector and deliver President Trump a victory to take to the 2020 election. Beijing was never going to deliver the exorbitant promises of imports and was not likely to implement the difficult structural provisions until Trump achieved a second electoral mandate. Trump always had the option of accusing China of insufficient compliance, particularly if he won re-election. Now, however, both governments are faced with a global recession and are seeking scapegoats for the COVID-19 crisis. Xi Jinping doesn’t have an electoral constraint but he does have to maintain control of the party and rebuild popular confidence and legitimacy in the wake of the crisis. China’s private sector has suffered a series of blows since Xi took power. China’s trend growth is slowing, it is sitting on an historic debt pile, and it is now facing the deepest recession in modern memory. The protectionist threat from the United States and other nations is likely to intensify amid a global recession. Former Vice President Joe Biden has clinched the Democratic nomination and does not offer a more attractive option for China than President Trump. On the US side, Trump’s economic-electoral constraint is vanishing. Trump’s chances of reelection have been obliterated unless he manages to recreate himself as a successful “crisis president” and convince Americans not to change horses in mid-stream. Primarily this means he will focus on managing the pandemic. Yet it also gives Trump reason to try to change the subject and adopt an aggressive foreign or trade policy, particularly if the virus panic subsides. The economic downside has been removed but there could be political upside to a confrontation with China. The US public increasingly views China unfavorably and is now particularly concerned about medical supply chain vulnerabilities. A diplomatic crisis is already unfolding. China’s propaganda machine has gone into overdrive to distract its populace from the health crisis and recession. The main thrust of this campaign is to praise China’s success in halting the virus’s spread through draconian measures while criticizing the West’s ineffectual response, symbolized by Italy and the United States. This disinformation campaign escalated when Zhao Lijian, spokesman for the Ministry of Foreign Affairs, tweeted that COVID-19 originated in the United States. The conspiracy theory holds that it brought or deployed the coronavirus in China while a military unit visited for a friendly competition in Wuhan in October. A Hong Kong doctor who wrote an editorial exposing this thesis was forced to retract the article. President Trump responded by deliberately referring to COVID-19 as the “Chinese virus.” He defended these comments as a way of emphasizing the origin although China and others have criticized the president for dog-whistle racism. Secretary of State Mike Pompeo and Yang Jiechi, a top Chinese diplomat, met to address the dispute, but relations have only gotten worse. After the meeting China revoked the licenses of several prominent American journalists.4 The fact that conspiracy theories are being spouted by official and semi-official sources in the US and China reflects the dangerous combination of populism, nationalism, and jingoism flaring up in both countries – and the global recession has hardly begun.5 The phase one trade deal may collapse. Investors must now take seriously the possibility that the phase one trade deal will collapse. While China obviously will not meet its promised purchases for the year due to the recession, neither side has abandoned the deal. The CNY-USD exchange rate is still rising (Chart 10). President Trump presumably wants to maintain the deal as a feather in his cap for the election. This means that any failure would come from the China side, as an attack on Trump, or from Trump deciding he is a lame duck and has nothing to lose. These are substantial risks that would blindside the market and trigger more selling. Chart 10US And China Could Abandon Trade Deal Military and strategic tensions could also flare up in the South and East China Seas, the Korean peninsula, or the Taiwan Strait. While we have argued that Korea is an overstated geopolitical risk while Taiwan is understated, at this point both risks are completely off the radar and therefore vastly understated by financial markets. A “fourth Taiwan Strait crisis” could emerge from American deterrence or from Chinese encroachments on Taiwanese security. What is clear is that the US and China are growing more competitive, not more cooperative, as a result of the global pandemic. This is not a “G2” arrangement of global governance but a clash of nationalisms. Another risk is that President Trump would look elsewhere when he looks abroad: conflict with Iran-backed militias in Iraq is ongoing, and both Iran and Venezuela are on the verge of collapse, which could invite American action. A conflict or revolution in Iran would push up the oil price due to regional instability and would have major market-negative implications for Europe. Bottom Line: The US-China trade conflict had only been suspended momentarily. The economic collapse removes the primary constraint on conflict, and the US election is hanging in the balance, so Trump could try to cement his legacy as the president who confronted China. This is a major downside risk for markets even at current crisis lows. Investment Implications What are the market implications of the themes reviewed in this report? First, the virus will precipitate another leg down in globalization, which was already collapsing (Chart 11). Chart 11Globalization Has Peaked The US dollar will remain strong in the near term. It is too soon to go long commodities and emerging market currencies and risk assets, though it is notable that our Emerging Markets Strategy has booked profits on its short emerging market equity trade (Chart 12). Chart 12Too Soon To Go Long EM/Commodities Second, the Anglo-Saxon shift away from laissez faire leads toward dirigisme, an active state role in the economy. US stocks can outperform global stocks amid the global recession, but the rising odds that Trump will lose the election herald a generational anti-corporate turn in US policy. We are strategically long international stocks, which are far more heavily discounted. The combination of de-globalization and dirigisme is ultimately inflationary so we recommend that investors with a long-term horizon go long TIPS versus equivalent-maturity nominal Treasuries, following our US Bond Strategy. Third, Germany, the EU, and the ECB are taking dramatic steps to reinforce our theme of continued European integration. We are strategically long German consumers versus exporters and believe that recommendation should benefit once the virus outbreak is brought under control. There is more downside for EUR-USD in the near term although we remain long on a strategic (one-to-three year) horizon. Fourth, China will not come out the “winner” from the pandemic. It is suffering the first recession in modern memory and is beset by simultaneous internal and external economic challenges. It is also becoming the focus of negative attention globally due to its lack of integration into global standards. Economic decoupling is back on the table as the US may take advantage of the downturn to take protective actions. The US stimulus package in the works should be watched closely for “buy America” provisions and requirements for companies to move onshore. A Biden victory will not remove American “containment policy” directed toward China. Stay strategically long USD-CNY. The chief geopolitical insight from all of the above is that the market turmoil can be prolonged by geopolitical conflict, especially with Trump likely to be a lame duck president. With nations under extreme stress, and every nation fending for itself, the probability of conflicts is rising. We do however see the potential for collapsing oil prices to force Russia and Saudi Arabia back to the negotiating table, so we are initiating a tactical long Brent crude oil / short gold trade. Moreover we remain skeptical toward companies and assets exposed to the US-China relationship, particularly Chinese tech.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Margherita Stancati, "Lockdown of Recovering Italian Town Shows Effectiveness of Early Action," Wall Street Journal, March 16, 2020. 2 The conservatives Stephen Moore, Art Laffer, and Steve Forbes are virtually isolated in opposing the emergency fiscal measures – and will live in infamy for this, their “Mellon Doctrine” moment. 3 Costas Pitas and Andy Bruce, “UK unveils $420 billion lifeline for firms hit by coronavirus,” Reuters, March 17, 2020. 4 China retaliated against The Wall Street Journal for calling China “the sick man of Asia.” The United States responded by reducing the number of Chinese journalists licensed in the US. (Washington had earlier designated China state press as foreign government actors, which limited their permissible actions.) Beijing then ordered reporters from The Wall Street Journal, New York Times, and Washington Post whose licenses were set to expire in 2020 not to return. 5 Inflicting an epidemic on one’s own people is a very roundabout way to cause a global pandemic and harm the United States – obviously that is not what happened in China. It is also absurd to think that the US has essentially initiated World War III by committing an act of bioterrorism against China.

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

Dear clients, In addition to this short weekly report, you will also receive a Special Report penned by my colleague Jonathan LaBerge on Sweden, with implications for the SEK. I hope you will find the report both useful and insightful. In the interim, I wish safety for you and your families. Best Regards, Chester Ntonifor Highlights The lack of dollar liquidity had been a tailwind behind the dollar bull market. However, an expansion in the Federal Reserve’s balance sheet should help stem the global shortage of dollars. Ditto if there is an expansion of swap lines beyond the five major central banks. The risk is that the shortage of dollars has already begun to trigger negative feedback loops in a few countries. Until tentative signs emerge that the global economy is on better footing, expect spikes in the dollar. The caveat is that a big fiscal spending package in the US should lead to a deterioration in the current account. This will improve the offshore dollar liquidity situation. Feature The latest flare-up in risk aversion has also rotated to the offshore dollar funding market. Across G10 countries, US dollar cross-currency basis swaps - a measure of the costs to obtain greenbacks domestically - have been rising at an alarming pace. During the Federal Reserve’s emergency meeting on Sunday, swap lines were extended to five major central banks. The terms were very generous, with costs at the overnight index swap rate + 25 basis points, as well as a maturity of 84 days. However, the following day, the dollar continued its fervent rally, with the euro-US cross-currency basis swap touching -120 points (Chart 1). Chart 1A Broad-Based Funding Crisis The lack of follow through from the Fed’s liquidity injection highlights a fundamental risk to our sanguine view that the dollar should top out sooner rather than later. While we maintain this view, it has been discouraging that the DXY has broken above 100. We had anticipated a move higher on February 21, prompting us to close our long DXY position for a loss. Today, we suggest waiting for better signposts to short the greenback outright.1 US Dollar Flows The dollar remains the reserve currency of today, with the Fed at the center of the global financial architecture. The process behind dollar shortages is a simple one: Chart 2Global FX Reserve Growth Was Anemic Countries that are experiencing falling trade balances (because of a trade slowdown or trade war) will see a fall in their foreign exchange reserves. This naturally means that their supply of dollars is declining (Chart 2). Wary of seeing local dollar interest rates rise (leading to a higher dollar, and some companies going bust), central banks could sell dollars to the private sector in exchange for local currency. As a reserve currency, the US trade deficit is also settled in dollars. This naturally leads to a flow of greenbacks outside US borders. However, it also means that the current account deficit finances the budget deficit. Therefore, a falling trade surplus in exporting countries naturally means a falling deficit in the US. In order to stimulate the US economy, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. The central bank helps finance this fiscal deficit via expanding the monetary base (Seigniorage). The drop in rates causes the yield curve to steepen. This incentivizes banks to lend, which in turn boosts US money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, the current account deficit widens. This leads to a renewed outflow of dollars. It is easy to see where the process can get short-circuited, especially via an external shock. If you accept the premise that the sum of the Fed’s custody holdings together with the US monetary base constitutes the root of global dollar liquidity, then it is not yet accelerating fast enough.2 Like in the past, the Fed has been quick to correct the situation: Recently, it has instituted swap lines. However, they remain inadequate for three key reasons: The swap lines should be extended from the five central banks to many countries, because Covid-19 is now a global pandemic. Not even China (along with other emerging markets) was  included in the swap agreements. The swap lines usually have terms/limits/amounts, which means that even if the domestic central bank decided to be the lender of last resort, it could still run short of dollars. Widespread fiscal measures have been announced, but this has been mostly geared towards sustaining income. Until governments unilaterally backstop airlines, shipping firms, restaurants, or any other company afflicted by the virus from going bankrupt, a negative self-reinforcing feedback loop will remain. Chart 3The Dollar As An Arbiter Of Growth We continue to recommend standing aside on the dollar until the dust has settled. Longer-term fundamentals suggest a dollar-bearish view, but until the world gets a sense that global growth is bottoming soon, the dollar uptrend remains intact (Chart 3). We continue to use internals and market fundamentals as a guide for when to time a top.3  Finally, we have been stopped out of a few trades and are tightening stops on a few. Please see this week’s trade table for a few recommendations.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1    Please see Foreign Exchange Strategy Weekly Report,  “The Near-Term Bull Case For The Dollar”, dated February 28, 2020, available at fes.bcaresearch.com. 2   Please see Foreign Exchange Strategy Weekly Report,  “Is The World Short Of Dollars?”, dated September 13, 2019, available at fes.bcaresearch.com. 3   Please see Foreign Exchange Strategy Weekly Report,  “Currency Technicals And Market Internals”, dated March 13, 2020, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Chart I-3B…But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Overweight We recommend investors continue to take refuge in health care stocks within the defensive universe as the coronavirus pandemic unfolds. If severe government measures are a prerequisite to stop the spread of the virus then growth will suffer a massive setback. Were President Trump to eventually take draconian measures similar to what the Italian Prime Minister imposed recently, and to effectively shut down the country, then PCE will collapse. In fact, PCE excluding health care will take a beating. Health care outlays will rise both in absolute terms and relative to overall spending (see chart, second & third panels). Given the safe haven status of the S&P health care index and the stable cash flows these businesses command, when growth is scarce, investors flock to any source of growth they can come by and health care stocks definitely fit that bill. The implication is an earnings-led durable health care sector outperformance phase, a message that our relative macro EPS growth model is forecasting for the rest of the year (see chart, bottom panel). Bottom Line: We reiterate our overweight recommendation in the largest market capitalization weighted defensive sector in the SPX, the S&P health care sector. For more details, please refer to this Monday’s Weekly Report.