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Dear client, Next Monday instead of sending you a Weekly Report we will be hosting a live webcast at 10am EST, addressing the recent market moves and discussing the US equity market outlook.  Kind Regards, Anastasios Highlights Portfolio Strategy The passing of the mega fiscal package, turning equity market internals, the collapse in net earnings revisions all underscore that we may have already seen the recessionary equity market lows. Investors with higher risk tolerance and a cyclical 9-12 month time horizon will be handsomely rewarded. Firming operating metrics, the defensive nature of tech services at a time when macro data are about to nosedive, compel us to boost the S&P data processing index to overweight. Grim macro data, the rising threat of a debt deflation spiral, poor operating metrics and lofty valuations, all warn that the path of least resistance is lower for REITs. Recent Changes Boost the S&P data processing index to overweight today. Last week we obeyed our rolling stops in our cyclically underweight position in the S&P homebuilders index and cyclically overweight positions in the S&P hypermarkets and S&P household products indexes for gains of 41%, 26% and 5%, respectively.1 Feature The SPX had a streak of three green days last week as congress finally passed a $2tn fiscal easing bill. In fact the last time the S&P 500 had two consecutive green days was right before its February 19 peak. Our view remains that the risk/reward tradeoff for owning equities is favorable for investors with higher risk tolerance and a cyclical 9-12 month time horizon, as we highlighted last Monday in our “20 reasons to start buying equities” part of our Weekly Report.2 As a reminder, during the Great Recession, equities troughed 20 days after the American Recovery and Reinvestment Act of 2009 took effect on February 17, 2009. Thus if history rhymes, an equity market bottom is likely near if not already behind us.  Does this mean the SPX has definitively troughed? Not necessarily, but our playbook/roadmap calls for a retest and hold of the recent lows as we have been highlighting in recent research.3 Keep in mind that S&P 500 futures (ES) have fallen over 36% from peak to trough. This is similar to the median fall during recession bear markets dating back to the Great Depression. Most importantly, comparing the two most recent iterations is instructive in attempting to figure out what is baked in the cake. Namely, in the 9/11 catalyzed recession and subprime mortgage collapse catalyzed recession, EPS got halved. Similarly, equities fell 50% from their respective peaks. If we use that assumption – i.e. a recessionary equity bear market fall predicts the eventual profit drubbing – then what the ES futures clocking in at 2174 discounted is that trailing EPS will fall from $162 to $104 and forward EPS from $177 to $113 (Chart 1). Chart 1Joined At The Hip While we have no real visibility on EPS, our sense is that we will not fall further than what was already discounted in the broad market. If we are offside and a GFC or Great Depression ensues, then profits will get halved to $81 and the SPX will fall to 1700. Another simple way of looking at the EPS drawdown is by considering $162 as trend EPS. Then for every month that the economy is shut down roughly $13.5 get shaved off EPS. Thus, triangulating both approaches, a $104 EPS level has discounted a shutdown lasting 4 months and 10 days. This is a tall order and we would lean against such extreme pessimism. Meanwhile, analysts are scrambling to cut estimates the world over. Not only SPX net earnings revisions (NER) are at the lowest point since the GFC, but so is the emerging market NER ratio. The Eurozone and Japan are following close behind (Chart 2). Once again the speed of this downward adjustment suggests that a lot of bad news is already priced in now depressed NER. Chart 2Bad News Is Priced In Chart 3Market Internals Ticking Higher Moreover, equity market internals underscore that we may have already seen the recessionary equity market lows. Chart 3 shows that hypersensitive small caps have been outperforming their large cap peers of late, chip stocks are sniffing out a reflationary impulse and even emerging markets are besting the SPX. Finally, the best China proxy out there, the Aussie dollar, corroborates the bullish signal from all these indicators and suggests that this mini “risk-on” phase can last a while longer (third panel, Chart 3). Nevertheless, the spike in the TED spread (Treasury-EuroDollar spread, gauging default risk on interbank loans) was quite unnerving last week. While we have shown in the past that equity volatility and credit risk are joined at the hip, this parabolic move in the, up to very recently calm, TED spread disquieted us. We will keep on monitoring it closely as the coronavirus pandemic continues to unfold (Chart 4). Chart 4Disquieting Another significant risk that this crisis has exposed is the massive non-financial business debt uptake that has taken root during the ten-year expansion (top panel, Chart 5). We deem investors will be more mindful of debt saddled companies going forward, despite the government’s sizable looming bailout of select severely affected industries from the coronavirus pandemic. Stock market reported data also corroborate the national accounts’ debt deterioration data (bottom panel, Chart 5). Chart 5Watch The Debt Burden… The yield curve has already forewarned that a significant default cycle is looming (Chart 6) and this time is not different. Chart 6…A Default Cycle Looms Importantly, both the equity and bond markets have been sending these debt distress signals for quite some time now (Chart 7). Chart 7Distress Signals Sent A long Time Ago What interest us most from a US equity sector perspective is identifying weak spots that may come under intense pressure in the coming weeks as the economy remains shut down likely until Easter Sunday. Chart 8 shows the current level of net debt-to-EBITDA for the overall non-financial equity market, and the 10 GICS1 sectors (we use telecom services instead of communications services and exclude financials). In more detail, the bar represents the 25 year range of net debt-to EBITDA and the vertical line the current reading for each sector (Appendix 1 below showcases the net debt-to-EBITDA time series for the GICS1 sectors). Chart 8Mind The… Chart 9 goes a step further and juxtaposes EV/EBITDA with net debt-to EBITDA on a two dimensional map. Real estate and utilities clearly stand out as the most debt burdened sectors, with a pricey valuation (For completion purposes Appendix 2 below delves deeper into sectors and shows net debt-to-EBITDA for the GICS2 sectors). Chart 9…Outliers Frequent US Equity Strategy readers know that we believe the excesses this cycle have been in the commercial real estate (CRE) segment of the economy, where prices are one standard deviation above the previous peak and cap rates have collapsed to all-time lows fueled by an unprecedented credit binge (Chart 10). This week we reiterate our underweight stance in the S&P real estate sector and boost a defensive tech services index to an overweight stance. Chart 10CRE: The Epitome This Cycle’s Excesses Reality Bites We continue to recommend investors avoid the S&P real estate sector. For investors seeking defensive protection we would recommend hiding in the S&P health care sector instead, as we highlighted in our mid-March report.4 Chart 11 shows a disturbing breakdown in the inverse correlation between the relative share price ratio and the 10-year Treasury yield. While it makes intuitive sense that this fixed income proxy sector (i.e. high dividend yielding) should move in the opposite direction of the competing risk free yielding asset, at times of tumult this correlation reverts to positive (top panel, Chart 11). In other words, fear grips investors and they frantically shed REITs despite the fact that interest rates collapse. Why? Because these are highly illiquid assets that these REITs are holding and investors demand the “return of” their capital instead of a “return on” their capital when volatility and credit risk soar in tandem (see TED spread, Chart 4). While CRE prices remain extended and vulnerable to a deflationary shock (bottom panel, Chart 11), there is no real price discovery currently as no landlord would dare put any properties for sale in this market starved for liquidity. With the exception of distressed sales, we deem that the “mark to model” mantra will make a comeback, eerily reminiscent of the GFC. Using an example of how all this may play out in the near-term is instructive. As the economy remains shut down, a tenant may forego a rent payment to a landlord and if the landlord is levered and starved of cash, he/she in turn may miss a debt payment to the outfit that holds his mortgage, typically a bank. Chart 11BreakdownAt first sight this may not seem as a big problem on a micro level as the bank may have enough liquidity to withstand a delinquent borrower’s no/late payment. If, however, the bank is itself scrambling for cash, it will foreclose and then put this asset for sale in order to recover some capital. This will put downward pressure on the underlying asset’s price that all borrowing was based upon and a debt deflation spiral ensues (Chart 12). Chart 12Debt Deflation Warning The biggest problem however arises from the bond market. If these deflating assets are all in a CLO or concentrated in a select REIT, then our current financial system setup is not really equipped to handle a failure/delay of payment. This is especially true if some bond holders have hedged their bets and bought CDS on these bonds and demand payment as a “default clause” will in practice get triggered.  The longer the economy remains shut down, the higher the credit, counterparty and default risks will rise. Therefore, given that the real estate sector has an extremely high reading on a net debt-to-EBITDA basis (Chart 8), we are concerned about the profit prospects of this niche sector in the coming months. Moreover, the economy is in recession and the recent Markit services PMI is a precursor of grim data to follow. Historically, REITs move in the opposite direction to the PMI services survey and the current message is to expect a catch down phase in the former (Chart 13). Adding insult to injury, the supply response especially on the multi-family construction side is perturbing. In fact, multi-family housing starts have gone parabolic hitting 619K recently, the highest reading since 1986! Such a jump in supply is deflationary and will weigh on the relative share price ratio (multi-family starts shown inverted, bottom panel, Chart 13). Chart 13Tiiimber Finally, lofty valuations warn that if our bearish thesis pans out in the coming months, there is no cushion left to absorb a significant profit shock that likely looms (Chart 14). Chart 14No Valuation Cushion In sum, grim macro data, the rising threat of a debt deflation spiral, poor operating metrics and lofty valuations, all warn that the path of least resistance is lower for REITs.   Bottom Line: Shy away from the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST – CCI, AMT,  PLD, EQIX, DLR, PSA, SBAC, AVB, EQR, FRT, SPG, WELL, ARE, CBRE, O, BXP, ESS, EXR, DRE, PEAK, HST, MAA, UDR, VTR, WY, AIV, IRM, PEG, VNO, SLG. Boost Data Processing To Overweight We have been offside on the data processing tech sub-index and today we are booking losses of 39% and boosting exposure to overweight. Data processing stocks are a services-based defensive tech index that typically thrive in deflationary and recessionary environments, according to empirical evidence (Chart 15). We are currently in recession, thus a deflationary impulse will grip the economy and investors will flock to defensive tech stocks when growth is scarce. Tack on the spike in the greenback, and the disinflationary backdrop further boosts the allure of these tech services stocks (third panel, Chart 15). Beyond the recessionary related tailwinds, data processing stocks should also enjoy firming relative demand. While the two bellwether stocks, V and MA, will suffer from the decrease in consumption that requires physical visits and from select services outlays that are severely affected by the coronavirus, online spending by households and corporations should at least serve as a partial offset. Chart 15Time To Buy Defensive Tech Chart 16What’s not To Like? Already, industry pricing power gains have been accelerating at a time when overall inflation has been tame. This will boost revenues – and given high operating leverage and high and rising profit margins – that will flow straight through to profits (Chart 16). While relative profit growth and sales estimates may appear uncharacteristically high and unrealistic to attain, this is what usually transpires in recessions: sell side analysts trim SPX profit and revenue forecasts more aggressively than they do for the defensive data processing index (Chart 17). In fact, given that we are still in the early stages of recession, we expect a further surge in relative EPS and sales estimates in the coming months. Chart 17Seeking Growth When Growth Is Scarce Chart 18Risk: Lofty Valuations However, there is a key risk to our bullish stance in this tech service index: valuations. Relative valuations are still pricey despite the recent fall from three standard deviations above the historical mean to half that, according to our relative valuation indicator. Technicals have also corrected from an extremely overbought reading, but a cleansing washout has yet to occur (Chart 18). Netting it all out, firming operating metrics and the defensive nature of tech services at a time when macro data are about to nosedive, compel us to boost the S&P data processing index to overweight.   Bottom Line: Boost the S&P data processing index to overweight today from previously underweight for a loss of 39% since inception. The ticker symbols for the stocks in this index are: BLBG: S5DPOS – ADP, V, MA, PYPL, FIS, FISV, GPN, PAYX, FLT, BR, JKHY, WU, ADS.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix 1 Chart A1Appendix A1 Chart A2Appendix A2   Appendix 2 Chart A3Chart A4 Footnotes 1     Please see BCA US Equity Strategy Daily Report, “Housekeeping” dated March 26, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 3    Please see BCA US Equity Strategy Daily Report, “Gravitational Pull” dated March 12, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

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Highlights The odds of an emergency meeting of OPEC 2.0 to get supply under control are growing, based on the repeated overtures from Russian officials providing the Kingdom of Saudi Arabia (KSA) an opening to resume talks on their production-management regime. We have developed a not-unreasonable scenario in which global oil consumption falls by ~ 20% y/y in April to assess the COVID-19-induced price impact. Even an aggressive 3.5mm b/d cut from OPEC 2.0 – presuming a rapprochement between KSA and Russia – and an additional 200k b/d market-induced cut by North American producers still sees Brent prices bottoming over the next two months at ~ $18/bbl. OECD inventories surge, reaching ~ 3.6 billion by June 2020, before production cuts and demand restoration start to drain them. Comments from Texas Railroad Commission (RRC) leadership indicate they could be back in the business of pro-rating production in the Lone Star state. If a new OPEC 3.0 described here can move quickly enough, Brent prices could revive to ~ $45/bbl by year end, and clear $60/bbl by 2Q21.  We are getting long Dec20 Brent and WTI at tonight’s close. Feature Refiners worldwide are reducing runs as the COVID-19 pandemic continues to cut through oil demand like a scythe through wheat.1 Refiners’ inability to sell gasoline, diesel and jet fuel, and a host of other products, is forcing crude oil to back up globally in storage facilities, pipelines and, soon, on ships (Chart 1).2  This is occurring while KSA and Russia wage a global market-share war, targeting each others’ refinery customers with lower and lower prices. Without a concerted effort by OPEC 2.0 – the coalition led by KSA and Russia – and the US shales to rein in production, the global supply of storage will be exhausted and oil prices will push well below $20/bbl to force output to shut in.  Indeed, numerous grades of crude oil worldwide already are trading below $20/bbl after factoring in their spreads vs. Brent crude oil as regional takeaway and storage infrastructure are overwhelmed (Chart 2). Chart 1Even With Production Cuts Oil Inventories Will Surge Chart 2Global Crude Prices Trading Below $20/bbl Chart 3“The Other Guys” Production Declines Will Accelerate The consequences for oil producers outside core-OPEC will be disastrous, as they were following the last market-share war led by OPEC in 2014-16.  The producer group we’ve dubbed “The Other Guys” – producers outside core-OPEC – will continue to see production falling, most likely at an accelerating rate, if the market-share war persists (Chart 3).  Even within core-OPEC – principally the GCC states – governments will be required to cut spending on public works, salaries for workers, and services.3 Sovereign wealth funds and foreign reserves will have to be drawn down to fill holes in budgets, as happened during the last market-share war of 2014-16 launched by OPEC.  The IMF last week noted the world economy is in recession, and that EM economies in particular will see growth fall sharply as a result of the COVID-19 pandemic.4 “We are in an unprecedented situation where a global health pandemic has turned into an economic and financial crisis. With a sudden stop in economic activity, global output will contract in 2020. … emerging market and developing countries, especially low-income countries, will be particularly hard hit by a combination of a health crisis, a sudden reversal of capital flows and, for some, a sharp drop in commodity prices. Many of these countries need help to strengthen their crisis response and restore jobs and growth, given foreign exchange liquidity shortages in emerging market economies and high debt burdens in many low-income countries.”  For commodity markets, this means the principal source of demand growth is being severely hobbled. The Oil Demand Hit … Estimating the demand destruction caused by COVID-19 is fraught with uncertainty.  Instead of attempting such an estimate, we simulate a sharp drop in oil demand of close to 20% y/y in April 2020, which is consistent with the lockdowns that are bringing the global economy to a standstill.  Specifically, we have 2Q20 demand falling ~ 12mm b/d (y/y vs. 2Q19).  Thereafter, demand picks up rapidly in 2H20, reaching a growth rate of 800k b/d by 4Q20.  For all of 2020, we model average demand losses equal to 3.8mm b/d.  For next year, we expect the combination of massive fiscal and monetary stimulus hitting markets globally will lift demand 5.3mm b/d. Net, we view the COVID-19 demand shock as transitory.  But it leaves a huge amount of unrefined crude oil in storage and massive amounts of unsold products in inventory. Left unaddressed, crude oil will continue to fill storage globally, as will unsold refined products.  This will leave oil producers and refiners in an untenable situation, even after demand returns to normal following the pandemic. Strategists in Riyadh, Moscow and Austin, Texas, know this. … Requires A Supply Offset KSA is forcing its competitors to endure what John Rockefeller, one of the founders of Standard Oil Co., once called a “good sweating.”5  A good sweating was a price-cutting strategy designed to drive competitors out of business and force them to sell to Rockefeller’s company.  This occurred in 2014-16 and in 1986, when KSA had to rein in fellow OPEC members that were free-riding on its production discipline. We believe KSA is well aware it cannot endure a years-long market-share war, nor does it want to.  Its primary goal in the current circumstances is to remind oil producers globally that it can, when it choses, take as much market share as it deems necessary.  After flooding global markets in April 2020 we expect the core-OPEC producers in the Gulf (Kuwait, the UAE, Iraq and, of course, KSA) to reduce production by ~ 2.5mm b/d starting in May 2020, and hold these cuts until 2021 (around the time inventories are drawn down to their 5-year average).  In 2021, we have the group increasing production by 2.5mm b/d in 1Q21. As for Russia, we have them increasing production in April 2020 – contributing to the surge in inventories globally.  However, beginning in May, we believe Russia and its non-OPEC allies will agree to remove ~ 1mm b/d , in line with the cuts we expect from core-OPEC. Russia faces political and geopolitical constraints that work against maintaining the market-share war. First, President Vladimir Putin has already been forced to shift his national strategy over the past three years to address growing concerns with domestic discontent due to the recession caused by the 2014 oil shock and the economic austerity policies his government pursued afterwards. These policies give Putin policy room to fight today’s market-share war, but they also portend another massive blow to the livelihood and wellbeing of the nation. Second, Putin is in the midst of arranging an extension of his term in office through 2036, which requires the constitutional court to approve of constitutional changes as well as a popular referendum. The referendum has been delayed due to the pandemic and need for an emergency response. While Putin is generally popular and has underhanded means of orchestrating the referendum, it would be extremely dangerous for him to compound the pandemic and global recession with an oil market-share war that makes matters even worse for the Russian people while simultaneously preparing for a plebiscite.   Third, internationally, Putin cannot ultimately defeat the Saudis or US shale in terms of market share. Therefore the domestic risks posed above are not compensated by an improvement in Russia’s international standing – neither in oil markets nor in broader strategic influence, given that an economic recession hurts Russia’s ability to maintain and modernize its military and security forces. In the US shales, we are modeling a sharp fall-off in production starting as early as May 2020.  For the rest of 2020, production will gradually decline naturally from low rig counts. In 2H20 – probably in 4Q20 – we expect the Texas Railroad Commission to once again regulate oil production in the state, provided other state regulators (e.g., in North Dakota) and producing countries, (e.g., Russia and KSA) also sign on to take on a similar role.6 In addition to the market-driven shut-ins between now and 4Q20, we expect the RRC to secure production cuts of up to 1.5mm b/d by Dec 2020. As prices pick up next year, shale production will stabilize and slowly move up. The supply-demand assumptions we make in this scenario produce a physical surplus for the better part of 2020 (Chart 4). Chart 4Supply-Demand Imbalance Leads to Physical Surplus Prices Could Fall Further, Then Take Off Even if we see OPEC 2.0 cut, and sharp drops in US shale output followed by renewed pro-rationing by state regulators in the US led by Texas, the fact that they’ve all increased production for April means storage will inevitably rise drastically in the coming months (Chart 5).  As inventory skyrockets in the wake of both the massive demand and supply shocks in 1Q20 and April 2020, prices will fall to $20/bbl (Chart 6). Chart 5Inventories Swell on Demand Shock, Then Drain on Supply Cuts Chart 6Brent Prices Forced Lower, Then Move Above $60/bbl Once the large-scale OPEC 2.0 cuts start, prices rebound rapidly. Demand also starts picking up this summer, which also will lift prices. For 2020, we expect Brent prices to average $35/bbl, while in 2021 we expect Brent to average $66/bbl. Over this period, WTI will trade $2-$4/bbl below Brent.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1     Please see Global oil refiners shut down as coronavirus destroys demand published by reuters.com March 26, 2020, and S&P Global Platts report Refinery margin tracker: Global refining margins take a severe hit on falling gasoline demand published March 23. 2     This appears to be happening now, as pipeline operators ask shippers to reduce the rate at which they fill the lines.  Please see Pipelines ask U.S. drillers to slow output as storage capacity dwindles published by worldoil.com March 30, 2020.  3    Prominently among the GCC states, KSA cuts public spending 5% and introduced fiscal measures meant to cushion the blow of the COVID-19 shock and to offset the low prices resulting from its market-share war with Russia.  Please see Saudi Arabia announces $32 billion in emergency funds to mitigate oil, coronavirus impact published by cnbc.com March 20, 2020. 4     Please see the Joint Statement by the Chair of International Monetary and Financial Committee and the Managing Director of the International Monetary Fund issued by International Monetary and Financial Committee Chair Lesetja Kganyago and International Monetary Fund Managing Director Kristalina Georgieva March 27, 2020. 5     Please see Daniel Yergin’s The Prize: The Epic Quest for Oil, Money & Power, published by Simon & Schuster in 1990, particularly Chapter 2 for a discussion of Rockefeller’s “good sweating,” in which competitors were driven out of business by low prices engineered by Rockefeller if they refused to sell out to Standard Oil. 6     The tone of remarks from TRR Chairman Wayne Christian has become more agreeable to having the TRR Commission return to pro-rating oil production in the Lone Star state.  His recent editorial for worldoil.com notes, “Any action taken by Texas must be done in lockstep with other oil producing states and nations, ensuring that they cut production at similar times and in similar amounts.”  Please see  Christian’s editorial, Texas RRC Chairman Wayne Christian: We must stabilize worldwide oil markets, published by worldoil.com March 25, 2020.  

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Highlights Wells Fargo’s path, before and after deregulation, has been similar to every other SIFI bank’s: It began by serving a single area in a single state, expanded within the state, and then pieced together its regional and national footprint via combinations. A review of 50 years of Wells Fargo’s financials offers multiple insights into the way that banking has evolved at the regional and SIFI bank level: Several community banks are at risk amidst the economy’s unprecedentedly sudden stop, but the overall banking system’s health turns on the condition of the regional banks and the SIFIs. Larger banks are far less reliant on lending than they used to be, … : Net interest income has contributed just 53% of Wells Fargo’s revenues since 2009. The banks would prefer wider net interest margins, but narrow ones won’t wreck their earnings power. … have considerably more capital, and are holding more cash, Treasury and agency securities to stabilize the asset side of the balance sheet: The big banks have two sources of additional ballast: more equity capital to absorb losses, and more stable asset portfolios to limit them in the first place. Feature We are top-down researchers at BCA, using macro data to make conclusions about how financial markets will fare against the economic backdrop they’ll face in the future. We also occasionally glean macro insights from micro data, which we are happy to incorporate into our process when it helps augment our understanding. Wells Fargo is a good proxy for the SIFIs and regional banks which make up the heart of the banking system, because it traveled the same serial acquisition path as its peers once prohibitions on interstate banking began to be eased in the mid-‘80s, and were wiped away for good in 1994. Wells Fargo makes all of its annual reports since 1969 available on its website, and their balance-sheet and income-statement detail fills in some gaps in the system-wide data available from the FDIC and the Fed. We will dig into the system-wide data in next week’s second installment of our examination of banking system vulnerability. This week, we focus on five decades of Wells Fargo data for insight into how banks have fared during the last seven recessions, and how they’re positioned heading into the current one. Banking, Then And Now A time-traveling visitor who worked in banking between the New Deal and the beginning of bank deregulation in the late seventies would find that banks fulfill the same two primary functions as they did in his/her day. They still promote financial intermediation by turning savers’ deposits into fuel for investment and accelerated consumption via loans to businesses and households, and they still administer the payments system. S/he might be unfamiliar with many of the ways they carry out those duties, however, and especially surprised at the way that lending and maturity transformation have been eclipsed. The biggest banks have become far less reliant on lending over the last 50 years, and they no longer engage in maturity transformation, ... At the largest banks, lending is no longer the be-all and the end-all, as revenue from fees has very nearly caught up to net interest income (Chart 1). After adjusting net interest income for loan-loss provisions, lending accounted for just 44% and 48% of Wells Fargo’s revenues in the 2000s in the 2010s, respectively. On that basis, fee revenue exceeded net interest income every year from 2007-2013, inclusive. The rise of fee income has made bank earnings more stable and bank capital levels less dependent on borrower fitness. Chart 1Lending Is No Longer The Only Game In Town Banks also no longer engage in maturity transformation, or borrowing short to lend long, which placed them at the mercy of the yield curve. When it inverted, profitability was squeezed as new deposit-taking-and-lending activity became less lucrative. When the curve shifted out, even if it remained upward-sloping, there was a risk that interest expense on new short-term borrowings would exceed interest income on legacy portfolio assets. The latter is what killed the savings and loans, which were chartered expressly to channel household savings into 30-year fixed-rate home mortgages. ... so investors shouldn't obsess over the yield curve's every wiggle. There is no doubt that bank stocks have closely followed moves in the 10-year Treasury yield for the last several years, and the correlation makes some sense. With deposit rates stuck at zero, the spread between the rate banks pay for funds and the rate at which they lend them out (net interest margin), should move with long yields. Over the last two decades, however, Wells Fargo’s profitability (Chart 2, top panel) has largely detached from net interest margins (Chart 2, bottom panel). It and other banks would welcome higher long yields, but equity investors’ fixation on them is misplaced in a banking industry which has rigorously matched the duration of its assets and liabilities for decades. Chart 2NIM's Influence Has Faded Bank Balance Sheets Have Become Considerably More Conservative In the wake of the 2008-9 crisis, Wells Fargo and other banks have been managed much more cautiously. The share of Wells Fargo’s assets held in cash, Treasury and agency securities is at its highest level in the last 50 years (Chart 3). Its loan-to-deposit ratio is around 50-year lows, indicating that sticky core deposits1 are amply capable of funding its loan book (Chart 4). Wells’ overall leverage,2 or the value of assets supported by each dollar of common equity, is also way down (Chart 5). All banks have de-levered from their peaks, as mandated by regulators after the 2008-9 crisis, making the banking system safer, if less profitable. Mitigating some of the drag on profits brought about by lessened leverage, banks have become considerably more efficient since the early ‘70s. The ATM has reduced the need for physical branches and staff, check processing has been streamlined, and online banking is continuing to help push costs even lower. Chart 3Playing It Safe Chart 4Not Anywhere Close To Extended Chart 5Safety First Credit Costs: The Elephant In The Room The main concern for bank stability, profitability and capital adequacy is the effect of the economic sudden stop on credit performance. Credit performance is acutely sensitive to the business cycle, and banks have headed into this recession, as always, with very low loan-loss reserve balances (Chart 6, top panel). Loan-loss provisions, which reduce net income and chip away at capital positions, are bound to rise, suddenly and significantly (Chart 6, middle panel). (Please see the Box, below, for a brief description of the mechanics of accounting for credit impairments.) Chart 6Banks Have A Lot Of Catching Up To Do Box: Accounting For Lending Losses Every business that makes sales on credit maintains an allowance for doubtful accounts to reflect the fact that not every bill will be paid in full. That allowance reduces the carrying value of its accounts receivable to something below their aggregate face value. Using a loan-loss reserve account, banks apply the same principle to loan repayments. The loan-loss reserve is increased by provisions for loan losses, projections of future loan losses that are immediately recognized as an expense. At the time that a bank provisions for future losses, it does not map the as-yet unrealized losses to individual loans. The value of the loans that are not going to be fully repaid are marked down once they reveal themselves, and the sum of all of the individual write-downs is aggregated as a net charge-off. Identifying individual loan impairments reduces the pool of unspecified loan-loss reserves represented by the reserve account. Net charge-offs do not have any direct impact on bank earnings or bank capital, but by consuming existing reserves, they herald a rebuild of the reserve buffer. Table 1 shows the accounting entries involved in recognizing credit losses, demonstrating the underlying rules. Provisions increase reserves and charge-offs reduce them, triggering a need for more provisions, and ensuring a continuing drain on income and equity capital. Table 1Loan-Loss Accounting The current recession, emerging from the widespread shutdown of economic activity to counter COVID-19, will mark the sharpest downturn since the Great Depression. The sudden stop in activity, and borrowers’ revenue streams, should induce a high level of defaults. Perhaps Wells Fargo’s loan-loss reserves as a share of outstanding loans will ultimately exceed their 1993 peak of nearly 6.5%, following the 1990-91 recession, which wreaked particular havoc on real estate, and in California, where the bank conducted substantially all of its business. Banks would be in a tricky spot if the economy were left to face the coronavirus crisis by itself, but policymakers are doing their utmost to support it. Chart 7There's Nothing Unusual About Credit Line Exposures Wells Fargo barely broke even in 1991, and its book value declined by 6%. Investors seem to fear that it, and other banks, are at risk of net losses and book value declines in 2020. With nearly $1 trillion of outstanding loans, and an annual earnings run rate of around $20 billion, Wells Fargo would appear to be at risk of a nasty capital hit if the economic effects were left alone to play themselves out. The CARES Act coronavirus relief measure, however, clearly signals that the federal government is not going to leave the economy on its own to face the recession’s ravages. As a part of the act, banks were granted the option of delaying the implementation of CECL, the new credit loss recognition standard, which would have had the effect of speeding up the recognition of losses, until the virus emergency passes. The act also provided relief from a loan modification rule, thereby encouraging banks to work out new, easier terms to prevent defaults, and allowed community banks to operate with a reduced minimum equity capital cushion. The $850 billion dedicated to supporting small business borrowers ($350 billon) and other borrowers, including airlines and companies deemed critical to national security ($500 billion) will also benefit their creditors. It is clear to us that forbearance, which will help debtors and creditors weather the social-distancing storm, has been established as a guiding principle for managing through the crisis. Policymakers are out to help banks, not to clip their wings. Investors should also recognize that a lot of lending to small businesses and industrial borrowers has migrated away from banks. They do not stand as squarely in the path of the default storm as they would have in the ‘70s, ‘80s and ‘90s. Direct-lending funds sprung up in the wake of the 2008-9 crisis like mushrooms after the rain, and publicly-traded business development companies (BDCs) have steadily grown their SMID lending share. The biggest industrial borrowers are much more likely to turn to the bond market than they are to call on a syndicate of banks. Finally, the existence of unused loan commitments has occasioned concern among commentators and investors over the last several weeks. If corporate borrowers were to tap their credit lines en masse, would banks find themselves significantly more leveraged? Not at Wells Fargo, where total unfunded lending commitments are about at the middle of their range over the past 25 years (Chart 7, top panel), and its commitments to corporate borrowers are at the low end of their range (Chart 7, second panel). Credit card borrowers may be more inclined to max out their capacity (Chart 7, bottom panel), but that may not be a bad thing for bank profits. Interest on unpaid card balances produces juicy returns, and the 2005 bankruptcy overhaul makes it more difficult to discharge credit card debt. Bullish Or Bearish? Based on what we know now, we do not expect that the SIFI banks will pose a systemic threat to the financial system. Entire industries are at risk, and a multitude of small businesses are reeling, but banks have less exposure than they have in the past, and the Fed and Congress are on a war footing to try to protect the most vulnerable parts of the economy. The looming hit to the banks may be less severe than markets expect. Banks are especially exposed to the business cycle, and the market rule is to avoid them ahead of recessions. From a fundamental perspective, though, the last seven recessions have not been so bad for Wells Fargo. Its per-share book value managed to rise in all of them except the ’90-’91 recession3 (Chart 8). The stock slid in recessions because its book value multiple was slashed (Chart 9). Chart 8Book Value Doesn't Suffer Too Much In Recessions, ... Chart 9... But Multiples Are Regularly Crushed Wells Fargo’s multiple has been slashed again; as of Friday’s close, using its December 31st book value, it had fallen by 44%, from 1.33 to 0.75, and it had been more than halved as of last Monday. It trades at just 90% of its year-end tangible book value. On our first day on an equity trading desk, an old-timer told us that you “buy ‘em at one [times book], and sell ‘em at two.” He was talking about the investment banks, but Wells Fargo’s history suggests the maxim applies to commercial banks, too. In our view, SIFI banks offer an appealing margin of safety to investors who buy them at or below their tangible book value. The degree to which individual banks’ book values fall in this quarter and beyond depends on the size of their loan-loss provisions, but the selloff appears extreme. We noted the appeal of writing out-of-the-money puts on the SIFI banks last week, when the VIX was in the high 70s. Selling those options has lost some appeal after the S&P 500’s 10% surge last week, but writing them could again be alluring if the SIFIs revisit their lows in the coming days and weeks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Loans that exceed deposits, or very nearly match them, are a sign of potential instability because banks often rely on “hot-money” flows to fund them by offering above-market interest rates on instruments like CDs. A bank must continue to pay above-market rates to retain these flows, which are prone to leave the bank for higher interest rates elsewhere. Loan-to-deposit ratios well below 100% can be funded entirely with core deposits, like checking and savings accounts, or market-rate CDs placed with core banking customers who are unlikely to move their business. 2 A bank’s leverage is calculated by dividing its total assets by its common shareholders’ equity. 3 Book value would have shrunk in 2008 if not for the purchase of Wachovia Bank at a significant discount.

Dear Client, I will be discussing the economic and financial implications of the pandemic with my colleague Caroline Miller this Friday, March 27 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). I hope you will be able to join us for this webcast. Next week, we will send you a special report prepared by BCA’s Chief Economist Martin Barnes. Martin will provide his perspective on the current crisis, focusing on some of the longer-run implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The world is in the midst of a deep recession. Growth should recover in the third quarter as the measures taken to compensate for the initial slow response to the crisis are relaxed and existing measures are better calibrated to reduce economic distress. Continued monetary support and unprecedented fiscal stimulus should help drive the recovery once businesses reopen and workers return to their jobs. Investors should maintain a modest overweight to global equities. US stocks will lag their foreign peers over the next 12 months. The US dollar has peaked. A weaker dollar should help lift commodity prices and the more cyclical sectors of the stock market. High-yield credit spreads will narrow over the next 12 months, but we prefer investment-grade credit on a risk-reward basis. Investors are understating the potential long-term inflationary consequences of all the stimulus that has been unleashed on the global economy. Buy TIPS and gold. I. Macroeconomic Outlook The global economy is now in recession. The recession has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus. Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On a sequential annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history. Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus. Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending. A One-Two Punch The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would. This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash. All this reduces aggregate demand. On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home (Chart 1). Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally. Chart 1US: Who Can Work From Home And Who Cannot? Think of this as a Great Depression-style demand shock combined with a category five hurricane supply shock.  The fact that both of these shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse (Chart 2). During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing. This time is different. Chart 2The Service Sector Accounts For A Big Chunk Of GDP And Has Been Very Hard Hit The Shape Of The Recovery: L, U, or V? Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. What will the recovery look like? From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP. Chart 3 shows three scenarios: 1) An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend; 2) A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year; and 3) A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend. Chart 3Profile Of The Recovery: L, U, or V? We had previously thought that the recovery from the pandemic would be V-shaped. Compared to the sluggish recovery following the Great Recession, that is likely still true. However, at this point, we would prefer to characterize the probable recovery as being more U-shaped in nature. This is mainly because the measures necessary to contain the virus may end up having to remain in place, in one form or another, for the next few years. Why Not L? Given the likelihood that containment measures will continue to weigh on economic activity, how can an L-shaped “recovery” be avoided? While such a dire outcome cannot be ruled out, there are three reasons to think “U” is more likely than “L”. Reason #1: We Will Learn From Experience It is almost certain that we will figure out how to fine-tune containment measures to reduce the economic burden without increasing the number of lives lost. There are still many questions that remain unanswered. For example: Are restaurants where family members sit together really more dangerous than bars or conferences where strangers are milling about talking to one another? How dangerous is air travel? Modern airplanes have hospital-grade filtration systems that recirculate all the air in the cabin every three minutes. Might this explain why there has only been a handful of flight attendants that have tested positive for the virus? How contagious are children, who often may not present any symptoms at all? Which drugs might slow the spread of the disease or perhaps even cure it? To what extent would widespread mask-wearing help? Yes, a mask may not prevent you from catching the virus, but if there is major social stigma associated with being unmasked in public, then people who have the virus and may not know it will be less of a threat to others. One study estimates that the virus could be completely eradicated if 80% of people always wore masks.1  With time, we will learn the answers to these questions. We will also be able to stockpile masks, ventilators, respirators, and test kits – all of which are currently in short supply – to better combat the virus. Reason #2: We Are NowOvercompensating For Lost Time Second, most countries are currently at the stage where they are trying not just to bring down the basic reproduction number for the virus to 1, but to drive it down to well below 1. There is merit in doing so. If you can reduce the reproduction number to say, 0.5, meaning that 100 people with the virus will pass it on to only 50 other people, then the number of new infections will fall rapidly over time. This is what China was finally able to achieve. A recent study documented that China succeeded in bringing down the reproduction number in Wuhan from 3.86 to 0.32 once all the containment measures had been implemented (Chart 4).2 Chart 4Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak The critical point is that once you reduce the number of new infections to a sufficiently low level, you can then relax the containment measures by just enough so that the reproduction number rises back to 1. At that point, the number of new infections at any given point in time will be constant. One can see this point by imagining a bicycle coasting down a mountain road. Ideally, the rider should apply uniform pressure on the brakes at the outset of the descent to prevent the bicycle from accelerating too quickly. However, if the rider is too slow to apply the brakes and ends up going too fast, he or she will then need to overcompensate by pressing hard on the brakes to slow the bike down before easing off the brakes a bit. Most of the world is currently in the same predicament as the cyclist who failed to squeeze the brakes early on. We are overcompensating to get the infection rate down. However, once the infection rate has fallen by enough, we can ease off the most economically onerous measures, allowing GDP to slowly recover. Reason #3: Containment Measure Will Be Eased As More People Acquire Immunity Much of the popular discussion of the epidemiology of COVID-19 has failed to distinguish between the basic reproduction number, R0, and the effective reproduction number, Re. The former measures the average number of people a carrier of the virus will infect in an entirely susceptible population, whereas the latter measures the average number of people who will be infected after some fraction of the population acquires immunity either by surviving the disease or getting vaccinated. Mathematically, Re = R0*(1-P), where P is the proportion of the population which has acquired immunity. For example, suppose P=0.5, meaning that half the population has acquired immunity. In this case, the average number of people a carrier will infect will be only half as high as when no one has immunity. As we discuss below, there is considerable uncertainty about how fast P will increase over time, including whether it could spike upwards if a vaccine becomes widely available. Still, any increase in P will make it more difficult for the virus to propagate. Over time, this will permit policymakers to raise R0 at an accelerating rate towards the level it would naturally be in the absence of any containment measures (Chart 5). Such a strategy would allow economic activity to increase without raising Re; that is to say, without triggering an explosion in the number of new cases. Chart 5Populations Acquiring Immunity Is Key The Virus Endgame How long will it take to dismantle all the containment measures completely? This partly depends on what medical breakthroughs occur and what measures are needed to “flatten the curve” of new infections (Chart 6). Right now, most countries are trying to drive down the number of new infections to very low levels in the hopes that either a vaccine will be invented or new treatment options will become available. Chart 6Flattening The Curve We are not medical experts and will not offer an opinion on how likely a breakthrough may be. What we would say is that combating the virus has become a modern-day Manhattan project. If the project succeeds, a V-shaped recovery could still ensue. What if the virus evades the best efforts of scientists to eradicate it? In that case, the only way for life to return to some semblance of normalcy is for the population to acquire herd immunity. How many people would need to be infected? In the context of the foregoing discussion, this is equivalent to asking how high P needs to rise for Re to fall below 1. The equation above tells us this must correspond to the value of P for which R0 (1-P) <1. Solving for P yields P > 1-1/R0. In the absence of social distancing and other containment measures, most estimates of R0 for COVID-19 place it between 1.5 and 4. This implies that between one-third (1-1/1.5) to three-quarters (1-1/4) of the population would need to be infected for herd immunity to set in. Even if one allows for the likelihood that significantly more resources will be marshalled to allow hospitals to service a greater number of patients, we estimate that it would take 2-to-3 years to reach that point.3 To be clear, the virus’ ability to spread will decline even before herd immunity is achieved. An increase in the share of the population who survived and became naturally inoculated against the virus would allow policymakers to relax containment measures, perhaps to such an extent that eventually only the simplest of actions such as increased hand-washing and widespread mask-wearing would be enough to prevent hospitals from being overwhelmed. This underscores our baseline expectation of a U-shaped economic recovery. Second-Round Effects Suppose the global economy starts to recover in the third quarter of this year as the measures taken to compensate for the initial slow response to the crisis are relaxed, existing measures are better calibrated to reduce economic distress, and more younger and healthier people acquire natural immunity to the virus, thus reducing the vulnerability of the old and frail. Does that mean we are out of the woods? Not necessarily! We still have to worry about the second-round economic effects. Even if the virus is contained, there is a risk that the economy will be so scarred by the initial drop in output that it will fail to recover. A vicious circle could emerge where falling spending leads to higher unemployment, leading to even less spending. In the current environment, the tendency for unemployment to rise may be initially mitigated by the decision of a few large companies with ample financial resources to pay their workers even if they are confined to their homes. This would result in a decline in labor productivity rather than higher unemployment. That said, given the severity of the shock and the fact that many of the hardest-hit firms are in the labor-intensive service sector, a sharp rise in joblessness is still inevitable, particularly in countries with flexible labor markets such as the US. Chart 7Worries Over Job Security Abound Today’s spike in US initial unemployment claims is testament to that point (Chart 7). In fact, the true increase in the unemployment rate will probably be greater than what is implied by the claims data because many state websites did not have the bandwidth to handle the slew of applications. In addition, under existing rules, the self-employed and those working in the “gig economy” do not qualify for unemployment benefits (this has been rectified in the bill now making its way to the White House). The Role Of Policy Could we really end up in a world where the virus is contained, and people are ready and able to work, only to find that there are no jobs available? While such a sorry outcome cannot be dismissed, we would bet against it. This outcome would only arise if there is insufficient demand throughout the economy when it reopens. Unlike in 2008/09 when there was a lot of moralizing about how this or that group deserved to be punished for their reckless behavior, no one in their right mind today would argue that the workers losing their jobs and the companies facing bankruptcy somehow had it coming. What can policymakers realistically do? On the monetary side, policy rates are already close to zero in most developed economies. A number of emerging markets still have scope to cut rates, but even there, many find themselves not far from the zero bound (Chart 8). Chart 8DM Rates At The Zero Bound, With EM Rates Approaching Chart 9A Mad Scramble For Cash   That said, cutting interest rates right now is not the only, and probably not the most important, way for central banks to stimulate their economies. The global economy is facing a cash shortage. Companies are tapping credit lines at a time when banks would normally be looking to increase their own cash reserves. The mad scramble for cash has caused libor, repo, and commercial paper spreads to surge (Chart 9). And not just any cash. As the world’s reserve currency, the dollar is increasingly in short supply (Chart 10). This explains why cross-currency basis spreads have soared and why the DXY index has jumped to the highest level in 17 years. Chart 10Dollars Are In Short Supply   Flood The Zone Chart 11US Mortgage Spreads Have Spiked The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency mortgage-backed securities (MBS) since relaunching its QE program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields (Chart 11). The Fed has also dusted off the alphabet soup of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses. In order to ease overseas funding pressures, the Fed has opened up swap lines with a number of central banks. We expect these lines to be expanded to more countries if the situation necessitates it. The Coming Mar-A-Lago Accord? We also think that there is at least a 50-50 chance that we could see coordinated currency interventions designed to drive down the value of the US dollar. Federal Reserve, Treasury, and IMF guidelines all permit currency intervention to counter “disorderly market conditions.” While a weaker dollar would erode the export competitiveness of some countries, this would be more than offset by the palliative effects of additional dollar liquidity stemming from US purchases of foreign securities, as well as the relief that overseas dollar borrowers would receive from dollar depreciation. Thus, on balance, a weaker dollar would result in an easing of global financial conditions. Liquidity Versus Solvency Risk Some might complain that the actions of the Fed and other central banks go well beyond their mandates. They might argue that it is one thing to provide liquidity to the financial system; it is quite another to socialize credit risk. We think these arguments are largely red herrings. For one thing, concern about credit risk can be addressed by having governments backstop central banks for any losses they incur. Moreover, there is no clear distinction between liquidity and solvency risk during a financial crisis. The former can very easily morph into the latter. For example, consider the case of Italy. Would you buy more Italian bonds if the yield rises? That depends on two competing considerations. On the one hand, a higher yield makes the bond cheaper. On the other hand, a higher yield may make it more difficult for the government to service its debt obligations, which raises the risk of default. If the second consideration outweighs the first, your inclination may be to sell the bond. To the extent that your selling causes yields to rise further, that could lead to another wave of selling. As Chart 12 illustrates, this means that there may be multiple equilibria in fixed-income markets. It is absolutely the job of central banks to try to steer the economy towards the good ”low yield” equilibrium rather than the bad “default” equilibrium. Chart 12Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort In this light, ECB president Christine Lagarde’s statement on March 12th that “we are not here to close spreads” –  coming on the heels of a spike in Italian bond yields and a 13% drop in euro area stocks the prior day – was one of the most negligent things a central banker has ever said. To her credit, she has since walked back her comments. The ECB has also launched the Pandemic Emergency Purchase Programme (PEPP), a EUR 750bn asset-purchase program, which gives the central bank considerable flexibility over the timing, composition, and geographic makeup of purchases. Further actions, including upsizing the PEPP, creating a “conditionality-lite” version of the ESM program, and perhaps even issuing Eurobonds, are possible. All this should help Italy. Accordingly, BCA’s global fixed-income team upgraded Italian government bonds to overweight this week. Using Fiscal Policy To Align Financial Time With Economic Time While central banks will play an important role in mitigating the crisis, most of the economic burden will fall on fiscal policy. How much fiscal support is necessary and what should it consist of? To get a sense of what is optimal, it is useful to distinguish between the concept of financial time and economic time. Financial time and economic time usually beat at the same pace. Most of the time, people have financial obligations – rent, mortgage payments, spending on necessities – that they match with the income earned from work. Likewise, companies have expenses that they match with the revenue that they derive from various economic activities.  No one worries when economic time and financial time deviate in predictable ways. For example, GDP collapses around 5pm on Monday only to recover at 9am on Tuesday. The fact that many western Europeans take most of August off for vacation is also not a problem, since everyone expects this. The problem occurs when economic time and financial time deviate in unpredictable ways. That is the case at present. Today, economic time has ground to a halt as businesses shutter their doors and workers confine themselves to their homes. Yet, financial time continues to march on. This implies that in the near term, the correct course of action is for governments to transfer money to households and firms to allow them to service their financial obligations. One simple way of achieving this is through wage subsidies, where the government pays companies most of the wage bill of their employees who, through no fault of their own, are unable to work. Note that this strategy does not boost GDP. By definition, an idle worker is one who does not contribute to economic output. What this strategy does do is alleviate needless hardship, while creating pent-up demand for when businesses start to open their doors again. Once the virus is contained, traditional fiscal stimulus that boosts aggregate demand will be appropriate. How much money are we talking about? In the case of the US, suppose that annualized growth is -5% in Q1, -25% in Q2, and +10% in Q3 and Q4, respectively. That would leave the level of real GDP down 4% on the year compared to 2019. Assuming trend GDP growth of 2%, that implies an annual shortfall of income (consisting of wages and lost profits) that the government would have to cover amounting to 6% of GDP. The $2 trillion stimulus bill amounts to 10% of GDP, although not all of that will be spent during the next 12 months and about a quarter of the amount is in the form of loans and loan guarantees. Still, on size, we would give it an “A”. On composition, we would give it a “B”, as it lacks sufficient funding for state and local governments to cover the likely decline in the tax revenues that they will experience. This could result in layoffs of first responders, teachers, etc. Given that the US was running a fiscal deficit going into the crisis, all this additional stimulus could easily push the budget deficit to over 15% of GDP. While this is a huge number, keep in mind that in a world where interest rates are below the trend growth rate of the economy, a government can permanently increase its budget deficit by any amount it wants while still achieving a stable debt-to-GDP ratio over the long haul.4 Today, we are not even talking about a permanent increase in the deficit, but a temporary increase that could last a few years at most. If we end up in a depression, don’t blame the virus; blame politicians. Fortunately, given that the political incentives are aligned towards fiscal easing rather than austerity, our guess is that a depression will be averted. Appendix A summarizes the monetary and fiscal measures that have already been taken in the major economies. II. Investment Strategy As anyone who has ever watched a horror movie knows, the scariest part of the film is the one before the monster is revealed to the audience. No matter how good the makeup or set design, our imaginations can always conjure up something much more frightening than Hollywood can invent. Right now, we are fighting an invisible enemy that is ravaging the world. Victory is in sight. The number of new infections has peaked in China and South Korea. I mentioned during last week’s webcast that we should watch Italy very carefully. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control. While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past five days (Chart 13). Chart 13A Peak In The Number Of New COVID-19 Cases In Italy Would Send An Encouraging Signal Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. However, as we spelled out in this report, there are good reasons to think that these measures will not need to be as severe as the ones currently in place. As such, it is likely that global growth will begin to rebound in the third quarter of this year. Equities: A Modest Overweight Is Warranted We turned more cautious on the near-term outlook for global equities earlier this year, but upgraded our recommendation on the morning of February 28th after the MSCI All-Country World Index fell by 12% over the prior week. While stocks did rally by 7% during the following three trading days, they subsequently plunged to multi-year lows. In retrospect, we should have paid more attention to our own warnings in our earlier report titled “Markets Too Complacent About The Coronavirus.” 5 For now, we would recommend a modest overweight to stocks on both a 3-month and 12-month horizon. Monetary and fiscal easing and the prospect of a peak in the number of new cases in Italy could continue to support stocks in the near term, while a rebound in growth starting this summer should pave the way for a recovery in corporate earnings over a 12-month horizon. Chart 14US Equity Valuations Are Not Yet At Bombed-Out Levels Of course, when it comes to financial markets, one should always be prepared to adjust one’s conviction level if prices either rise or fall significantly. We mentioned two weeks ago that we would move to a high-conviction overweight if the S&P 500 fell below 2250. While the index did briefly fall below this level, it has since bounced back to about 2630. At its current level, the S&P 500 is trading at 15.3-times forward earnings (Chart 14). While this is not particularly expensive, it is still well above the trough of 10.5-times forward earnings reached in 2011 during the height of the euro crisis. And keep in mind that current earnings estimates are based on the stale assumption that S&P 500 companies will earn $172 over the next four quarters, down only 3% from the peak earnings estimate of $177 reached in February. With this in mind, we are introducing a lower and upper bound for global equity prices at which we will adjust our view. To keep things simple, we will focus on the S&P 500, which accounts for over half of global stock market capitalization. If the S&P 500 falls below (and stays below) 2250, we would recommend a high-conviction overweight to global stocks. If the index rises above 2750, we would recommend a neutral equity allocation. Anything between 2250 and 2750 would justify the current stance of modest overweight. Going forward, we will adjust this range as events warrant it. Our full slate of views can be found in the table at the end of this report. Sector And Regional Equity Allocation: Favor Cyclicals and Non-US Over A 12-Month Horizon Not surprisingly, defensive equity sectors outperformed cyclicals both in the US and abroad during this month’s selloff. Financials also underperformed on heightened worries about rising defaults and the adverse effect on net interest margins from flatter yield curves (Chart 15). Chart 15Cyclicals And Financials Underperformed On The Way Down Chart 16Non-US Stocks Are Cheaper Even After Adjusting For Differences In Sector Weights   Cyclicals and financials have outperformed the broader market over the past few days as risk sentiment has improved. They are likely to continue outperforming over a 12-month horizon as global growth eventually recovers and yield curves steepen modestly. To the extent that cyclicals and financials are overrepresented in stock market indices outside the US, this will give non-US equities the edge. Stocks outside the US also benefit from more favorable valuations. Even after adjusting for differences in sector weights, non-US stocks are quite a bit cheaper than their US peers as judged by price-to-earnings, price-to-book, and other valuation measures (Chart 16). The US Dollar Has Probably Peaked Another factor that should help cyclical stocks later this year is the direction of the US dollar. The greenback has been buffeted by two major forces this year (Chart 17). Chart 17The Dollar Has Been Facing Crosscurrents Chart 18USD Is A Countercyclical Currency   Between February 19 and March 9, the dollar weakened as US bond yields fell more than yields abroad. This eliminated some of the yield advantage that had been supporting the dollar last year. Starting around the second week of March, however, global financial stresses escalated. Money began to flow into the safe-haven Treasury market. Global growth prospects also deteriorated sharply. As a countercyclical currency, this helped the dollar (Chart 18). Looking out, interest rate differentials are unlikely to return anywhere close to where they were at the start of this year, given that the Fed will probably keep rates near zero at least until the middle of 2021. Meanwhile, aggressive central bank liquidity injections should reduce financial stress, while a rebound in global growth will allow capital to start flowing back towards riskier foreign markets. This should result in a weaker dollar. Once Growth Bottoms, So Will Commodities Chart 19Low Prices Force US Shale Cutbacks The combination of a weaker dollar, a rebound in global growth starting this summer, and increased infrastructure stimulus spending in China should help lift resource prices. This will also buoy currencies such as the AUD, CAD, and NOK in the developed market space, and RUB, CLP, ZAR, and IDR, in the EM space. Oil prices have tumbled on the back of the sudden stop in global economic activity and the breakdown of the agreement between OPEC and Russia to restrain crude production. BCA’s commodity strategists expect the Saudis and Russians to come to an agreement to reduce output, as neither side has an incentive to pursue a prolonged price war. They see Brent prices averaging $36/barrel in 2020 and $55/barrel in 2021. However, prices are not likely to go much higher than $60/barrel because that would take them well above the current breakeven cost for shale producers, eliciting a strong supply response (Chart 19). Spread Product: Favor IG Over HY A rebound in oil prices from today’s ultra-depressed levels should help the bonds of energy companies, which are overrepresented in high-yield indices. This, together with stronger global growth and improving risk sentiment, should allow HY spreads to narrow over a 12-month horizon. Chart 20High-Yield Credit Is Pricing In Only A Moderate Recession Nevertheless, we think investment grade currently offers a better risk-reward profile. While HY spreads have jumped to more than 1000 basis points in the US, they are still nowhere close to 2008 peak levels of almost 2000 basis points. Like the equity market, high-yield credit is pricing in only a modest recession, with a default rate on par with the 2001 downturn (Chart 20). Moreover, central banks around the world are racing to protect high-quality borrowers from default. The Fed’s announcement that it will effectively backstop the investment-grade corporate bond market could be a game changer in this regard. Unfortunately for HY credit, the moral hazard consequences of bailing out companies that investors knew were risky when they first bought the bonds are too great for policymakers to bear. Government Bonds: Deflation Today, Inflation Tomorrow? As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary impulse will be exacerbated by rising unemployment. Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be deflationary. On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. This could be particularly true in the US, where our geopolitical team now expects Joe Biden to win the presidential election. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy. Our hunch is that the more inflationary scenario will unfold over the next 2-to-3 years. Interestingly, that is not the market’s opinion. For example, the 5-year US TIPS breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take. Finally, a word on gold. Just as during the Global Financial Crisis, gold failed to be an attractive hedge against financial risk during the recent stock market selloff – bullion dropped by 15% from $1704/oz to $1451/oz, before rebounding back to $1640/oz over the past few days as risk sentiment improved. Nevertheless, gold remains a good hedge against long-term inflation risk. And with the US dollar likely to weaken over the next 12 months, gold prices should move up even if near-term inflationary pressures remain contained. As such, we are upgrading our outlook on the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Appendix A Appendix A Table 1Central Banks Still Had Some Options When Crisis Hit Appendix A Table 2Massive Stimulus In Response To Pandemic Footnotes 1  Jing Yan, Suvajyoti Guha, Prasanna Hariharan, and Matthew Myers, “Modeling the Effectiveness of Respiratory Protective Devices in Reducing Influenza Outbreak,” U.S. National Library of Medicine, (39:3), March 2019. 2  Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. 3  This calculation assumes that 5% of infected people need ICU care and each spends an average of 2 weeks in the ICU. It also assumes that hospitals are able to expand their capacity by 30 additional ICU beds per 100,000 people per year to treat COVID-19. 4  Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, available at gis.bcarearch.com. 5  Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020, available at gis.bcaresearch.com. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Equity market bloodletting likely reached a climax last Thursday as indiscriminate selling pushed correlations to the extremes of +/-1. Since then however, hypersensitive stocks have made an attempt for a comeback. These greenshoots are most visible in the highest beta areas of the market, namely chip stocks and small cap indexes. The chart shows that both the Philly SOX index and the Russell 2000 are ticking higher versus the NASDAQ 100 and S&P 500 indexes, respectively. While it is still too soon to call the ultimate trough in stocks and a retest will likely materialize, it is encouraging that investors are no longer pressing the panic sell button. Tack on the extreme short interest and lack of depth in ES futures and a significant short-covering reflex rally is likely to continue in the coming days.  Bottom Line: We recommend investors with higher risk tolerance and a 9-12 month cyclical time horizon to continue nibbling on the broad equity market.​​​​​​​