Europa

Highlights Inflation-Linked Bonds: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy awakens from the COVID-19 slumber, depressed market-derived inflation expectations can move higher across the developed markets – most notably in the US, the UK, Australia and Canada. Favor inflation-linked government bonds versus nominals in those countries on a strategic (6-12 months) basis. UK Corporates: The Bank of England (BoE) is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases, with credit spreads at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from BoE buying. Feature Chart of the WeekThe Link Between Oil & Bond Yields Remains Strong The shocking, albeit brief, journey of the West Texas Intermediate (WTI) oil price benchmark below zero last week was another in a long line of stunning market moves seen during the COVID-19 pandemic. Those negative oil prices were technical in nature and lasted all of one day, but the ramifications for global bond markets of the falling cost of oil in 2020 have been more enduring. Government bond yields have largely followed the ebbs and flows in energy markets for most of the past decade, and this year has been no exception (Chart of the Week). That link from oil has been through the inflation expectations component of yields, which have been (and remain) highly correlated to oil prices in virtually every developed market country. This is likely due to the persistent low global inflation backdrop since the 2008 financial crisis, which has made cyclical swings in energy prices the marginal driver of both realized and expected inflation. Chart 2BCA's Commodity Strategists Expect Oil Prices To Recover Our colleagues at BCA Research Commodity & Energy Strategy now anticipate higher oil prices over the next 12-18 months.1 Global growth is expected to recover from the COVID-19 recession sooner (and faster) than global oil production, helping to improve the demand/supply balance in energy markets and boost oil prices (Chart 2). Our energy strategists expect the benchmark Brent oil price to rise to $42/bbl by the end of 2020 and $78/bbl by the end of 2021. Those are big moves compared to the current spot price around $20/bbl, and would impart significant upward pressure on inflation expectations if the history of the past decade is any guide. That kind of move in oil prices should also help lift overall nominal government bond yields. Although the real (inflation-adjusted) component of yields is likely to remain low as major central banks like the Fed and ECB will remain highly accommodative, even when growth and inflation begin to recover, given the severity of the COVID-19 global recession. With market-based inflation expectations now at such beaten-up levels, and with the disinflationary effect of falling energy prices set to fade, we see an opportunity to play for a cyclical rebound in inflation breakevens across the developed markets by favoring inflation-linked government bonds versus nominal yielding equivalents. A Simple Framework For Finding Value In Inflation Breakevens Given the remarkably tight correlation between oil prices and market-determined inflation expectations in so many countries, it should be fairly straightforward to model the latter using the former as the main input. We have developed a series of fair value regressions for breakevens in the major developed countries which do exactly that. In this simple approach, we attempt to model the 10-year breakeven from inflation-linked bonds for eight countries – the US, the UK, Germany, Japan, France, Italy, Canada and Australia - as a function of a short-run variable (oil prices) and a long-run variable (the trend in realized inflation). Specifically, we are using the annual percentage change in the Brent oil price benchmark in local currency terms (i.e. converted from US dollars at spot exchange rates) as the short-run variable and a five-year moving average of realized headline CPI inflation as the long-run variable. The latter is included to provide an “anchor” for breakevens based on the actual performance of inflation in each country. In other words, expectations about what inflation will look like in the future are informed by what it has done in the past – what economists refer to as “adaptive” expectations. The generic regression equation used for each country is: 10-year inflation breakeven = α + β1 * (annual % change of Brent oil price in local currency terms) + β2 * (60-month moving average of headline CPI inflation) In Table 1, we present the results of the regressions of each of the eight countries, which use weekly data dating back to the start of 2012 to capture the period when oil prices have most heavily influenced inflation expectations. The coefficients, R-squareds and standard errors of the regressions are all shown, as well as the most recent model residual (i.e. the deviation of 10-year inflation expectations from model-determined fair value). All the coefficients for each model are significant. The R-squareds of the models vary, with the models for France and Australia doing the best job of explaining changes in inflation expectations in those two countries. Table 1Details Of Our New 10-Year Inflation Breakeven Models For the UK and Japan, we added an additional “dummy” variable to control for the unique situations that we believe have influenced inflation breakevens in those countries. For the UK, the period since the June 2016 Brexit vote has seen the path of inflation expectations stay nearly 50bps higher than implied by moves in GBP-denominated oil prices and the trend in actual UK inflation. For Japan, the period since the Bank of Japan initiated its Yield Curve Control policy in September 2016 has seen breakevens stay nearly 60bps below fair value as derived from JPY-denominated oil prices and the trend in actual Japanese inflation. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. In Charts 3 to10 over the next four pages, we show the models for each country. 10-year inflation breakevens versus the independent variables in the models are shown in the top two panels, the model fair value is presented in the 3rd panel, and the deviation from fair value is in the bottom panel. In all cases, breakevens are below fair value, suggesting that inflation-linked bonds look relatively attractive versus nominal government bonds. Chart 3Our US 10-Year TIPS Breakevens Model Chart 4Our UK 10-Year Breakeven Inflation Model Chart 5Our France 10-Year Breakeven Inflation Model Chart 6Our Italy 10-Year Breakeven Inflation Model Chart 7Our Japan 10-Year Breakeven Inflation Model Chart 8Our Germany 10-Year Breakeven Inflation Model Chart 9Our Canada 10-Year Breakeven Inflation Model Chart 10Our Australia 10-Year Breakeven Inflation Model Chart 11Real Inflation-Linked Bond Yields Will Remain Subdued For Longer The largest deviations from fair value can be found in Canada (-70bps), Australia (-48bps), the UK (-29bps), and the US (-26bps). 10-year breakevens are also below fair value in the euro zone countries and Japan, but not by more than one standard deviation as is the case for the other four countries. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. Focus on the four markets with breakevens furthest from fair value, although from a market liquidity perspective it is easier to implement those positions in the US and UK, which represent a combined 69% of the Bloomberg Barclays Global Inflation-Linked bond index. A rise in inflation expectations should also, eventually, put some sustained upward pressure on nominal bond yields. We would rather play that initially by positioning for higher inflation breakevens, rather than having outright below-benchmark duration exposure, as developed market central banks will stay accommodative for longer given the severity of the COVID-19 recession - that will keep real bond yields lower for longer (Chart 11). Breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Bottom Line: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy starts to awaken from the coronavirus induced slumber, breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Favor linkers over nominals in those countries. Where Is The Value In UK Corporate Bonds? Chart 12Upgrade UK IG Corporates To Overweight On BoE Buying The Bank of England (BoE) initiated its Corporate Bond Purchase Scheme (CBPS) in August 2016 as part of a package of stimulus measures to cushion the economic blow from the UK’s vote to exit the European Union. As we noted in recent joint report with our sister service, BCA Research US Bond Strategy,2 the CBPS helped tighten spreads by lowering downgrade and default risk premiums and also helped spur corporate bond issuance (Chart 12). Shortly after that report was published, the BoE announced that it would be purchasing a further £10 billion in investment grade nonfinancial corporate bonds in the coming months, doubling the scheme’s aggregate holdings to £20 billion. In addition, the bank would make these purchases at a significantly faster pace than in 2016, which implies a faster transmission towards tightening of spreads. Compared to other central bank peers, however, the BoE’s program still has room to expand, which makes UK investment grade credit attractive over tactical and strategic investment horizons. Using the market value of the Bloomberg Barclays UK corporate bond index (excluding financials) as a proxy for the total value of eligible bonds, the CBPS is on track to own roughly 9% of all eligible bonds by the time the £20 billion target is reached. The neighboring European Central Bank, on the other hand, already owns 23% of the stock of eligible euro area corporate bonds in its market, and that figure is only set to increase with policymakers set to do “whatever it takes” to backstop the investment grade market. Year-to-date, UK corporate bonds appear to have recovered somewhat from the panicked selloff earlier this quarter (Table 2), with the Bloomberg Barclays UK investment grade corporate bond index down only -0.3% in total return terms. In excess return terms relative to duration-matched UK corporate bonds, however, the index is down -5.2%, indicating that weakness has persisted in the pure credit component. Table 2UK Investment Grade Corporate Bond Returns At the broad sector level, Other Industrials appear to be the outlier, having delivered positive excess returns (+0.6%) and significant total returns (+16%). These returns are not nearly as attractive, however, on a risk-adjusted basis once you consider that this sector has an index duration more than three times that of the overall index.3 Outside of that sector, the best performers, in excess return terms, are predominantly the more “defensive” sectors—Utilities (-3.4%), Technology (-3.7%), Communications (-4.2%) and Consumer Non-Cyclical (-4.6%). Meanwhile, the sectors most exposed to vanishing consumer demand and weak global growth have performed the worst—Transportation (-9.5%), Capital Goods (-7%), Energy (-6.8%), and Basic Industry (-6.2%). Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases. Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases (Chart 13). The overall index spread, although still elevated at 228bps, has already tightened by 57bps from the peak in late March. The gap between the index spreads of Baa-rated and Aa-rated UK debt remained relatively stable through the wave of sell-offs, peaking at +53bps, below the 2019 high of +55bps, and settling now to +36bps. Outside the purview of the CBPS, however, the situation is a bit rockier, with the overall high-yield index spread +590bps above that of the investment grade index. Broadly speaking, there is a clear disparity between those credit tiers that have the support of the monetary authorities and those that do not. Investment grade spreads will continue to tighten as the BoE rapidly increases its holdings of investment grade corporate bonds. However, high-yield bonds remain exposed to downgrade/default risk and ongoing uncertainty stemming from the COVID-19 economic shock. To drill down into which credit tier spreads offer the most value within the UK investment grade space, we use the 12-month breakeven spread percentile rankings. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. Chart 14 shows the 12-month breakeven spread percentile rankings for all the credit tiers in the UK investment grade space. Aaa-rated debt appears most unattractive, with the spreads currently ranking below the historical median. Between the other three tiers, Aa-rated debt offers the most value, although all three are at historically attractive levels. Chart 13UK IG Has Held Up Well During The COVID-19 Shock Chart 14UK IG Breakeven Spreads Look Most Attractive For Aa-Rated Bonds On the sector-level, the disparity in spreads is most clearly visible in the sectors most exposed to the pandemic. In Charts 15 & 16, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays UK investment grade corporate index. Spreads look widest relative to history for sectors such as Energy and Transportation, while spread widening has been contained in more insulated sectors such as Financials. Chart 15A Mixed Performance For UK IG By Sector In 2020 … Chart 16… But Spreads, In General, Remain Below Previous Cyclical Peaks Another way to assess value across UK investment grade corporates is our sector relative value framework. Borrowing from the methodology used for US corporate credit by our colleagues at BCA Research US Bond Strategy, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall UK investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The dependent variables in the model are each sector's duration, 12-month trailing spread volatility and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. We see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. The latest output from the UK relative value spread model can be found in Table 3. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 17 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 17UK Investment Grade Corporate Sectors: Valuation Versus Risk We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. Amid a backdrop of global uncertainty, we reiterate one of our major themes this quarter—buy what the central banks are buying. Given that UK corporate spreads are attractive on a breakeven basis, and with the BoE purchasing corporate debt at an even faster pace than during the volatile period following the shock Brexit vote in 2016, we see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. This is both on a tactical (0-6 months) and strategic basis (6-12 months). In our model bond portfolio, we have added two percentage points to our recommended UK corporate bond allocation, funded by reducing further our existing underweight on Japanese government bonds. At the sector level, given this positive backdrop for credit performance, we do not see a need to favor lower risk sectors with a DTS score below that of the overall UK investment grade index. On that basis, we are looking to go overweight sectors with higher relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 17. Based on the latest output from the relative value model, the strongest overweight candidates are the following UK investment grade sectors: selected Financials (Insurance, Subordinated Bank Debt, and Other Financials), Media Entertainment, Cable Satellite, Tobacco, Diversified Manufacturing, and Communications. The least attractive sectors within this framework are: Packaging, Lodging, REITs, Other Industrials, Metals, Natural Gas, Restaurants, Transportation Services, Financial Institutions, and Midstream Energy. Bottom Line: The BoE is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases. Spreads have already begun to tighten in response but are still at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across credit tiers, favor Aa-rated debt. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from the CBPS.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, "US Storage Tightens, Pushing WTI Lower", dated April 16, 2020, available at ces.bcaresearch.com. 2 Please see BCA US Bond Strategy Special Report, "Trading The US Corporate Bond Market In A Time Of Crisis", dated March 31 2020, available at usbs.bcaresearch.com. 3 Other Industrials has an index duration of 28.6 years, compared to 8.5 years for the overall UK investment grade corporate bond index. 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 Social distancing makes it impossible to do jobs that require close personal interaction, yet these are the very job sectors that have kept jobs growth alive in recent decades. If social distancing persists, then AI will penetrate these job sectors too. Aggregate wage inflation is set to collapse – not just temporarily, but structurally. Structurally overweight US T-bonds versus the core European bonds in Germany, France, Netherlands, Switzerland and Sweden. Structurally overweight big technology, structurally underweight banks. Structurally overweight S&P 500 versus Euro Stoxx 50. Fractal trade: long Australian 30-year bond versus US 30-year T-bond. Feature Social distancing will feature large in our lives for the foreseeable future, and it carries a profound consequence. Social distancing really means physical distancing. And physical distancing diminishes the ways that we can interact with other humans – through the qualities of empathy, sympathy, the ability to recognise and respond to emotional cues, and to express ourselves through complex movements. You cannot hug someone on Facetime. Social distancing makes it impossible to do jobs that require close personal interaction. From an economic perspective, social distancing makes it impossible to do jobs that require close personal interaction. It follows that in the recent bloodbath of job losses, the biggest casualties have been in employment sectors that rely on this close personal interaction: food services and drinking places (waitresses, bartenders, and baristas), ambulatory healthcare services, hotels, and social assistance (Table I-1). Table I-1Social Distancing Is Destroying Jobs That Require Close Personal Interaction A profound consequence arises because these are the very sectors that have kept jobs growth alive in recent decades (Table I-2). Millions of new jobs that rely on close personal interaction have more than offset the structural job destruction in manufacturing and finance. As well as being export-proof, jobs that require this close personal interaction have been ‘artificial intelligence (AI) proof’. That is, until now. Table I-2Jobs That Require Close Personal Interaction Have Been The Engine Of Jobs Growth One UK doctor told the New York Times “we’re basically witnessing 10 years of change in one week”. Before the virus, online consultations made up only 1 percent of doctors’ appointments. But now, three in four UK patients are seeing their doctor remotely. Moravec’s Paradox + Social Distancing = A Very Tough Jobs Market Regular readers will know that one of our mega-themes is the far-reaching societal and economic implications of Moravec’s Paradox. Named after the professor of robotics, Hans Moravec, the paradox points out that: For AI the hard things are easy, but the easy things are hard. By the hard things, we mean things that require ‘narrow-frame pattern recognition’ within a defined body of knowledge. For example, playing chess, translating languages, diagnosing medical conditions, and analysing legal problems. We find these tasks hard, but AI finds them effortless. By the easy things, we mean our social skills: empathy, sympathy, the ability to recognise and respond to emotional cues, and to express ourselves through complex movements. To us, all these things are second nature, but AI finds them very hard to replicate. The reason, it turns out, is that the higher brain that enables us to learn and play chess and solve similar abstract problems evolved relatively recently. Whereas the ancient lower brain that enables complex movement and the associated giving and receiving of emotional signals took much longer to evolve. As AI is just reverse engineering the human brain, AI has found it easy to replicate the less-evolved higher brain functions, but very difficult to replicate the skills that emanate from the deeply evolved lower brain. Millions of new jobs that rely on close personal interaction have more than offset the structural job destruction in manufacturing and finance. The far-reaching societal and economic implication is that we have misunderstood and mispriced what is difficult and what is easy. By reverse engineering the brain, AI is correcting this mispricing. So far, AI has been most disruptive to high-paying jobs requiring abstract problem-solving skills, such as in finance. AI has been less disruptive to jobs requiring close personal interaction (Table I-3). But if social distancing persists, then AI will disrupt those jobs too, especially during a recession. Table I-3New Jobs That Require Close Personal Interaction Have Offset Lost Jobs In Manufacturing And Finance Labour Market Disruption Intensifies During A Recession To paraphrase Ernest Hemingway, industries adopt labour-saving technologies gradually then suddenly. And the suddenly tends to be during a recession. This is because once an industry has already shed many workers, it is easier to restructure the industry with a new labour-saving technology that reduces labour input permanently. At the start of the Great Depression a substantial part of the US automobile industry was still based on skilled craftsmanship. These smaller, less productive craft-production plants were the ones that shut down permanently, while plants that had adopted labour-saving mass production had the competitive advantage that enabled them to survive. The result was a major restructuring of the auto productive structure. Likewise, until the late 1990s, the ‘typing pool’ was a ubiquitous feature of the office environment. But once the 2000 downturn arrived, these typing jobs became extinct to be replaced by the wholesale roll-out of Microsoft Word. After the 2008-09 recession, UK economic power became focussed in a few large firms that could access the finance to ensure their survival. As small firms went by the wayside, job growth came disproportionately from self-employment and the ‘gig economy’. In this case, the labour market disruption hurt productivity as an army of freelancers ended up doing their own sales, marketing and accounts in which they had no specialism (Chart I-1 and Chart I-2). Chart I-1The 1990s UK Recovery Produced No Increase In Self-Employment... Chart I-2...But The 2010s UK Recovery Produced A Huge Increase In Self-Employment The point is that all recessions produce major structural changes in the labour market and the current recession will be no different. If social distancing persists, it will nullify the social skill advantage that humans have over AI. Therefore, one structural change will be that AI disrupts the more ‘human’ job sectors that have so far escaped its penetration. All recessions produce major structural changes in the labour market. To repeat, labour market disruption arrives suddenly. Within the space of a few weeks, most UK patients have switched to receiving their medical care online or by telephone. Admittedly, the patients are still ‘seeing’ a human doctor, but the question and answer consultations are a classic example of narrow-frame pattern recognition. Meaning that it would be a small step to upgrade the human doctor to the superior diagnosis from AI. And if AI can produce a superior diagnosis to your human doctor, why can’t AI also produce a a superior legal analysis to your human lawyer? The Investment Implications Even when the labour market seemed to be humming and unemployment rates were at multi-decade lows, aggregate wage inflation was anaemic (Chart I-3 and Chart I-4). A major reason was the hollowing out of high paying jobs and substitution with low paying jobs. Now that unemployment rates are surging, and AI is penetrating even more job sectors, aggregate wage inflation is set to collapse – not just temporarily, but structurally. Chart I-3Unemployment Rates Have Been At Multi-Decade Lows... Chart I-4...But Wage Inflation Has Been ##br##Anaemic This leads to the following investment implications: 1. All bond yields will gravitate to their lower bound, so any bond yield that can go lower will go lower. 2. It follows that bond investors should continue to overweight US T-bonds versus the core European bonds in Germany, France, Netherlands, Switzerland and Sweden (Chart I-5). Chart I-5Any Bond Yield That Can Go Lower Will Go Lower 3. Underweight banks structurally. Depressed and flattening yield curves combined with shrinking demand for private credit constitutes a strong headwind. Banks are now underperforming in both up markets and in down markets (Chart I-6). Chart I-6Banks Are Underperforming In Both Up Markets And Down Markets 4. Overweight technology structurally. As AI penetrates even more job sectors, the superstar companies of big tech will continue to thrive. The duopoly of Apple and Google are designing proximity-tracking apps for every smartphone in the world. Big tech is laying down the law to governments, and there is not even a hint of antitrust suits. Tech is now outperforming in both up markets and in down markets (Chart I-7). Chart I-7Tech Is Outperforming In Both Up Markets And Down Markets 5. Finally, if big tech outperforms banks, the sector composition of the S&P 500 versus the Euro Stoxx 50 makes it inevitable that the US equity market will structurally outperform the euro area equity market (Chart I-8). Chart I-8If Big Tech Outperforms Banks, The S&P 500 Must Outperform The Euro Stoxx 50 Fractal Trading System* The steep decline in the US 30-year T-bond yield means that it has crossed below the Australian 30-year bond yield for the first time in recent history. Resulting from this dynamic, this week’s recommended trade is long the Australian 30-year bond versus the US 30-year T-bond. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-930-Year Govt. Bonds: Australia Vs. US In other trades, long IBEX versus Euro Stoxx 600 hit its 3 percent stop-loss, while long nickel versus copper is half way to its 11 percent profit target. The rolling 12-month win ratio now stands at 63 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Stay tactically neutral to equities. The market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. The long-term threat to equities comes from the pandemic’s lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. Long-term investors should prefer equities over bonds, with the caveat that the threat does not materialise. Long-term equity investors should avoid oil and gas and European banks at all costs… …but healthcare, European personal products, and European clothes and accessories should all form core long-term holdings. Fractal trade: long nickel / short copper. Feature Chart of the WeekSales Per Share Must 'Catch Down' With GDP, Just Like In 2008 The sharp snapback rally in stock markets has reached an important resistance point – the critical Fibonacci level of a 38.2 percent proportionate retracement of the sell-off.1 Technical analysts define the sell-off in terms of the most recent peak to trough. But we define it differently. We define it in terms of the longest time horizon of investors that capitulated at the sell-off. The market may meet some short-term resistance. The longest time horizon of investors that capitulated at the sell-off’s climax on March 18 was a seven-quarter horizon. Hence, we define the sell-off as the seven-quarter decline to March 18. On that basis, and using the DAX as our benchmark, we would expect the index to meet resistance at around a 21 percent retracement rally from the March 18 low. Which is pretty much where the DAX stands right now (Chart I-2).2 Chart I-22020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement After A Sharp Snapback Rally What Happens Next? The maximum length of investment horizons that capitulated on March 18 was unusually long at seven quarters. This should comfort long-term investors because of an important investment identity: Financial markets have fully priced a downturn when the longest time horizon of investors that have capitulated = the length of the downturn. So, the good news is that the March 18 bottom should hold if the downturn does not last longer than seven quarters. In this regard, the main risk of a protracted downturn comes not from the pandemic itself. Even if the pandemic returns in second and third waves, any economic shutdowns, full or partial, should last considerably less than seven quarters. Instead, the main risk comes from lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. The long-term threat comes from the pandemic’s after-effects on economic and political systems. But a protracted downturn of what? As we are focussing on the stock market, the downturn is not of GDP per se but its stock market equivalent: sales per share. In the long run, sales per share and GDP advance at the same rate. But the sector compositions of the stock market and GDP are not the same, so over shorter periods sales per share can underperform or outperform GDP. In which case, sales per share must catch up or catch down (Chart of the Week). In 2008, sales per share had to catch down. As a result, world sales per share declined for seven quarters through 2008-10, considerably longer than the decline in GDP (Chart I-3). Hence, the stock market found its bottom in early March 2009 when the longest time horizon of investors that had capitulated had reached seven quarters (Chart I-4). Chart I-32008-10: Sales Per Share Fell For Seven Quarters Chart I-42009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement From this March 2009 bottom, the Fibonacci retracement equated to a 35 percent advance, which the market achieved by early June 2009. Thereafter, stocks met short-term resistance and gave back some of the snapback rally. Fast forward to 2020. Having likewise reached the Fibonacci retracement, the market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. Assuming no lasting after-effects from financial distress or political backlash, the next sustained advance will happen later this year. Valuations Flatter Equities, But They Still Beat Bonds Turning to long-term investors the three most important things are: valuation, valuation, and valuation. Our favourite valuation measure is price to sales, which has been a good predictor of 10-year prospective returns going back to at least the 1980s (Chart I-5). Chart I-5Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 But the predictive power depends on a crucial underlying assumption – that the past is a good guide to the future. Specifically, today we must assume that the pandemic causes just a brief blip in the multi-decade uptrend in stock market sales and profits. To repeat, the main long-term threat to stock markets comes not from the pandemic itself. The long-term threat comes from the pandemic’s after-effects on economic and political systems – such as crippled banking systems or large-scale nationalisations of the private sector. Furthermore, price to sales will err in its prediction if sales per share have deviated from GDP – implying either a future catch up or catch down. In the 1990s sales per share had underperformed GDP, so future returns outperformed the valuation prediction. However, in 2008 sales per share had outperformed GDP, so future returns underperformed the prediction. Today, just as in 2008, sales per share have become overstretched relative to GDP, so there will be a catch down. Which will weigh down prospective returns relative to what valuations appear to imply. Still, even adjusting for this, equities are likely to produce annualised nominal returns in the mid-single digits, comfortably higher than the yields on long-term government bonds. Hence, with the caveat that the pandemic does not generate lasting after-effects for economic and political systems, long-term investors should prefer equities over bonds. What Not To Buy, And What To Buy If a stock, sector, or stock market maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. In this case, the lower share price is stretching the elastic between the price and the up-trending profits, resulting in an eventual snap upwards. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the elastic may be forced to snap downwards! Do not buy sectors whose profits are in major downtrends. This leads to a somewhat counterintuitive conclusion for long-term investors. After a big drop in the stock market, do not buy everything that has dropped. And do not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. Specifically, the profits of oil and gas and European banks are in major structural downtrends (Chart I-6 and Chart I-7). Long-term equity investors should avoid these sectors at all costs. Chart I-6Oil And Gas Profits In A Major ##br##Downtrend Chart I-7European Banks Profits In A Major Downtrend Conversely, the profits of healthcare, European personal products, and European clothes and accessories are all in major structural uptrends (Chart I-8 - Chart I-10). As such, all three sectors should be core holdings for all long-term equity investors. Chart I-8Healthcare Profits In A ##br##Major Uptrend Chart I-9European Personal Products Profits In A Major Uptrend Chart I-10European Clothing Profits In A Major Uptrend Fractal Trading System* Given the outsized moves in markets over the past month, all assets have become highly correlated making it more difficult to find candidates for trend reversals. Chart I-11Nickel Vs. Copper However, we find that some relative moves within the commodity complex have not correlated with risk on/off. Specifically, the underperformance of nickel versus copper is technically stretched, so this week’s recommended trade is long nickel / short copper, setting a profit target of 11 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 67 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 0.382 = 1- phi. Where phi is the Golden Ratio, defined as the ratio of successive Fibonacci numbers in the limit. Alternatively, phi =1 / (1 + phi). 2 The seven-quarter sell-off in the DAX (capital only) to March 18 2020 was 39.4 percent, so a full retracement rally equals 65.1 percent, and a 0.382 geometric retracement equals 21.1 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations