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  Highlights China should fare a global recession better than most G20 economies, given its large domestic market and powerful policy response. China is likely to frontload a large portion of its multi-year infrastructure investment projects to this year. We project a near 10% increase in infrastructure investments in 2020. While at the moment we do not have high conviction in the absolute trend in Chinese stock prices, we think Chinese equities will still passively outperform global benchmarks in a global recession. Feature Chart 1A Black Monday Triggered By A "Perfect Storm" Investors are now pricing in a global recession, triggered by a worsening COVID-19 epidemic outside of China and a full-blown price war in the oil market. Global stocks tumbled by 7% on Monday March 9 while the US 10-year Treasury yield dropped to a record low (Chart 1).  This extreme volatility reflects investors’ inability to predict how the epidemic will evolve or how long the oil price war will persist. If growth in the US and other major economies turns negative, then China’s disrupted supply side in Q1 will be met with weaker global demand in Q2 and even Q3. While our visibility is limited on the predominantly medically- or politically-oriented crisis, what we have conviction in forecasting at this point is that the Chinese economy will weather the storm better than most G20 economies. China’s policy response and the recovery in domestic demand will more than offset weaknesses from external demand. Thus Chinese stocks will likely outperform global benchmarks in the next 3 months and over a 6-12 month span, even though the absolute trend in both Chinese and global stock prices remains unclear over both these time horizons. A One-Two Punch In a recessionary scenario affecting the entire global economy, China would receive a one-two punch through shocks to both supply and demand tied to the COVID-19 outbreak and shrinking global demand. However, while a global recession would impact China’s export growth, it would not have the kind of bearing on China’s aggregate economy as it did in either 2008/2009 or 2015/2016. The reason is that the Chinese economy is less reliant on exports than it was in 2015 and considerably less than in 2008 (Chart 2). Domestic demand is now dominant, accounting for more than 80% of China’s economy, meaning that the country is less vulnerable to reductions in global demand. Chart 2The Chinese Economy Is Much Less Reliant On Exports Chart 3Global Economy Showing Reflation Signs Before COVID-19 Our current assessment is that the shocks from the virus epidemic and oil price rout on global demand will be brief.Global manufacturing and trade were on a path to recovery prior to the crisis (Chart 3). China’s external and domestic demand rebounded sharply in December and likely have improved even further until late January when the COVID-19 outbreak took hold in China (Chart 4). Even though China’s trade figures in the first two months of 2020 were distorted by COVID-19 (Chart 5),1 a budding recovery in both China’s domestic and global demand before the outbreak suggests the epidemic should disrupt rather than completely derail the global economy. Moreover, a rebound in trade following the crisis will likely be powerful, as the short-term disruption in business activities will lead to a sizable buildup in manufacturing orders. A rebound in trade following the crisis will likely be powerful. Chart 4Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chart 5Chinese Demand Likely To Pick Up Sharply In Q2   Bottom Line: China’s export growth will moderate if the virus outbreak prolongs and substantively weakens the global economy. However, the demand shock should have a relatively minor impact on China’s aggregate economy and the subsequent recovery should be robust. Infrastructure Investment Comes To Rescue, Again Chart 6Substantial Acceleration In Infrastructure Investment Likely In 2020 Infrastructure investment in China will likely ramp up significantly in 2020, which will mitigate the influence on the domestic economy from both COVID-19 and slowing global growth. The message from the March 4th Politburo Standing Committee2 chaired by President Xi Jinping further supports our view, that Chinese policymakers are committed to a major increase in infrastructure investment in 2020. Our baseline projection suggests a near 10% increase in infrastructure investment growth in 2020 (Chart 6). Local governments’ infrastructure investment plans for the next several years amount to about 34 trillion yuan.3 While local government budget and bond issuance will be approved at the annual National People’s Congress, which is delayed due to the epidemic, we have high conviction that a significant portion of the planned spending will be frontloaded this year. A significant portion of the multi-year infrastructure projects will likely be moved up to this year. In the first two months, local governments have frontloaded 1.2 trillion yuan worth of bonds, including nearly 1 trillion yuan of special-purpose bonds (SPBs). The consensus forecasts a total of 3-3.5 trillion yuan of SPBs to be issued in 2020, a 30% jump from 2019. Given tightened restrictions on the use of SPBs, we expect that 50% of the bonds will be invested in infrastructure projects, up from about 25% from 2019. This should contribute to about 10-15% of infrastructure spending in 2020. We are likely to also see significant additional funding channels to support infrastructure spending this year: Debt-swap program: With the aggressive easing by the PBoC in recent weeks, there is a high probability that another round of debt-swap program will materialize this year – a form of fiscal stimulus similar to the debt-to-bond swap program that the Chinese government initiated during the 2015-2016 cycle (Chart 7).  As we pointed out in our report dated July 24, 2019, the Chinese authorities were formulating another round of local government off-balance-sheet debt swaps, which we estimated would be about 3-4 trillion.4 What was absent back then was a concerted effort from the PBoC to equip commercial banks with the required liquidity and further lower policy rate (Chart 8). Both monetary and policy conditions are now ripe for such a program to be rolled out. Chart 7Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Chart 8Monetary Conditions Are Ripe For Major Money Base Expansion   Construction bond issuance: Borrowing through local government financing vehicles (LGFV) has climbed since the second half of last year. This follows two years of tightened regulations on local government borrowing. Net issuance of urban construction investment bonds (UCIB) reached 1.2 trillion in 2019, nearly doubling the amount from a year earlier. A total of 457 billion yuan in UCB has already been issued in the first two months of 2020, which indicates that the authorities are further relaxing LGFV borrowing.  We think that net UCIB issuance could reach 1.5 trillion this year, a 25% increase compared with last year. Chart 9More Room To Widen Government Budget Deficit Government budget:  Funding from the central and local governments budgets accounts for about 15% of overall infrastructure financing. We think that the government budget deficit will likely expand by about 2% of GDP in 2020. As Chart 9 shows, this figure is a conservative estimate compared with the 3%+ widening in the budget deficit during the 2008 and 2015 easing cycles. Bottom Line: Fiscal efforts to support the economy will significantly escalate this year. Monetary conditions and policy directions have already paved the way for a 2015-2016 style credit expansion. We expect infrastructure investment to rise to about 10% in 2020 compared with 2019. Will The RMB Join The Devaluation Club? The RMB appreciated by more than 1% against the USD in the past week, fanned by the expectation that China will have a faster recovery than other countries. The latest round of interest rate cuts by central banks around the world also pushed yield-seeking investors to RMB assets (Chart 10). Still, it is highly unlikely that the PBoC will allow the RMB to continue to appreciate at this rate. When other economies are in a competitive currency devaluation cycle, a strong RMB will generate deflationary headwinds for China’s economy and will partially offset the PBoC’s easing efforts (Chart 11). Chart 10Too Much Too Fast? Chart 11A Strong RMB Will Choke Off PBoC's Easing Efforts If the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. Chart 12PBoC Likely To Rapidly Expand Its Balance Sheet Again We do not expect the PBoC to follow the US Federal Reserve and chase its policy rate even lower.  However, if the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. This further raises the probability that local government debt-swap programs will develop this year (Chart 12). The government may allow financial institutions to extend or swap maturing local government off-balance sheet debt with bank loans that carry lower interest rates and longer maturities. Or, it will simply move the debt to the PBoC’s balance sheet. Bottom Line: If upward pressure in the RMB endures, the PBoC will likely expand its balance sheet and make more room to buy local government debt, but it is unlikely to aggressively cut interest rates. Investment Conclusions Chart 13Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Our recent change in view5 concerning the willingness of Chinese authorities to “stimulate the economy at all costs” meant that Chinese stocks were likely to outperform the global benchmarks in a rising equity market.  In a global recessionary, which is now a fait accompli, Chinese leadership’s willingness to stimulate the economy will only intensify. China’s large domestic economy also makes the country less vulnerable to a global demand shock. At this point in time we do not have high conviction in the absolute trend in either Chinese or global stock prices, as their near-term performance is predominantly driven by a medically- and politically-oriented crisis. However, as we expect the Chinese economy to outperform in a global recession, our overweight call on Chinese equities remains intact on both a 3-month and 12-month horizon, in relative terms (Chart 13).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    China had postponed January’s data release and instead, has combined the first two months of the year. 2   “We should select investment projects; strengthen policy support for land use, energy use, and capital; and accelerate the construction of major projects and infrastructure that have been clearly identified in the national plan.” http://cpc.people.com.cn/n1/2020/0305/c64094-31617516.html?mc_cid=2a979… 3   https://m.21jingji.com/article/20200306/504edc15217322ab37337da2ca35a49e.html?[id]=20200306/nw.D44010021sjjjbd_20200306_9-01.json  4   Please see China Investment Strategy Weekly Report "     Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?," dated February 26, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Dear Clients, This week we are issuing two Special Alerts on the Russo-Saudi market share war, one of which you have already received. Our weekly publication will proceed as usual on Friday, March 13. In this Special Alert, we update our view of the US election and address the urgent question of US fiscal stimulus. Upcoming reports will address the question of stimulus outside the United States. All very best, Matt Gertken Vice President Geopolitical Strategy Feature Turmoil has engulfed financial markets as a Russo-Saudi market share war erupts at the same time as panic over the coronavirus spreads from China to Europe and the United States. The US and global stock markets are nearing bear market territory while the 10-year Treasury and global bond yields plumb new lows and deeper negatives (Chart 1). Our key risk-off indicators have all broken down (Chart 2). Chart 1The Bear Awakens Chart 2Global Risk-Off While the daily new cases of the virus are far from peaking in the US, the Democratic Party nomination process has eliminated the downside risk of a left-wing populist presidency. Political risk in the US will shift to Congress, fiscal stimulus, the general election, and the “lame duck” risk now threatening President Trump. Trump Not Yet Doomed, But No Longer Favored The US election is now “too close to call,” with the risks tilted toward a Trump loss. Bear markets tend to coincide with recessions (Chart 3). Woe betide a president seeking reelection amid a recession. Chart 3Bear Markets Tend To Coincide With Recessions We need to look to a previous era to identify precedents for Trump’s survival. William McKinley hung onto the office in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924, all despite recessions.1 Rising unemployment will undo Trump’s re-election bid. In today’s terms, it is still possible that the virus panic will subside over the summer while a wave of global monetary and fiscal stimulus will kick in around September, creating a rebound that sends voters to the polls in an optimistic mood. But it is increasingly unlikely. Unemployment will rise as consumer confidence collapses in the face of the virus outbreak (Chart 4). This is deadly to a president with such narrow margins of victory in the key swing states. Chart 4Confidence Will Suffer, Layoffs To Ensue Chart 5Trump’s Approval Heading South Chart 6Republican Revival To Fall Back The coronavirus scare is already derailing President Trump’s approval rating. It had only tentatively recovered from a very low level throughout his first term and is highly unlikely ever to breach 50% (Chart 5). The surge in voters identifying as Republicans – which had recently, remarkably, surpassed Democrats – will reverse (Chart 6). Our quant election model is “too close to call” but will soon signal Trump loss. Our quant model was already flashing that the election is “too close to call,” due to the negative impact of Trump’s trade war on key swing states like Michigan and Pennsylvania. The weight of a feather can shift Wisconsin into the Democratic camp and turn the election against Trump (Chart 7). The model will inevitably show Trump losing the election once state-level data starts to reflect the virus shock. Chart 7Our Quant Election Model Says “Too Close To Call” … But Virus Panic Will Cause Wisconsin To Switch Bottom Line: The US election is too close to call at this point. With eight months to go, many things could still change, but a spike in unemployment will ruin Trump’s reelection bid. Biden, Not Sanders, Waiting In The Wings Chart 8Biden Has All But Clinched The Democratic Nomination The bad news for Trump – but the good news for markets – is that former Vice President Joe Biden has solidified his status as presumptive nominee for the Democratic Party presidential candidate. Biden romped to victory in Michigan and Missouri on March 10 – and is virtually tied with Vermont Senator Bernie Sanders in Washington, a liberal state that should favor the self-professed democratic socialist Sanders. Biden now clearly leads the count of pledged delegates to the Democratic National Convention on July 13 – and voting patterns in the remaining primary elections would have to reverse entirely in order to give Sanders a 1,991-vote majority of delegates in the first round of voting in July (Chart 8). It is unlikely that Sanders can deprive Biden of a majority of delegates even though he will trounce Biden in the final debate on March 15. The important state elections on March 17 are all favorable to Biden: Arizona, Florida, Illinois, and Ohio. Our delegate projections show Biden winning an outright majority by May 12 (Chart 9). Chart 9Biden Set To Win Majority Of Democratic Delegates By Spring Over the past year many clients have argued to us that neither Biden nor Sanders is electable. We have rejected this view on the basis that the economic cycle would most likely determine the election, since Trump had the misfortune of being a late-cycle president. The financial markets have dodged a bullet with Biden’s nomination since Sanders was capable of winning the nomination and now, with an impending recession, would be even odds (or favored) to take the White House. Chart 10Head-To-Head Polls Show Trump Vulnerability Average head-to-head polls show both Biden and Sanders beating Trump in the battleground states. This always suggested that Trump was highly vulnerable. But on the margin Biden is more electable than Sanders: he polls better against Trump than any Democrat, while Trump polls worse against him than any Democrat. Biden has an Electoral College pathway to victory via Florida and Arizona, as well as via the Midwestern states where Sanders is also competitive (Chart 10). Democrats ultimately chose Biden because he seemed the most likely to beat Trump. He also has the best position on the issue most important after the economy, which is health care (Chart 11). This reputation comes from his association with both President Barack Obama and the Affordable Care Act (Obamacare). A contested convention, in which the Democratic Party splits and progressive voters sit out the election, was always unlikely and is now virtually foreclosed. As he clinches the nomination Biden will seek to win over the support of progressives by choosing a progressive running mate and adopting more left-leaning policies on issues like inequality and the environment. Chart 11Democrats Chose Biden To Win And Restore Obamacare Chart 12Democratic Primary Turnout Strong In Vital Midwest Voter turnout in the primary elections suggests that voters are fired up in the Midwest (Michigan, Minnesota) but more complacent in the South (Texas, North Carolina) (Chart 12). Primary elections are different from general elections, but a worsening economy will provoke higher turnout. At minimum these data reinforce the point above that Trump is highly vulnerable in the Midwestern “Blue Wall” that narrowly brought him to power. Bottom Line: Biden is not only electable but at this stage equally likely as Trump to sit in the Oval Office in 2021. This is a market-positive policy outcome compared with the alternative – a Sanders presidency – which was almost equally probable in the event of a recession. Financial markets will see Biden as less negative than Sanders on regulation and taxes, and less negative than Trump on trade and foreign policy. Fiscal Stimulus A major source of uncertainty surrounding the election is fiscal policy, as a Democratic victory implies an increase in taxes on households and businesses. Not only is there a spike in tax provisions set to expire (top panel, Chart 13), but President Trump’s signature Tax Cut and Jobs Act could be repealed if he loses or made permanent if he wins. Chart 13Fiscal Uncertainty Looms Over US The short-term outlook is also in flux because the Trump administration is frantically trying to piece together an economic stimulus package to respond to the coronavirus shock. Democrats control the House of Representatives and have an incentive to delay and water down Trump’s stimulus proposals. However, they cannot be seen as playing politics with the nation’s health and livelihood and will ultimately agree to fiscal stimulus. This contradiction implies that financial markets will experience ongoing volatility as talks take place. Ultimately, Trump and the Democrats will cooperate, particularly as the financial constraint intensifies through market selling. Trump’s bid will be to stimulate the overall economy while House Speaker Nancy Pelosi and Senate Minority Leader Chuck Schumer will target the virus so as to keep the nation’s attention on health care without granting Trump a re-election fiscal bonus. The most significant short-term stimulus on offer would be a cut to payroll taxes. Trump’s preference may be to eliminate the entire 6% tax levied on worker income permanently, but he is more likely to get something on the magnitude of the 2011-12 temporary payroll tax cut (second panel, Chart 13). This was a two percentage point reduction in the tax (to 4%) for one year that ended up being extended for a second year. The size of the impact is roughly $75 billion for each percentage point for each year ($300 billion for two percentage points over two years). The risk is that the House Democrats may require modifications to Trump’s Tax Cut and Jobs Act that cause an impasse and financial markets to sell off before an agreement is reached.2 The Democrats, for their part, have a wish list of spending programs that they will insist on in exchange for a payroll tax cut. In particular they will seek to expand unemployment insurance for workers who lose their jobs in the impending slowdown, food stamps for unemployed and for children at home amid school closures, and mandatory paid leave (for parents with kids at home as well as sick people). The bill for such items can easily add up to $50-$100 billion in new spending. In addition, Congress and the White House have already approved an $8 billion virus mitigation package and additional packages of this size can happen quickly as the crisis requires. Trump is interested in another round of farm aid, given that China will fall short of its commodity purchases under the “phase one” trade deal, which could amount to $12-$15 billion. And Trump could always unilaterally rollback some of his tariffs on China or other trade partners. The combination of new spending and payroll tax cuts could bring the package to the $300-$400 billion range that Trump’s top economic adviser, Larry Kudlow, disapprovingly said was out of the question. It could easily amount to half of that. If the market continues to tank and the outlook for the US economy grows blacker, it will convince the Democrats that Trump is ruined unless they hurt their own image by appearing blatantly obstructionist amid a crisis. Bear in mind that the market wants a substantial stimulus not only because of the desire for a clear rebound in activity once the virus panic subsides, but also because the increasing odds of a Democratic victory in November mean that US tax rates will go up and corporate earnings will be revised downward. The country now faces a 50% chance of a 1%-2% fiscal tightening for each year in 2021-25 (Chart 14). Chart 14Biden Tax Hike Will Hit Corporate Earnings Chart 15US Fiscal Thrust To Surprise To Upside Thus a 1% of GDP fiscal stimulus for 2020 is the minimum necessary to improve sentiment. The US fiscal thrust – the change in the cyclically adjusted budget deficit – has already turned slightly positive this year, from what was expected to be a slight negative, due to a fiscally profligate budget deal between Trump and the Democrats last year (Chart 15). The one thing these blood enemies have in common is the need for more spending. Infrastructure spending is popular and has room to rise. Eventually the US will get stimulus, and it will surprise to the upside, even if the Democrats drag their feet to ensure that maximum political damage is inflicted on Trump this year. Not only is the fiscal setting inherently more dovish than it was in 2008, but Congress is bailing out plague-stricken households, not just Wall Street, this time around. The real game changer would be an infrastructure package. Americans spend about $140 billion or 0.7% of GDP each year on transport infrastructure, but popular opinion in both major political parties supports increases (Chart 16). The proposed sums are very large – Trump is proposing $1 trillion over a decade while Biden is proposing $1.3 trillion. The House Democrats have a bill worth $760 billion in new spending over five years ready to be passed. Also Trump is willing to capitulate on the Democrats’ preferred type of spending (direct deficit spending) due to his election constraint. These plans are all projecting considerable infrastructure spending on top of the Congressional Budget Office’s base line projection (Chart 17). Chart 16US Spends 0.7% Of GDP On Infra Each Year Chart 17Median Voter Wants More Infra Spending The fiscal multiplier of government spending is generally higher than tax cuts. Furthermore, the coronavirus hurts the economy by frightening households into their homes, which means that even the Democrats’ proposed cash transfers for low-income earners (those with a high marginal propensity to consume) may be impeded. Government-mandated infrastructure spending, by contrast, ensures that economic activity will pick up once the measures take effect (that is, with a 6-12 month lag … something the Democrats will become increasingly willing to agree to this spring given the election calendar). The impending US fiscal stimulus provides justification for going long infrastructure, construction, engineering, materials, mining, and environmental services sub-sectors included in the BCA Infrastructure Equity Basket (Chart 18). China’s large-scale stimulus measures reinforce this recommendation, since these firms are levered to China/EM growth. On a tactical basis, this trade is akin to catching a falling knife. Given our expectation that the world still faces challenges in overcoming the current turmoil, and the Democrats will hem and haw so as not to grant Trump his re-election wish list immediately, we await an opportune time to initiate this trade. A final reason to remain defensive on risk assets: the “lame duck” risk. If and when Trump’s re-election appears out of reach, he has an incentive to turn the tables. This could involve a radical or disruptive move in foreign or trade policy (e.g. on Iran, North Korea, Venezuela, China, or even Russia). At that point Trump could attempt to cement his legacy of cold war with China, or he could even lash out against Russian President Vladimir Putin, who has ostensibly stabbed him in the back by initiating a market share war with Saudi Arabia that may not be pieced back together in time to prevent job losses in shale oil swing states (Chart 19). Chart 18Look For Chance To Go Long Infrastructure Stocks Chart 19A Russo-Saudi Oil Market War Hurts Trump In Shale Swing States Presidential powers are least constrained in the international sphere. At the moment Trump is trying to save the economy and his presidency. But if it becomes a foregone conclusion that they cannot be saved, then he becomes a pure liability for risk assets. Housekeeping We are throwing in the towel on our US tech sector shorts for a loss of 36% and 11%, respectively, and also closing our long Thailand relative trade for a loss of 17%. We are also closing our tactical long Italian government bonds relative to Spanish for a loss of 2%. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 Coincidentally all were Republicans, like Trump – not that it matters. 2 The Democrats may seek to have Trump increase the tax rate on the highest income earners to the pre-TCJA level, or they may seek to increase the cap on the state and local tax deduction, which allows households (mostly high-income earners) in high-tax states to reduce their federal tax bill.

Highlights Duration: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Fed: Low inflation expectations mean that the Fed is unconstrained when it comes to easing policy. Rate cuts will continue until either the funds rate reaches zero, or financial markets signal that enough stimulus has been delivered. Spread Product: Investors with 12-month investment horizons should neutralize allocations to spread product versus Treasuries, including high-yield where the recent oil supply shock will weigh heavily on returns. Investors should also downgrade exposure to MBS with the goal of re-deploying into corporate credit once the current risk-off episode runs its course. Feature Risk off sentiment prevailed in financial markets again last week, as COVID-19 continues to spread throughout the world. Most recently, the city of Milan has been placed under quarantine and New York state has declared a state of emergency. It is difficult to have much certainty about the virus’ ultimate economic impact, but the prospect of US recession looms larger and larger. In bond markets, the 10-year Treasury yield has fallen to 0.54% and the yield curve is pricing-in 91 bps of Fed rate cuts over the next 12 months (Chart 1). If those expectations are met, it would bring the funds rate down to 0.18%, only slightly above the zero-lower-bound. Chart 1Market Priced For A Return To The Zero-Lower-Bound On the bright side, there is ample evidence that global economic growth was trending up before the virus struck in late January, and we remain confident that a large amount of pent-up demand will be unleashed once its impact fades. However, we have no clarity on how much longer COVID-19 might weigh on growth. For this reason, we recommend a much more defensive US bond portfolio allocation, even for investors with 12-month horizons. Specifically, investors should keep portfolio duration close to benchmark and reduce spread product allocations to neutral. The market is sending the message that more rate cuts are needed. We will be quick to re-initiate a below-benchmark duration recommendation when we think that bond yields are close to bottoming. In the below section titled “How To Call The Bottom In Yields”, we discuss the factors that will help us make that decision. A State Of Monetary Policy Emergency The Fed took quick action last week, delivering an inter-meeting 50 basis point rate cut as the stock market tumbled on Tuesday morning. Alas, the market is sending the message that those 50 bps won’t be enough. Fed funds futures are pricing-in another 82 bps of easing by the end of next week’s FOMC meeting, followed by further cuts in April (Table 1). Table 1Expectations Priced Into The Fed Funds Futures Curve Of course, easier monetary policy is not the solution to what ails the global economy. At his press conference last week, Fed Chair Powell justified the emergency cut by saying that it will help “avoid a tightening of financial conditions which can weigh on activity, and it will help boost household and business confidence.” This is a fair assessment of what monetary policy can hope to accomplish in the current environment. At most, monetary policy can limit the damage in financial markets, which is a worthwhile goal given the strong historical correlation between financial conditions and economic growth (Chart 2). Chart 2Fed Must Do Its Best To Support Financial Conditions What’s more, with inflation expectations at very low levels – as we go to press the 10-year TIPS breakeven inflation rate is a mere 1.03% – there is no reason for the Fed to resist easing policy, even if the expected benefits from easing are small. Chart 3Markets Demand More Easing From our perch, the only possible reason for the Fed to refrain from cutting rates quickly all the way back to zero would be to preserve some monetary policy ammunition for when it is needed most. The Fed probably doesn’t see things this way. In conventional economic models it is the level of interest rates that influences economic activity. Therefore, the way to get the most bang for your stimulus buck is to cut rates to zero as quickly as possible. However, if monetary policy is primarily influencing the economy via its impact on financial conditions and investor sentiment, as Chair Powell claimed, then it would be advisable to only deliver rate cuts when financial conditions are tightening rapidly. That is, don’t cut rates if the stock market is rebounding, save your ammo for when equities are in free fall and panic is widespread. We can’t know for certain what the Fed will do between now and the next FOMC meeting. But we can say that, with inflation pressures low, there are no constraints against cutting rates back to the zero bound. The safest takeaway for bond investors is to assume that rate cuts will continue until either (i) the fed funds rate hits zero or (ii) we see signs that the markets and economy are no longer calling for further stimulus. Those signs would be (Chart 3): Yield curve steepening, particularly at the short end. Stocks outperforming bonds. A rising gold price. A falling US dollar. Bottom Line: More rate cuts are coming, and they won’t stop until either the fed funds rate hits zero or financial markets signal that sufficient stimulus has been delivered. We can’t be certain whether that will occur with more or less than the 91 bps of rate cuts that are currently priced for the next 12 months. As such, we recommend keeping portfolio duration close to benchmark. How To Call The Bottom In Yields The US economy is on the cusp of entering a downturn of uncertain duration that will likely be followed by a rapid recovery. Given that outlook, the next big call to make is: When will bond yields put in a bottom? We identify four catalysts that we will monitor to make that call. 1. Virus Panic Abates This is the most important catalyst that could lead us to re-initiate a below-benchmark duration recommendation. The pattern of past viral outbreaks is that bond yields tend to fall until the number of daily new cases reaches zero. This is precisely what happened during the 2003 SARS epidemic (Chart 4A). As for COVID-19, the number of daily new cases looked like it was approaching zero a few weeks ago, but then reversed course as the virus moved on from China to the rest of the world (Chart 4B). One ray of hope is that the number of new cases in China is approaching zero. This suggests that it will also be possible for other countries to contain the virus, but right now it is unclear how long that will take. Chart 4AYields Will Bottom When New Cases Reach Zero Chart 4BNew COVID-19 Cases Still ##br##Rising   In sum, we will keep tracking the global daily number of new cases and will shift to a below-benchmark duration recommendation as it approaches zero. 2. Global Economic Data Improve (Especially China) Chart 5Waiting For A Global Growth Rebound China is where the COVID-19 outbreak started and it is also where we are now seeing the impact in the economic data. The Global Manufacturing PMI dropped from 50.4 to 47.2 in February, due in large part to the plunge in China’s index from 51.1 to 40.3 (Chart 5). In order to call the bottom in US bond yields we will need to see evidence that China can come out the other side of the economic downturn. This means seeing an improvement in the Chinese and Global Manufacturing PMIs. We would also like to see improvement in other global growth indicators such as the CRB Raw Industrials index (Chart 5, panel 2) and the relative performance of cyclical versus defensive equity sectors (Chart 5, bottom panel). Aggressive Chinese stimulus (both monetary and fiscal) might help speed this process along. China’s credit impulse is on the rise (Chart 5, panel 2), and our China Investment Strategy service observed that recently announced policy initiatives related to infrastructure, housing and the automobile sector resemble those that led to a V-shaped Chinese economic recovery in 2016.1  We will be inclined to shift back to below-benchmark portfolio duration when the Global Manufacturing PMI, CRB Raw Industrials index and the relative performance of cyclical versus defensive equities move higher. 3. The US Economic Data Worsen Chart 6Waiting For Weaker US Data While the Global and Chinese economic data are currently in the doldrums, we still haven’t seen COVID’s impact on the US economy. The US ISM Manufacturing PMI is in expansionary territory and the Services PMI is at a healthy 57.3 (Chart 6). Meanwhile, US employment growth has averaged +200k during the past 12 months (Chart 6, panel 2) and the US Economic Surprise Index is above 60 (Chart 6, bottom panel)! Until the US economic data take a hit, another downleg in US bond yields is likely. Looking ahead, if the Global and Chinese economic data are improving as the US data are weakening, financial markets will extrapolate from the Chinese experience and start to price-in an eventual US recovery. Therefore, bond yields will probably start to move higher while the US economic data are still weak. For this reason, one catalyst for us to re-initiate below-benchmark portfolio duration will be when the US economic data weaken. 4. Technical Signals Table 2The 3-Month Golden Rule We don’t recommend relying on technical trading rules when forming a 12-month investment view, but technical signals can help add discipline to investment strategies, especially when calling tops and bottoms. One framework with a decent track record is our Golden Rule of Bond Investing applied to a shorter 3-month investment horizon.2 While this 3-month rule doesn’t work as well as when it is applied to a 12-month horizon, we still find that if you correctly predict whether the Fed will deliver a hawkish or dovish surprise relative to market expectations during the next three months, you will make the right duration call 63% of the time (Table 2). The 3-month Golden Rule worked better for dovish surprises than for hawkish surprises in our sample but delivered solid results in both cases. The median 3-month excess Treasury index return versus cash was -1.09% (annualized) when there was a hawkish Fed surprise, compared to +2.56% (annualized) when there was a dovish Fed surprise. For context, the median annualized 3-month excess Treasury index return versus cash during our sample period was +1.79%. Until the US economic data take a hit, another downleg in US bond yields is likely. The overnight index swap curve is currently priced for 94 bps of rate cuts during the next three months, which would essentially take the funds rate back to the zero bound. As of now, we cannot rule out this possibility and are therefore not inclined to look for higher yields during the next 3 months. Momentum, Positioning & Sentiment Other technical signals can also help call tops and bottoms in bond yields. One such signal comes from our Composite Technical Indicator, an indicator that is based on yield changes, investor sentiment surveys and positioning in bond futures markets. Right now, the indicator is sending a strong “overbought” signal with a reading below -1 (Chart 7). Chart 7Technical Treasury Signals In isolation, an overbought signal from our Composite Technical Indicator is not a strong reason to call for higher yields. We found that, historically, a reading below -1 from our indicator precedes a 3-month move higher in the 10-year Treasury yield only 53% of the time (Table 3). Table 3Technical Treasury Indicator Performance (1995 – Present) One reason for the Composite Technical Indicator’s mediocre performance is that, even at low levels, the market can always become more overbought. But we can partially control for this by combining the overbought signal from our indicator with simple momentum measures that might signal a trend reversal. For example, a reading below -1 from our Composite Technical Indicator combined with a 1-week increase in the 10-year yield precedes a higher 10-year yield during the next three months 58% of the time. If we wait for a 2-week increase in the 10-year yield the rule’s success rate rises to 60%, and it rises to 71% if we wait for the 10-year yield to break above its 4-week moving average. At present, our Composite Technical Indicator shows that Treasuries are extremely overbought, but momentum measures are sending no signals about an imminent trend change (Chart 7, bottom 3 panels). Bottom Line: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Some Quick Notes On TIPS, MBS And Spread Product Allocations Along with raising recommended portfolio duration to benchmark on a 12-month horizon, we also recommend neutralizing exposure to spread product in US bond portfolios. This includes reducing exposure to high-yield corporate bonds. High-yield remains attractively valued but will continue to sell off as long as risk-off market sentiment prevails. The looming oil price war will also weigh heavily on the sector, which is highly exposed to the US shale energy space. Once again using the SARS epidemic as a comparable, we see that – like Treasury yields – junk excess returns bottomed when the number of daily new cases approached zero (Chart 8). We could still be relatively far from this point, so taking risk off the table makes sense.  New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. We also recommend moving MBS allocations to underweight. New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. This spike is not yet fully reflected in MBS spreads, which remain relatively tight (Chart 9) Chart 8Too Soon To Call For Peak Junk Spreads Chart 9Downgrade MBS . Going forward, even after the economic fallout from COVID-19 has passed and it is time to increase exposure to spread product, we will likely continue to recommend an underweight allocation to MBS because better opportunities will be available in investment grade and high-yield corporate bonds where spreads will be much more attractive. On TIPS, last weekend’s oil supply shock – combined with the demand shock from COVID-19 – will conspire to keep long-maturity TIPS breakeven inflation rates well below their “fundamental fair value” for some time yet. But for investors with longer time horizons we see exceptional value in TIPS relative to nominal Treasuries. Even before yesterday’s big drop in oil, the 10-year TIPS breakeven inflation rate was 52 bps cheap relative to the fair value reading from our Adaptive Expectations Model (Chart 10).3 Chart 10TIPS Offer A Ton Of Long-Run Value Investors with 12-month investment horizons should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?”, dated February 26, 2020, available at cis.bcaresearch.com 2  For more details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 3 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Financial markets have experienced two weeks of wild swings: Following the negative 5-standard-deviation weekly move in the S&P 500 two weeks ago, the index moved at least 2.8% in each of last week’s first four sessions. 10- and 30-year Treasury yields made one all-time low after another. The coronavirus has arrived in the United States: It would appear inevitable that the coronavirus is going to spread across the US; the unknowns are how long it will spread, how deadly it will be, and how much it will impact the economy. Confronted with these unknowns, markets shot first and left asking questions for later. The selling may have gone a little far. The Fed and the Democratic candidates for president were in the news last week, … : The Fed made its first intra-meeting rate cut since the financial crisis was raging, cutting the fed funds rate by 50 basis points instead of waiting for its regularly scheduled March 17-18 gathering. Super Tuesday upended the chase for the Democratic presidential nomination, as our geopolitical strategists foresaw. … and we offer our quick read on their market impact: We expect that the Fed’s rate cut will be modestly positive for markets and the economy, while Joe Biden’s move to the head of the Democratic pack greatly diminished a risk that would otherwise have troubled investors all the way to November 3rd. Feature US equities have endured a rollercoaster ride over the last two-and-a-half weeks. From its all-time intraday high of 3,393.52 on February 19th, to the February 28th intraday low of 2,855.84, the S&P 500 corrected by 15.8% in just seven sessions. The brunt of the decline occurred two weeks ago, when the index lost 11.5% in its fourth worst week in the last six decades. The decline amounted to more than a negative 5-standard-deviation event, and took its place among what we now consider to be landmark episodes in US stock market history (Table 1). Table 1Socialism + Pandemic = History (But Not The Good Kind) The epic rout followed a weekend of distressing news. First, the coronavirus (COVID-19) slipped its Asian bonds, popping up fully formed in Italy and Iran in a sobering demonstration of its global reach. Second, Bernie Sanders had seemingly solidified his grip on the Democratic presidential nomination by trouncing the rest of the crowded field in the Nevada caucuses with nearly twice the share of the vote that he captured in his Iowa and New Hampshire wins. We therefore characterize the February 28th intraday low as the coronavirus/Sanders bottom. The former is still running around freely, but the latter has been largely contained. COVID-19 will surely be with us for a while longer, and may yet push the S&P 500 below its February 28th low, but it will have to do so without help from Bernie Sanders. Joe Biden reclaimed front-runner status following his tremendous Super Tuesday performance, and support for him coalesced with remarkable speed, relieving investors’ acute concern about a Sanders presidency. The primary campaign is still in its early stages, and the gaffe-prone Biden is capable of multiple stumbles between now and the nominating convention, but a general election without a self-declared socialist bent on ending health insurance as we know it will provoke considerably less market anxiety. The Rate Cut Equities had been pining for a rate cut, beginning last week’s surge upon the news that central bankers would be joining the G-7 Finance Ministers on their hastily arranged Tuesday morning conference call. After an immediate 2.5% pop upon the announcement of the intra-meeting cut, however, the S&P 500 sagged and wound up ending Tuesday’s session nearly 2% lower than its pre-cut level. The dismal market reception, and Powell’s own halting, tepid responses to questions at the press conference to discuss the rationale for the move left investors wondering if the Fed had made a mistake. We neither know nor care if it will turn out to be good policy, but we expect that the rate cut will lend support to risk assets over our 12-month investment horizon. Why would the Fed use monetary policy to try to combat a public health crisis, or any supply shock? Monetary policy tools were not made to fight public health crises. They will not speed the development of an antidote, make medical care more widely available, or make up for a lack of preparedness at the public health agencies leading the effort to blunt COVID-19’s spread. They also are not particularly well-suited to combat supply shocks. They cannot resolve global supply bottlenecks, put more people back to work in China, South Korea and Italy, or create and distribute all the test kits and protective clothing that medical professionals sorely need. It is within the Fed’s power, however, to try to keep COVID-19’s second-order economic consequences from taking root. Negative headlines, deserted shopping districts and runs on products like hand sanitizer and face masks can drag down business and consumer confidence. Falling confidence can weigh on consumption and investment, hobbling output, stifling employment growth, and raising the specter of a negatively self-reinforcing dynamic in which layoffs lead to less consumption, which feeds more layoffs, and less investment, etcetera. If the Fed can bolster the spirits of consumers and businesses, it can help to contain COVID-19’s adverse economic impact. Won’t this move leave the Fed with less ammunition down the road? Yes, it surely will, especially if the Fed would prefer to stick to conventional policy tools to combat the next recession. Last week’s cut may postpone the start date of that recession, however, affording the Fed a chance to execute a series of rate hikes before it arrives. For an investor with a timeframe that doesn’t exceed twelve months, it may not matter, provided the increased accommodation successfully reduces near-term recession risk. Do you think this move will be effective? At the margin, yes, we think it will. First of all, it will contribute to the mortgage-refinancing wave that has been building since the beginning of the year (Chart 1). With an average 3.45% 30-year fixed-rate mortgage rate, data provider Black Knight estimates 11 million borrowers could save at least 75 basis points by refinancing their existing loans.1 If the average rate were to fall to 3%, as it would if the spread between mortgage rates and Treasury yields simply eases back to the 2% neighborhood (Chart 2), the pool of potential refinancers would expand to 19 million. Reduced mortgage payments put more money in homeowners’ pockets and will help support consumption at the margin. Chart 1Mortgage Refis Were Already Ramping Up, ... Chart 2... And There Will Be Even More Activity Once Mortgage Spreads Normalize Lower rates will also increase demand for new-home purchases, which have positive multiplier effects, and other big-ticket consumer goods. They will also support investment at the margin, as hurdle rates fall, and more opportunities are projected to generate a positive net present value. Potential homebuyers may be less prone to attend open houses or conduct home searches if COVID-19 spreads, and skittish managers may be less prone to invest, but easier monetary conditions do promote economic activity. Finally, a Fed that is demonstrably committed to easing monetary conditions to mitigate COVID-19’s potential negative impacts may help shore up business and consumer confidence. It will take confidence to keep gloomy virus headlines from becoming a self-fulfilling recession prophecy. As Figure 1 illustrates, the Fed does have the means to boost demand in financial markets and the real economy. Figure 1Monetary Policy And The Economy What will it mean for markets? It may encourage investors to pay more for each dollar of a corporation’s earnings, helping to cushion equities from falling earnings projections (the Confidence/Risk Taking channel in Figure 1), though we think a surer outcome is that it will keep the search for yield at a fever pitch. Life insurers, pension funds and endowments can no longer rely on highly-rated sovereign bonds to deliver the income to meet their fixed obligations, but have very little leeway to allocate away from fixed income. They have therefore been forced to venture further and further out the risk curve (Figure 1’s Portfolio Balance Effect), which has had the effect of providing an ample supply of funds for less-than-pristine borrowers. Under zero- and negative-interest-rate policy (ZIRP and NIRP, respectively) just about any borrower aside from brick-and-mortar retailers and thinly capitalized oil drillers can attract a line of would-be lenders out the door and around the corner simply by offering an incremental 50-75 bps of yield. Since no borrower defaults, or goes bankrupt, as long as there is a lender willing to roll over its maturing obligations, extraordinarily accommodative monetary policy has had the effect of limiting default rates. We expect that the Fed’s move back in the direction of ZIRP will continue to squeeze spreads and ease financial conditions. That’s far from an ideal fundamental basis for owning spread product, and it won’t keep credit outperforming forever, but we expect it will allow spread product to continue to generate positive excess returns over Treasuries and cash over the next twelve months. Recession Prospects There is no doubt that the probability of a recession is rising. COVID-19 is already exerting intense pressure on the airline and hotel industries, and strapped small businesses will find themselves in its crosshairs soon. It is certainly possible that a recession could sneak up on us while we focus on our assessment of the monetary policy backdrop. But just as COVID-19 survival rates are heavily influenced by a patient’s intrinsic condition, the economy’s prognosis may be a function of its pre-outbreak status. To assess the economy’s vital signs, we begin with housing, the major economic segment with the greatest interest-rate sensitivity. If monetary policy is less accommodative than we’ve estimated, the housing market might be gasping for air, but it appears to be as fit as a fiddle. Permits and starts turned sharply higher in the middle of last year (Chart 3, top panel), following the sales component of the NAHB survey (Chart 3, bottom panel) and purchase mortgage applications (Chart 3, middle panel). Homes are already quite affordable, relative to history (Chart 4, top panel), and they’re bound to get even more affordable as mortgage rates fall. Chart 3Housing Charts Are Up And To The Right Across The Board Chart 4Homes Are Amply Affordable Nothing in the available data indicates that housing is running too hot. Residential investment’s contribution to GDP has flipped from barely negative to modestly positive (Chart 5), and there are no signs that its current course is unsustainable. Unsold inventories and the share of vacant homes are at 25-year lows (Chart 6), and starts and permits are only just catching up with the multi-year average of household formations, suggesting that the market has been undersupplied since the crisis excesses were worked off. The overall takeaway is that the housing market is in the early days of an overdue recovery that has plenty of room to run. Chart 5Residential Investment's Current Pace Is Easily Sustainable, ... Chart 6... And The Housing Market Still Looks Undersupplied Chart 7The Labor Market Is Strong Table 2No Sign Of Recession Here February’s employment situation report, ignored by markets in the throes of Friday's selloff, suggests that the labor market, and by extension the economy, was in fighting trim before COVID-19 took root in American soil (Chart 7). February’s net job additions far surpassed consensus estimates, and the figures for January and December were revised appreciably higher (Table 2). With the three-month moving average of net additions coming in one-third higher than expected, the report was nothing short of tremendous. The March release is sure to be worse, and the all-time record streak of expanding monthly payrolls may well come to an end, but the patient was in an awfully robust state before it encountered the virus, and that bodes well for its immediate future. The Democratic Primaries Super Tuesday turned out to be super for US financial markets. With all of the Democratic party’s machinery now at the service of Joe Biden, the probability that frightening left-tail outcomes might emerge from the general election has been dramatically reduced. Markets can live with a Biden-Trump contest no matter how it turns out. Although we thought that markets were exaggerating the potentially negative conditions that would ensue under President Sanders, they would have been subject to rolling bouts of angst every time his general election prospects rose. Though our geopolitical strategists unwaveringly saw the former vice president as the Democratic frontrunner, theirs was a decidedly minority view. Following the Nevada caucus, Sanders was viewed far and wide as the presumptive nominee. Although a Biden administration would presumably be less market-friendly than the current administration, he himself is a card-carrying member of the establishment and wouldn’t do anything that would upset the apple cart. From an investment perspective, Biden is the candidate that would Make America Predictable Again, and even if re-election is markets’ preferred outcome, the prospect of a Biden presidency is hardly frightening. Investment Implications Although our conviction level has fallen in the face of COVID-19 uncertainties, we hold to our view that a soft patch is more likely than a recession, and a correction is more likely than a bear market. We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. We think the most plausible worst-case scenario is a sharp but short recession, produced by a nasty supply shock that frightens households and businesses enough that they cease to consume or invest. The demand strike would imperil indebted businesses that suffered the biggest revenue declines: airlines, hotels, restaurants, retailers, thinly capitalized oil producers and a range of small businesses. They would shrink their workforces and many would default on their loans. That would be bad, as all recessions are bad, but it wouldn’t be a replay of the crisis. Credit extended to the sorts of borrowers listed above, ex-small businesses, is well-dispersed throughout the economy via corporate bonds and securitizations. The exposures the SIFI banks and their large- and mid-cap regional bank cousins have retained will be easily absorbed by the layers of additional capital mandated by Dodd-Frank and Basel 3. It seems to us that markets are pricing in a significant probability of something much worse than a run-of-the-mill recession, and we think that sets up an attractive risk-reward profile for investors in risk assets. We reiterate our risk-friendly recommendations, though we now recommend that fixed-income investors maintain benchmark duration positioning. We failed to appreciate the potential scope for a decline in long yields and are correcting course now.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Boston, Claire and Raimonde, Olivia, “A 30-Year Mortgage Below 3%? Treasury Rally Offers Bargain Loans,” Bloomberg, March 5, 2020.

Highlights The latest interest rate cuts by central banks confirms the narrative that the authorities view economic risks as asymmetrical to the downside. This all but assures that competitive devaluation will become the dominant currency landscape in the near future. If the virus proves to be just another seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The dollar will be the ultimate loser in both scenarios, but this path could be lined with intermediate strength. Our highest-conviction call before the dust settles is to short USD/JPY. We are also making a few portfolio adjustments in light of recent market volatility. Buy NOK/SEK and NZD/CHF and take profits soon on long SEK/NZD. Feature The DXY rally that began last December faltered below overhead psychological resistance at 100, and has since broken below key technical levels. The V-shaped reversal has been a mirror image of developments in equity markets, with the S&P 500 off 6% from its lows. The catalyst was aggressive market pricing of policy action from the Federal Reserve, to which the authorities yielded. The latest policy action confirms the narrative that most central banks continue to view deflation as a much bigger threat than inflation, since few have been able to achieve their mandate. This all but assures that competitive devaluation will become the dominant currency landscape, as each central bank prevents appreciation in their respective currency. Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.   The US 10-year Treasury yield broke below 1% around 1:40 p.m. EST on March 3rd. This was significant not because of the level but because it emblematically erased the US carry trade for a number of countries (Chart I-1). Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies.  Chart I-1The Big Convergence To Buy Or Sell The DXY? If the virus proves to be only slightly more lethal than the seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. Chart I-2 shows that the global economy was already on a powerful V-shaped recovery path before the outbreak. More importantly, this recovery was on the back of easier financial conditions. Chart I-2V-Shaped Recovery At Risk Chart I-3A Second Wave Of Infections? Our roadmap is the peak in the momentum of new infections outside of China. During the SARS 2013 episode, the bottom in asset prices (and peak in the DXY) occurred when the momentum in new cases peaked. Currency markets are currently pricing a much worse outcome than SARS. The risk is that we are entering a second wave of infections outside Hubei, China, which will be more difficult to control than when it was relatively more contained within the epicenter (Chart I-3). As we aptly witnessed a fortnight ago, currency markets will make a binary switch to risk aversion on such an outcome. This warns against shorting the DXY index or buying the euro or pound in the near term. As we go to press, the virus has been identified on almost every continent except Antarctica. Even in countries such as the US, with modern and sophisticated health facilities, the costs to get tested are exorbitant for underinsured individuals.1 This all but assures that the number of underreported cases is likely non-trivial, which could trigger another market riot once they surface. Chart I-4DXY and USD/JPY Tend To Move Together Our highest-conviction call before the dust settles is therefore to short USD/JPY. As Chart I-1 highlights, the Bank of Japan is much closer to the end of their rope in terms of monetary policy tools. Long bond yields have already hit the zero bound, which means that real rates in Japan will continue to rise until the authorities are forced to act. One of the triggers to act will be a yen soaring out of control, which is not yet the case. Speculative evidence is that it will take a yen rally in the order of 12% to catalyze the BoJ. More importantly, the speed of the rally will matter. This was the trigger for negative interest rates in January 2016 as well as yield curve control in September of 2016. The first rally from USD/JPY 125 to around 112 and the subsequent rise towards 100 were both in the order of 12%. A similar rally from the recent peak near 112 will pin the USD/JPY at 100.   Bottom Line: The yen is the most attractive currency to play dollar downside at the moment. Remain short USD/JPY. If global growth does pick up and the dollar weakens, the USD/JPY and the DXY tend to be positively correlated most of the time, providing ample room for investors to rotate into more pro-cyclical pairs (Chart I-4). Competitive Devaluation? In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The Reserve Bank of Australia has already stated that QE is on the table if rates touch 0.25%.2 Other central banks are likely to follow suit. As the chorus of central banks cutting rates and stepping into QE on COVID-19 rises, the rising specter of currency brinkmanship is likely to unnerve countries pursuing more orthodox monetary policies. The currency of choice will be gold and other precious metals, though the dollar, Swiss franc, and yen are likely to also outperform.  The velocity of money in both the US and the euro area was in a nascent upturn, but has started to roll over.  Whether or not countries adopt QE, what is clear is that balance sheet expansion at both the Fed and the European Central Bank is set to continue. Chart I-5 shows that the velocity of money in both nations was in a nascent upturn, but has started to roll over. This tends to lead inflation by a few quarters. On a relative basis, our bias is that the pace of expansion should be more pronounced in the US. This will eventually set the dollar up for a significant decline, albeit after a knee-jerk rally. Chart I-5ADownside Risks To US Inflation Chart I-5BDownside Risks To Euro Area Inflation In terms of quantitative easing, it is most appealing when a country has low growth, low inflation, and large amounts of public debt. If we are right that inflation is about to roll over in the US, then the public debt profile and political capital to expand the budget deficit places the nation as a prime candidate for QE (Chart I-6). Fiscal stimulus is a much more difficult discussion in Europe, Japan, or elsewhere for that matter, and likely to arrive late. Chart I-6US Government Debt Is Very High The backdrop for the US dollar is a 37% rise from the bottom. The New York Fed estimates that a 10 percentage point appreciation in the dollar shaves 0.5 percentage points off GDP growth over one year, and an additional 0.2 percentage points in the following year.3 With growth now hovering around 2%, a strong currency could easily nudge US growth to undershoot potential.  The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. However, the path to QE will be lined by a strong dollar if the backdrop is flight to safety. This entails rolling currency depreciations among some developed and emerging markets. When looking for the next candidates for competitive devaluation, the natural choices are the countries with overvalued exchange rates that are exerting a powerful deflationary impulse into their economies. Chart I-7 shows the deviation of real effective exchange rates from their long-term mean, according to the BIS. Chart I-7Competitive Devaluation Candidates Bottom Line: The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. It will first occur among the safe havens (currencies with already low interest rates), before it rotates to more procyclical currencies. Where Does US Politics Fit In? Politics should start to have a meaningful impact on the dollar once the democratic nominee is sealed. Super Tuesday revealed a powerful shift to the center, pinning former Vice President Joe Biden as the preferred candidate (Chart I-8). The dollar tends to thrive as political uncertainty rises. While not a forgone conclusion, a Sanders–Trump rivalry would have been a very polarized outcome, putting a bid under the greenback. Markets are likely to take a more conciliatory tone from a Biden victory, which will be negative for the greenback.   Chart I-8US Politics Will Be Important Our colleague Matt Gertken, chief geopolitical strategist, just published his analysis of Super Tuesday.4 While a contested convention remains unlikely, it will likely favor Trump’s reelection odds. What is common about a Biden-Sanders-Trump trio is that fiscal policy is set to expand in the US. This will ultimately be dollar bearish (Chart I-9). Chart I-9The Dollar And Budget Deficits Bottom Line: The election is still many months away and much can change between now and then. For now, Biden is the preferred democratic nominee. Portfolio Adjustments Chart I-10Sell CHF/NZD The sharp rally in the VIX index has opened up a trading opportunity on the short side. The historical pattern of previous spikes in the VIX is that unless the market starts to price in an actual recession, which is quite plausible, the probability of a short-term reversal is close to 100%. Given our base case that we are not headed for a recession over the next six to 12 months, we are opening a short CHF/NZD trade today. The cross tends to benefit from spikes in volatility, correcting sharply as the market unwinds overreactions. More importantly, the cross has already priced in an overshoot in the VIX in an order of magnitude akin to 2008. Place stops at 1.75 with a target of 1.45 (Chart I-10). We are also placing a limit buy on NOK/SEK at parity. The risk to this trade is a further down-leg in oil prices, but at parity, the cross makes for a compelling tactical trade. Momentum on the cross is currently bombed out. We will be closely watching whether Russia complies with OPEC production cuts and act accordingly. Remain long NOK within our petrocurrency basket against the euro. We are also looking to take profits on our long SEK/NZD trade, a nudge below our initial target. The market has fully priced in a rate cut by the Reserve Bank of New Zealand, suggesting the kiwi could have a knee-jerk rally, similar to the Aussie on the actual announcement. Finally, we were stopped out of our short gold/silver trade for a loss of 5.5%. We will be looking to re-establish this trade in the coming weeks. Stay tuned. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Bertha Coombs and William Feuer, “The coronavirus test will be covered by Medicaid, Medicare and private insurance, Pence says,” CNBC, dated March 4, 2020. 2 Michael Heath, “RBA Says QE Is Option at 0.25%, Doesn’t Expect to Need It,” Bloomberg News, dated November 26, 2019. 3 Mary Amiti and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Federal Reserve Bank of New York, dated July 17, 2015. 4  Please see Geopolitical Strategy Special Report, titled “US Election: A Return To Normalcy?”, dated March 4, 2020, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI fell slightly to 50.9, dragged down by the prices paid and new orders component, while the non-manufacturing index ticked up to 57.3. Core PCE inflation increased to 1.6% year-on-year in January. Unit labor costs came in at 0.9% quarter-on-quarter in Q4 of last year. This is a deceleration from the previous print of 2.5%. The DXY index depreciated by 1.4% this week. Following a conference call with G7 central banks, the Fed made an emergency rate cut of 50bps. Chairman Powell cited risks to the outlook from Covid-19 but acknowledged that the Fed can keep financial conditions accommodative, not fix broken supply chains or cure infections. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Building A Protector Currency Portfolio - February 7, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: Core CPI inflation increased slightly to 1.2% year-on-year in February.  The producer price index contracted by 0.5% year-on-year in January. The unemployment rate remained flat at 7.4% in January. Retail sales grew by 1.7% year-on-year in January, remaining flat from the previous month. The euro appreciated by 3.6% against the US dollar this week. As the ECB is limited by the zero lower bound, the euro strengthened on expectations that rate differentials with the US will continue to narrow. The ECB could resort to policy alternatives such as a special facility targeting small and medium enterprises. Markets are pricing in an 81% probability of a rate cut as we go into the ECB meeting next week. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The Tokyo CPI excluding fresh food grew by 0.5% year-on-year in February from 0.7% the previous month. The jobs-to-applicants ratio decreased to 1.49 from 1.57 while the unemployment rate increased to 2.4% from 2.2% in January. The consumer confidence index declined to 38.4 from 39.1 in February. Housing starts contracted by 10.1% year-on-year in January from 7.9% the previous month. The Japanese yen appreciated by 2.5% against the US dollar this week. Lower US yields, combined with continued risk-on flows, have extended the rally in the Japanese yen. Weakness in the Japanese economy is broad based, but the BoJ has limited policy space and fiscal action looks unlikely anytime soon. Global central bank action will drive the yen in the near term. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: Consumer credit decreased to GBP 1.2 billion from GBP 1.4 billion while net lending to individuals fell to GBP 5.2 billion from GBP 5.8 billion in January. Mortgage approvals increased to 70.9 thousand from 67.9 thousand in January, while the Nationwide housing price index grew by 2.3% year-on-year in February from 1.9% the previous month.  The British pound appreciated by 0.2% against the US dollar this week. At a hearing this week, incoming governor Andrew Bailey stated that the BoE is still assessing evidence on the nature of the shock from Covid-19. The BoE has limited room to cut and is constrained by possible stagflation; we expect targeted supply chain finance and cooperation with fiscal authorities to take precedence.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: GDP grew by 2.2% year-on-year in Q4 2019, improving from 1.7% the previous quarter.  Imports and exports both contracted by 3% while the trade balance dropped to AUD 5.2 billion in January. Building permits contracted by a dramatic 15.3% month-on-month in January, compared to growth of 3.9% in December. The RBA commodity price index contracted by 6.1% year-on-year in February.  The Australian dollar appreciated by 0.8% against the US dollar this week. The Reserve Bank of Australia cut its official cash rate to 0.5%, an all-time low, citing the impact of Covid-19 on domestic spending, education, and travel. Watch to see if the signal from building permits is confirmed by other housing market indicators. The RBA might not be done easing. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The terms of trade index grew by 2.6% quarter-on-quarter in Q4 2019, improving from 1.9% in Q3. The ANZ commodity price index contracted by 2.1% in February, deepening from 0.9% the previous month. Building permits contracted by 2% month-on-month in January, from growth of 9.8% in December.  The global dairy trade price index contracted by 1.2% in March.  The New Zealand dollar appreciated by 0.3% against the US dollar this week. There is pressure on the Reserve Bank of New Zealand (RBNZ) to ease at its next meeting on March 27, with markets pricing in 42 basis points of easing over the next 12 months. However, the RBNZ has dispelled notions of a pre-meeting cut. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Annualized GDP grew by 0.3% quarter-on-quarter in Q4 2019, slowing from 1.4% the previous quarter.  The raw material price index contracted by 2.2% and industrial product price index contracted by 0.3% month-on-month in January.  Labor productivity contracted by 0.1% quarter-on-quarter in Q4 2019, compared to growth of 0.2% the previous quarter. The Canadian dollar depreciated by 0.1% against the US dollar this week. The Bank of Canada (BoC) followed the Fed and cut rates by 50bps. In addition to the confidence hit from Covid-19, the BoC cited falling terms of trade, depressed business investment, and dampened economic activity due to the CN rail strikes. The BoC stands ready to ease further, and Prime Minister Trudeau has raised the possibility of a fiscal response.   Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: GDP grew by 1.5% year-on-year in Q4 2019, from growth of 1.1% the previous quarter. The SVME PMI increased to 49.5 from 47.8 in February. The KOF leading indicator increased to 100.9 from 100.1 in February. CPI contracted by 0.1% year-on-year in February, from growth of 0.2% the previous month. The Swiss franc appreciated by 1.6% against the US dollar this week. A combination of strong domestic data and global risk-off flows contributed to strength in the Swiss franc. However, the Swiss government will be revising down growth forecasts and a recent UN report has estimated that Switzerland lost US$ 1 billion in exports in February due to Chinese supply disruptions. Combined with a strong franc, this puts the domestic outlook at risk.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The current account decreased to NOK 19.1 billion from NOK 29.5 billion in Q4 2019. The credit indicator grew by 5% year-on-year in January. Registered unemployment decreased slightly to 2.3% from 2.4% in February.  The Norwegian krone appreciated by 1.3% against the US dollar this week. Expect the petrocurrency to trade on news from the OPEC meetings in the coming days. The committee has proposed a production cut of 1.5 million barrels per day through Q2 2020, conditional on approval from Russia, to offset the demand shock from Covid-19.  Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: The Swedbank manufacturing PMI increased to 53.2 from 52 in February. Industrial production grew by 0.9% year-on-year, from a contraction of 2.6% the previous month. GDP grew by 0.8% year-on-year in Q4 2019, slowing from 1.8% the previous month. The Swedish krona appreciated by 1.5% against the US dollar this week. After hitting a 2-decade high near 10, USD/SEK has violently reversed and is now trading at the 9.45 level. What is evident from incoming data is that the cheap currency has been a perfect shock absorber, cushioning the domestic economy. We are protecting profits on long SEK/NZD today and we will be looking for other venues to trade SEK on the long side.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

The Fed’s inter meeting cut this week signals that the FOMC is panicky and has now acted a mere two days after the SPX fell 16% from the February 19 all-time highs. As a reminder, following the last 20% SPX correction in late 2018 it took the Fed seven months to cut rates! As the WSJ recently reported “Since 1998, the Fed has cut interest rates six other times between regularly scheduled meetings. Following each of those moves, the Fed has lowered rates again at its next policy meeting.” Thus, the fed funds rate is on the path to hitting the zero lower bound sooner rather than later, likely pulling longer term yields down with it. Tack on the safe haven flows the US Treasury market enjoys and the Treasury/Bund spread is also headed south. This spread has been an excellent leading indicator for the SPX over the past decades, as we have highlighted1 in the past, and warns that the S&P 500 will be lower in 9-12 months. Bottom Line: Stay cautious on the cyclical prospects of the broad equity market.   1    Please see U.S. Equity Strategy Insight Report, “Treasury/Bund Spread And The SPX,” dated April 18, 2019, available at uses.bcaresearch.com.

Highlights At the current rate of work resumption, March’s PMI should rebound to its “normal range” from February’s historic lows. If so, our simple calculation, using China’s PMI figures and GDP growth in Q4 2008 as a template, suggests that China's economic growth in Q1 2020 should come in at around 3.2%. Chinese stocks passively outperformed global benchmarks in the last two weeks.  The likelihood of a stimulus overshoot in the next 6-12 months continues to rise, supporting our view that Chinese stocks will actively outperform global benchmark in the coming months. Cyclical stocks have significantly outperformed defensives lately. While this is consistent with our constructive view towards Chinese equities in general, the magnitude of a tech stock rally in the domestic market of late appears to be somewhat excessive. As such, investors should focus their sector exposure in favor of resources, industrials, and consumer discretionary. The depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. Feature Despite the past week’s plunge in global equities due to the threat of a worldwide COVID-19 pandemic, Chinese stocks have outperformed relative to global benchmarks. This underscores our view that epidemic risks within China are slowly abating, and China’s reflationary response to the crisis will likely overcompensate for the short-term economic shock. Tables 1 and 2 highlight key developments in China’s economy and its financial markets in the past month. On the growth front, both the February official and Caixin PMIs dropped to historic lows as a result of the virus outbreak and nationwide lockdown. On the other hand, economic data from January confirmed that pre-outbreak activity in China was on track to recovery. Daily data also suggests that production in China continues to resume. Moreover, monetary conditions have significantly loosened and fiscal supports have materially stepped up.  Chinese equities in both onshore and offshore markets dropped by 2% and 7% respectively (in absolute terms) from their January 13 peaks. Nevertheless, they have both significantly outperformed global equities, particularly in the past week. Equally-weighted cyclical stocks versus defensives in the onshore market have also moved up sharply, driven by a rally in the technology sector stocks. While the outperformance of cyclical stocks is consistent with our constructive view towards Chinese stocks, the magnitude appears to be excessive. Thus, we would advise investors positioning for a cyclical recovery in China to favor exposure in resources, industrials and consumer discretionary stocks. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary In reference to Tables 1 and 2, we have a number of observations concerning developments in China’s macro and financial market data: Chart 1Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand February’s drop in the official PMI below 40% is reminiscent of November 2008, which was the height of the global financial crisis. The raw material inventory sub-index of the PMI in February fell to a record low, a clear indication of strain in China’s manufacturing sector. While the finished goods inventory sub-index ticked up slightly compared with January, factories will likely run out of existing raw materials to produce goods if transportation logistics do not return to normal soon (Chart 1). A higher number in the new orders sub-index relative to production output also suggests the pressure on the supply side will intensify if the virus outbreak in China worsens and continues to disrupt manufacturing activities. This will in turn undermine the effectiveness of Chinese policy response.   Daily data from various sources suggests Chinese industrial activities continue to pick up. Between February 10 (the first official return-to-work day after an extended Chinese New Year holiday) and February 25 (the cutoff date for responding to PMI surveys), daily coal consumption in China’s six largest power plants was only about 60% of consumption compared from the same period last year (adjusted for the Lunar Year calendar). This is in line with the 35.7 reading in February’s manufacturing PMI, versus 49.2 a year ago. In the last four days of February, however, coal consumption reached nearly 70% of last year’s consumption. This figure is in keeping with a 10 percentage point increase in the rate of work resumption of enterprises above-designated size in China’s coastal regions.1 If energy consumption and work resumption rates reach about 90% by the end of March compared with Q1 2019, then PMI in March should pick up to 45% or higher. A 45% or higher reading in March’s PMI will imply economic impact from the virus outbreak is mostly limited to February. A simple calculation using China’s GDP growth in Q4 2008 as a template suggests that China's economic growth in Q1 2020 should come in at around 3.2% in real terms. This is in line with the estimate from BCA's Global Investment Strategy service.2 As we pointed out in November last year,3 China is frontloading additional fiscal stimulus in Q1 2020 to secure the economic recovery, which started to bud prior to the virus outbreak. The increase in January’s credit numbers confirms our projection. The monthly flow in total social financing in January (with only three work weeks effectively) reached above RMB 5 trillion. This figure exceeded that in January 2019, the highest monthly credit number last year. Local government bond issuance in January was almost double that a year ago, and a total of 1.2 trillion local government bonds were issued in the first two months of this year - a 53% jump from the same period last year. This suggests that fiscal stimulus has indeed stepped up in 2020. Money supply in January was slightly distorted by the earlier Chinese New Year (it fell in January this year instead of February as in most years) and the COVID-19 outbreak.  M1 registered zero growth from a year ago, whereas it grew by 0.4% in January 2019.4 Normally, during the month of the Chinese New Year, households have more cash in deposits whereas corporations have less as they pay pre-holiday bonuses to employees. This seasonality factor causes the growth rate in M0 to rise and M1 growth to fall. The seasonality was exacerbated by the nationwide lockdown on January 20 this year, as many real estate developers reportedly suffered from a significant reduction in home sales and delays in deposits for down payments. Household consumption in the service sector during the Chinese New Year was also severely suppressed. This explains near-zero growth in M1 and a larger-than-expected increase in household deposits in January (Chart 2). We expect the growth in both M0 and M1 to start normalizing in March, as production and household consumption continue to resume. While we do not expect large fluctuations in housing prices, we think growth in home sales may accelerate from Q2 2020. There are early signs that the government is starting to relax restrictions on the real estate sector, on a region by region basis. Land sales remain a major source of local governments’ income, accounting for more than half of total revenues as of last year. Chart 3 shows that as government expenditures lead land sales, a major increase in fiscal stimulus and local government spending means that a significant bump in land sales will be needed in 2020. A strengthening supply of land, coupled with the unlikelihood of large fluctuations in property prices, suggests that there will be more policy supports to the real estate sector and more incentives to boost housing demand. Chart 2Corporates Are Short On Cash Chart 3Land And Home Sales Likely To Pick Up In 2020 In the past two weeks, China’s equity market has registered a near-vertical outperformance in both investable and domestic stocks relative to global benchmarks (Chart 4). While this recent outperformance was passive in nature, our policy assessment supports future active outperformance. The recently announced pro-growth policy initiatives increasingly resemble those rolled out at the start of the last easing cycle in 2015/2016. These policy initiatives increase the odds that the upcoming “insurance stimulus” will overcompensate for the short-term economic shock, and will likely lead to a significant rebound in corporate profits in the next 6-12 months.  This supports our bullish view on Chinese stocks. Chart 5 also shows that, unlike during the 2015’s “bubble and bust” cycle, both the valuation and margin trading as a percentage of total market cap in China’s onshore market remain materially lower than 2015. Equally-weighted cyclical sectors continue to outperform defensives in both China’s investable and domestic markets, particularly the latter where stock prices in the technology sector were up 12% within the past month. While the outperformance of cyclical stocks relative to defensives is consistent with our constructive view towards Chinese equities in general, the magnitude appears to be somewhat excessive. Given this, we would advise investors positioning for a cyclical recovery in China’s economy to focus their sector exposure in favor of resources, industrials, and consumer discretionary stocks. Chart 4Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chart 5Onshore Market Trading Does Not Seem Overly Leveraged China’s three-month repo rate (the de facto policy rate) has fallen significantly in the past month, roughly 30bps below its lowest level in 2016 (Chart 6). China’s government bond yields have also reached their lowest level since 2016. While corporate bond yield spreads in other major economies have picked up sharply in the past month, the reverse is happening in China. This suggests that the market is pricing in further easing and the notion that policy supports will be effective in preventing a surge in corporate bond default rate. From a global perspective, yield spreads on China’s onshore corporate bonds have been elevated since 2016. This indicates that investors have long either priced in a much higher default rate among Chinese corporate bond issuers, or demand an unjustifiably large risk premium (Chart 7). Since we expect Chinese policymakers to continue easing, risks of a surge in China’s corporate bond default rate remain low this year. As such, until we see signs that the Chinese authorities are reverting to a financial de-risking mode, we will continue to favor onshore corporate versus duration-matched government bonds. Chart 6Monetary Policy Now More Accommodative Than 2015-2016 Chart 7Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chart 8The RMB Likely To Continue Outperforming Other EM Currencies As we go to press, the Federal Reserve Bank has just made a 50bps cut to the Fed rate, the first emergency cut since the global financial crisis. The USD weakened against the Euro, the Japanese Yen, as well as the RMB immediately following the rate cut. While this reflects the market’s concerns of a worsening virus outbreak and the rising possibility of an economic slowdown in the US, the USD as a countercyclical currency will likely appreciate against most cyclical currencies as the virus continues spreading globally. Hence, the depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. The continuation of resuming production in China and the expectations of a Chinese economic recovery in Q2 will support an appreciation in the RMB against other EM currencies (Chart 8).   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://app.21jingji.com/html/2020yiqing_fgfc/ 2   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at gis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2020, available at gis.bcaresearch.com 4   M1 is mainly made up by cash demand deposits from corporations, whereas M0 is mainly deposits from households Cyclical Investment Stance Equity Sector Recommendations

Highlights Policy Responses To The Virus: Markets are now pricing in significant monetary policy easing in response to the growth shock from the COVID-19 outbreak and related financial market instability. It is not yet clear, however, that central banks will NOT ease by as much as currently discounted in the low level of bond yields – especially as risk assets will riot anew if policymakers are not dovish enough. Duration: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the virus. Spread Product: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates. Feature What a wild ride it has been for investors. Equity markets worldwide corrected sharply last week as investors were forced to downgrade global growth expectations with the COVID-19 outbreak spreading more rapidly outside of China. US equities were particularly savaged with the S&P 500 shedding -11% of its value in a mere five trading sessions, with the VIX index of implied equity volatility spiking over 40, evoking comparisons to some of the darkest days of the 2008 financial crisis. Chart of the WeekCOVID-19 Concerns Causing Market Jitters Government bond yields have collapsed alongside plunging equity values, with the benchmark 10-year US Treasury yield hitting an all-time intraday low of 1.04% yesterday. Investors are betting on aggressive rate cuts by global central bankers to offset weak growth momentum and disinflationary pressures that were already in place before the arrival of COVID-19. At the same time, corporate credit spreads widened worldwide last week, but the moves were relatively subdued and do not signal growing concern over future default losses (Chart of the Week). In this report, we discuss how to best position a global bond portfolio given these competing messages from government bond and credit markets. We conclude that maintaining selective strategic (6-12 months) overweights in global spread product versus governments, while also maintaining a neutral tactical (0-3 months) overall duration exposure - as a hedge against a more “U-shaped” recovery from the virus-driven downturn in global growth - is the best way to position for a backdrop where policymakers will need to be as easy as possible in a more uncertain world. What To Do Next On … Duration Risk assets were staging a massive rebound yesterday as we went to press, after policymakers worldwide signaled the need for stimulus measures to offset the COVID-19 growth shock. Both Fed Chairman Jerome Powell and Bank of Japan (BoJ) Governor Haruhiko Kuroda promised to ease monetary policy, if necessary, to stabilize markets. Meanwhile, looser fiscal policy may finally be on the way in Europe. The government of virus-stricken Italy announced a €3.6 billion stimulus package, while the German Finance Minister has hinted at a temporary suspension of Germany’s constitutional “debt brake” on deficit spending. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus (Chart 2). It’s a different story for government bonds, however, as a rebound in yields from current depressed levels is not assured, even if monetary policy is eased further. This is because central bankers must maintain a dovish bias until the virus-driven uncertainty over global growth begins to fade, or else risk assets will riot once again. It’s all about financial conditions now, especially in the US where COVID-19 and the stock market selloff have become front-page news in a presidential election year. Chart 2How Quickly Will China Rebound? For example, the entire US Treasury curve now trades below the mid-point of the fed funds target range, with the market now pricing in a very rapid dovish move by the Fed (Chart 3). Chart 3A Big Grab For Global Duration Yield curves are now very flat in other major developed market (DM) economies, as well. This is partly due to the risk aversion bid for safe assets, which is evident in the deeply negative term premium component of bond yields. Flat curves also reflect a more long-lasting component, with markets pricing in lower equilibrium rates in the future. Investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 4Markets Increasingly Pricing In Global ZIRP Our simple proxy for the market expectation of the nominal terminal rate- the 5-year overnight index swap (OIS) rate, 5-years forward – is between 0-1% for all major DM countries (Chart 4). The implication is that investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 5Our Central Bank Monitors Say More Easing Is Needed Chart 6Global Yields Reflect Dovish Rate Expectations At the moment, our global Central Bank Monitors – a compilation of economic and financial variables that influence monetary policy decisions – are all signaling a need for rate cuts (Chart 5). This is a function of sluggish growth & weak inflation. The plunge in global government bond yields already reflects that dovish shift in market expectations for central banks. Our 12-month discounters, which measure the expected change in short-term interest rates over the next year as extracted from OIS curves, are all priced for lower policy rates in the US (-97bps as of last Friday’s close), the euro area (-15bps) the UK (-35bps), Japan (-17bps), Canada (-72bps) and Australia (-46bps) (Chart 6). In the US, the current level of the benchmark 10-year Treasury yield is consistent with the extended slump in US industrial activity – as measured by the fall in the ISM manufacturing index – and risk-off sentiment measures like the CRB Raw Industrials/Gold price ratio (Chart 7). Yet at the same time, financial conditions remain very accommodative despite last week’s selloff, suggesting that the US economy can potentially weather a bout of COVID-19 uncertainty – as long as the Fed does not disappoint by delivering fewer rate cuts than the market is demanding and creating another down leg in the equity market. Chart 7UST Yields Need To Stay Lower For Longer Outside the US, other central banks that have non-zero policy rates – like the Bank of Canada, Reserve Bank of Australia and Bank of England – can deliver on the rate cuts discounted in their OIS curves to fight a COVID-19 global growth downturn, if needed. Chart 8UST Bullishness Still Not At Historical Extremes The negative rate club of the ECB and BoJ, however, is far less likely to actually cut rates and will rely on greater asset purchases and forward guidance to try and provide more policy stimulus. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. So what should a bond investor do with duration exposure? It is a difficult call with so many uncertainties on global growth momentum, the spread of the virus outside China, the size of any monetary or fiscal policy stimulus measures, and the degree of risk aversion still evident in financial markets. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. Therefore, we are raising our recommended overall duration exposure to neutral this week on a tactical basis. At the same time, we are maintaining an underweight stance on government bonds versus an overweight on corporate debt. We think a true bottom in yields will be reached when there are more decisive signs that bond positioning has reached a bullish extreme, according to indicators like the JP Morgan duration survey and the Market Vane US Treasury bullish sentiment index (Chart 8). In our model bond portfolio, we are expressing that extension of duration by shifting exposure from shorter maturity buckets to longer duration buckets in most countries. While also increasing exposure to “higher-beta” government bond markets like the US and Canada, at the expense of lower-beta Japanese government bonds. Bottom Line: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the COVID-19 outbreak. Increase allocations to countries with higher yield betas, like the US and Canada, at the expense of low-beta markets like Japan. What To Do Next On … Spread Product Allocations Chart 9US HY Selloff Was Focused On Energy Names Last week’s equity market meltdown did spill over into corporate bond markets, with credit spreads widening for both investment grade and high-yield corporate debt in the US and Europe. In the US, however, the jump in high-yield spreads was particularly acute among Energy names, with the index option-adjusted spread (OAS) climbing over 1000bps as oil prices plunged (Chart 9). US high-yield ex-energy has been relatively more stable, with the spread climbing to 436bps, despite the surge in equity volatility. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield.  According to our framework for calculating spread targets for global credit, last week’s selloff pushed US investment grade spreads back to our spread targets from very expensive levels (Chart 10).1 Baa-rated US investment-grade moved slightly above our spread target, but we would describe investment grade spreads as now overall fairly valued. US high-yield spreads, on the other hand, have widened well in excess of our spread targets across all credit rating tiers (Chart 11). Chart 10US Investment Grade Spreads Now Fairly Valued Chart 11US High-Yield Spreads Look Very Cheap In our framework, the spread targets are determined by looking at 12-month breakeven spreads – the amount of spread widening necessary to eliminate the yield cushion of owning corporates over government bonds on a one-year horizon – relative to their long-run history. We group those spreads according to phases of the monetary policy cycle, as defined by the slope of the US Treasury yield curve. The spread target is then calculated based on the median breakeven spread for that phase of the cycle. Currently, we are in “Phase 2” of the policy cycle, which means that the Treasury yield curve (10-year minus 3-year) is positively sloped between 0 and 50bps. In Charts 10 & 11, we add a new wrinkle to our existing way to present the spread targets. We also calculate the targets using the 25th and 75th percentile observations for the breakeven spreads for that phase of the monetary policy cycle. This gives us a range for the spread target that encompasses more of the historical data. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. The spread widening in US high-yield has very clearly restored value to spreads, which are well above the upper level of our spread target range. The same cannot be said for US investment grade, where spreads are in the middle of the target range. Chart 12European Corporates Now Offer Better Value Based on this analysis, we remain comfortable in maintaining our neutral recommended stance on US investment grade corporates and overweight stance on US high-yield. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. Thus, this week, we are adding to our recommended high-yield exposure (see Page 12). That increased allocation is “funded” by reducing our US Agency MBS exposure from overweight to neutral. Our colleagues at BCA Research US Bond Strategy are concerned that MBS spreads are likely to widen in the next few months to reflect the higher prepayment risk from the recent steep fall in US mortgage rates. One final note: our spread target framework for euro area corporates also indicates that last week’s global risk-off event also restored some value to European credit (Chart 12). Thus, we are maintaining our recommended overweights for both euro area investment grade and high-yield. Bottom Line: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We presented our framework for calculating global corporate spread targets, which builds on the work from our US Bond Strategy sister service, back in January. Please see BCA Research Global Fixed Income Strategy Special Report, "How To Find Value In Global Corporate Bonds", dated January 21, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Supply constraints and unstoppable demand growth – the result of stricter regulations requiring higher loadings in autocatalysts to treat toxic pollution in automobile-engine emissions – will continue to push palladium’s price higher, despite a near-vertical move higher that began in 2H19. South Africa’s power grid is in a state of near-collapse, which will add volatility to mining operations focused on platinum-group metals – chiefly palladium, platinum and rhodium. South Africa accounts for 36% of global palladium production and 73% of platinum production, which makes it difficult to make the case that platinum could be substituted for palladium as its price rises. Palladium stocks are at risk of being further depleted globally as demand from automobile manufacturers in China, the US and Europe remains robust. This will keep palladium forward curves backwardated for the foreseeable future. While pressure to find alternatives for palladium will grow as prices rise, in absolute terms the additional cost resulting from higher prices for the metal – ~ $400 per vehicle – is not yet enough to draw significant investment to this effort. Feature Palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Table 1Top 5 Best Performing Commodities In 2019, for the third year in a row, palladium prices outperformed other major commodities, returning an impressive 54% over the year (Table 1). This is the result of a massive 13% increase in demand for the metal – powered by strong autocatalyst demand for gasoline-powered cars in China and Europe, even as collapsing auto production globally and elevated trade uncertainty continue to dog automobile sales (Chart 1). This apparent contradiction is explained by stricter vehicle emissions regulations in major consuming markets – chiefly the Euro 6d, China 6 and US Tier 3 regimes – and power shortages in South Africa, which are introducing considerable volatility on the supply side in the second-largest producing country for the metal. Chart of the WeekSurging Autocatalyst Palladium Demand  Again this year, palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Palladium prices soared 39% YTD, its fastest 40-day increase since 2010. Unlike other commodity markets, palladium is completely disregarding the COVID-19 outbreak that originated in China late last year. Favorable supply-side fundamentals continue to drive the palladium rally: The metal’s decade-long physical supply deficit intensified in 2019 and we expect it to widen this year (Chart 2, panel 1). On the demand side, Chinese consumption is at risk. China is the world’s largest auto manufacturing market. Hubei Province – COVID-19’s epicenter – is a large car manufacturing hub, accounting for ~ 10% of the country’s annual automobile output. In the wake of COVID-19, the country’s car production is expected to fall 10% in 1Q20. In addition, the virus had infected more than 80,000 people globally, and has spread rapidly outside Hubei into Asia, Europe, the Middle East, Africa, and North America, raising the odds of a pandemic. Interestingly, speculative positioning and ETF investment demand is subdued, and is not inflating prices (Chart 2, panel 2). Chart 2Palladium Deficit To Widen This Year Palladium Demand Soars As Auto Production Collapses Strong global automobile catalyst demand drove the rally in palladium prices last year. This occurred as car production fell by 9%, 8%, and 15% in US, China, and India – an unusual divergence in fundamentals. The culprit: Technical changes to autocatalysts from stricter emissions regulations. In China, the latest phase of car emissions regulations – China 6 – was gradually introduced in high-population centers, which also suffer from high levels of pollution. These centers accounted for ~ 60% of annual Chinese car sales in 2019. China 6 represents a major shift in emissions regulations and will make the Chinese auto fleet compliant with Europe’s best practices. As a result, palladium loadings in conforming light-duty gasoline vehicles reportedly increased by ~20% in 2019. This pushed China’s autocatalyst consumption up by 570k oz despite the drop in annual car sales, which created the rare dislocation between the country’s car production and palladium prices (Chart 3). We expect this trend to continue this year: China 6 is on track to be enforced countrywide – i.e., the remaining 40% of car sales – by mid-year, providing an additional ~ 10% boost in loadings of the metal. Chart 3Stricter Regulations Support Prices Amid Falling Car Production In Europe, the introduction of Euro 6c legislation in September 2018 and the extension to all new vehicles of Euro 6d-TEMP regulations in September 2019 – mainly the real driving emissions (RDE) testing procedure adopted in the wake of the Volkswagen “dieselgate” scandal in 2015 – pushed palladium loading in autocatalysts up by ~ 25% from 2017 to 2019.1 The regulations became stricter in January 2020, putting additional stress on manufacturers to comply with the new standards, which will continue to support higher palladium loadings. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. Lastly, in the US – which remains an important market for autocatalyst palladium demand (Chart 4) – the ongoing implementation of the Tier 3 legislation will continue to gradually increase palladium content in autocatalysts until 2025. For 2020, we do not expect this to significantly boost loadings per vehicle and are factoring in 2% growth. These legislative changes in major automotive markets produced a structural break in our palladium demand model (Chart 5). After adjusting our estimates for greater palladium content in gasoline aftertreatment systems, our model suggests that demand provides strong support to palladium prices, but also suggests other factors – i.e. supply and inventory – are at play. Chart 4North America's Auto Sector Remains A Large Share Of Palladium Demand Chart 5Higher Palladium Loadings Largely Explains Last Year's Price Surge In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. In China, we expect the government will overstimulate its economy to meet its long-term goal of doubling its GDP and per capita income by 2020.2 Automobile ownership and vehicle sales there are low vs. DM economies, suggesting more upside for sales in China (Chart 6). In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. Car sales move in cycles around long-term demographic trends: The longer the current economic expansion, the further above-trend car sales can rise (Chart 7). Chart 6China: Structural Outlook For Autos Is Bright China Car Consumption Will Rebound In 2H20... Chart 7... Likewise For Europe And US Bottom Line: The combination of stricter environmental regulations in key gasoline-powered automobile markets and the post-coronavirus rebound in global auto consumption will push the palladium market further in deficit this year as it faces an inelastic supply, critically low inventories and low substitutability over the short-term (more on this below). Palladium Supply In 2020: Weak growth And Low Price-Elasticity Palladium supply is highly constrained. The largest supplies are concentrated in Russia (42%), South Africa (36%) and North America (14%). From 2015 to 2019, supply and capex grew by a very subdued 7% and 15.2% respectively, completely disregarding the 200% rise in prices (Chart 8, panel 1). This illustrates palladium supply’s extremely low price-elasticity.3 Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Primary supplies declined by close to 2% last year on falling shipments from Russia and record electricity load-shedding – i.e. blackouts – in South Africa (Chart 8, panel 2).4 As tight as palladium markets are fundamentally, South Africa’s crippled power grid – long in need of upgrading and repair – has been, and remains, a key driver of short-term platinum-group metals (PGM) prices.5 Following the breakdown of close to 25% of the country’s generating capacity, Eskom – the nation’s utility monopoly responsible for ~ 90% of its electricity generation – has been forced to implement rolling blackouts to balance power supply and demand and prevent permanent damage to the country’s power grid. Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Consequently, Stage 6 load-shedding events likely will become more frequent. These efforts are complicated by massive debt – ~ $30 billion – which has required government bailouts and forced the company to take loans from a Chinese industrial bank. Chart 8Top Palladium Producers' Capex Price-Elasticity Is Low This is playing havoc with PGM supplies. During the unmatched Stage 6 load-shedding in December 2019 – cutting power to 37% of grid users – PGM supplies were reduced by 50%. Stockpiles covered the loss, but persistent blackouts lasting years could push markets into an actual shortage of palladium as inventories would rapidly be depleted. This is a significant risk: Eskom itself warned rolling blackouts will persist for the next 18 months.6 Elevated local currency PGM prices are postponing announced shafts closures, as miners seek to profit from the favorable pricing environment (Chart 9). But insufficient electricity capacity will weigh on mine supply growth over the next few years as companies hold-back on much-needed long-term investments. The final units of Eskom’s Medupi and Kusile projects are expected to be completed over the next two years – adding 4800MW to its installed capacity. This can partially alleviate South Africa’s electricity difficulties, but these units are not enough to support a rebound in economic and mine production growth. South Africa is in profound need of large-scale investments in its power sector. Close to 5000MW of power capacity is scheduled to shut down over the next five years (Chart 10). Chart 9Favorable Domestic Metal Prices For South African Miners Chart 10South Africa Needs Additional Power Generation Capacity After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. The current political and economic climate is not constructive for meeting this challenge. The World Bank recently slashed South Africa’s 2020 GDP growth forecast to 0.9% from 1.5% previously on the back of electricity and infrastructure constraints impeding domestic growth and weak external demand. Likewise, rating agency Moody's signaled – ahead of its review of South Africa’s Baa3 credit rating in March – it could downgrade the country to speculative grade, citing the detrimental impact of recurring power outages on manufacturing and mining output. After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. This will provide much-needed help to the country’s power sector. According to the Minerals Council South Africa, mining companies could bring an additional ~ 1500MW capacity online in the next 9 to 36 months. But doubts remain with regard to the timeline for companies to obtain the necessary licenses and if these can easily be acquired. Johnson Matthey expects supply growth in Russia – the largest producer – will be capped this year as Nornickel’s processing of old mines' copper concentrate – which boosted the company’s palladium supply over the past few years – is finalized. Still, a paltry 1% gain is possible from expected efficiency gains at existing mines, according to Nornickel. The company also announced it will increase production at its Talnakh and South Cluster mines, but this additional supply will only reach markets gradually as processing capacity constraints won’t be resolved until 2023, according to Johnson Matthey. Bottom Line: Growth prospects in the top two palladium-producing countries are weak in 2020. This will not suffice to meet the soaring autocatalyst demand. Higher recycling and inventory releases – both incentivized by higher prices – will be needed to balance the market. Palladium Stockpiles Are Dangerously Low We expect palladium prices will move higher on the expanding deficit, and backwardation in the forward curve will persist to incentivize the release of inventories to market (Chart 11). Yet, global palladium stockpiles have been declining since 2014 and are now at critically low levels, raising the risk of a disrupting shortage of the metal:7 ETF and exchange inventories now stand at a paltry 600k oz (Chart 12). These are the most price-elastic stocks and will get close to zero as prices increase. Chart 10Expect Backwardation To Persist Chart 12Price-Sensitive Stockpiles Are Dangerously Low Exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. The Russian Ministry of Finance’s reserves – a state secret – are now almost exhausted, according to Russia’s Norilsk Nickel, the largest supplier of physical palladium in the world. Last year, Norilsk Nickel held an estimated 1mm oz of the metal in its Global Palladium Fund, and signaled it is increasingly using its reserves to balance markets and provide needed liquidity. Earlier this year, the company released 3 MT of palladium to the market from stocks. Complete exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. Don’t Count On Substitution, Yet Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers. We expect platinum prices to rise in 2020 supported by improving fundamentals, growing safe-haven demand, and markets pricing in increasing anticipation of substitution from palladium to platinum. Unlike palladium, platinum is also affected by safe-haven demand and gets bid up with gold and silver prices in periods of high uncertainty (Chart 13). With gold prices now above $1,600/oz, platinum will benefit from safe-haven flows due to its relative price advantage (Chart 14). Chart 13Safe-Haven Flows Support Platinum Prices Chart 14Platinum Is Cheap Relative To Gold We believe substitution will commence over the coming years, but this is a gradual process. Substitution from expensive palladium to low-priced platinum in industrial applications is the largest risk to our positive view on the palladium-to-platinum (Pd-to-Pt) ratio (Chart 15). This started in smaller and more price-elastic segments (e.g. dental, jewelry and diesel autocatalyst). However, to have a real impact on overall demand and thus the price ratio, substitution needs to take place in gasoline autocatalyst technology. The discount has been at a level consistent with substitution for more than a year, but the urgency to upgrade current designs to meet new environmental legislation and RDE regulations in China, Europe, and the US is the main focus of automakers this year. Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers scrambling to meet the latest anti-pollution regulations globally. Moreover, large-scale substitution will take place only if automakers’ cost-benefit analysis points to significant long-term profits from switching. That said, platinum’s supply security remains a risk in the long-term: South Africa accounts for 73% of global production and our analysis suggests output growth there likely will remain weak over the next few years, especially as Eskom rebuilds its failing power grid. This lack of diversity increases sourcing risks for automakers, who, not without reason, would not want to switch over to platinum only to find that supply is also in doubt down the road. The overall platinum market is 26% smaller than that of palladium. Assuming a one-for-one substitution of Pd to Pt in gasoline catalyzers, a 1.2mm oz reduction in Pd demand – the amount required to reduce palladium’s deficit to zero – would send platinum markets to a 1.4mm oz deficit.8 Without substantial production growth, platinum prices would spike, reducing the profitability of investing in these new catalysts. Thus, substitution will eventually impact the price ratio, but will not be large enough to overturn absolute price level trends. In addition, the amount of PGMs in the typical autocatalyst – ~ 5 grams – adds $400 to the cost of the average automobile (Chart 15, lower panel). We do not believe this cost drives automakers' decisions, which is another reason the substitution of Pt for Pd likely will remain a topic of discussion more than action. Chart 15Palladium's Price Surge Adds ~0 Per Gasoline Car Bottom Line: We believe substitution will commence over the coming years, but this is a gradual process and it will not happen on a meaningful scale this year. Thus, we expect the continuation of relative demand and inventory trends will provide a favorable setting for the Pd-to-Pt ratio this year (Chart 16). Chart 16Pd-to-Pt Price Ratio Will Increase Again in 2020   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent and WTI crude oil lost 5% and 4% this week, as fears of a global pandemic in the wake of the COVID-19 outbreak gripped markets. Reports of outbreaks in Asia ex-China, the Middle East and Europe fueled these concerns. Against this backdrop, OPEC 2.0 will be meeting in Vienna March 5 and 6 to consider cuts of 600k b/d recommended by its technical committee earlier this month. We continue to expect the full coalition to approve these cuts at the upcoming meetings. Saudi Arabia, Kuwait and the United Arab Emirates reportedly are considering an additional 300k b/d of cuts to offset the global demand hit delivered by COVID-19. The IEA estimates the COVID-19 outbreak will reduce Chinese refining throughput by 1.1mm b/d, and will reduce the call on OPEC crude by 1.7mm b/d in 1Q20. Base Metals: Neutral Iron ore prices weakened, following global equities lower, as the COVID-19 outbreak spread around the world. However, traders continue to report lower stocks of iron ore, which should keep prices supported, according to MB Fastmarkets (Chart 17). We remain long December 2020 high-grade iron ore (65% Fe) vs. short the benchmark 62% Fe contract on the Singapore Commodity Exchange, which we initiated November 7, 2019. This recommendation was up 5.3% as of Tuesday’s close, when we mark to market. Precious Metals: Neutral After retreating slightly from its run toward $1,700/oz earlier this week, gold remains well supported by safe-haven demand (Chart 18).  In addition, actual and expected policy stimulus – e.g., Hong Kong's “helicopter money” drop of USD 1,200 to all permanent residents over the age of 18 – and expectations of additional central bank easing globally to offset the global spread of COVID0-19 will keep gold and precious metals generally supported.  Markets should start pricing in higher inflation expectations as additional stimulus starts to roll in.  Ags/Softs:  Underweight Global grain markets could be set to rally sharply, as unusually wet weather in the Middle East and East Africa spawned by higher-than-usual cyclone activity produces perfect breeding conditions for desert locusts in the region over the next two months.  According to National Geographic, by June the locusts could increase their populations “400-fold compared with today, triggering widespread devastation to crops and pastures in a region that’s already extremely vulnerable to famine.”  This could put more than 13mm people in East Africa at risk of “severe acute food insecurity,” and imperil millions more.  Chart 17China's Iron Ore Stocks Tight Chart 18Safe Havens Gold, USD Well Bid   Footnotes 1     Please see New legislation planned in response to dieselgate, published by Autocar June 9, 2016. See also  Johnson Matthey’s February 2020 Pgm Market Report. 2     Our view of strong Chinese fiscal and monetary stimulus was discussed in detail in our February 13, 2020 weekly report titled Iron Ore, Steel Poised For Rally. 3    Historically produced as an inferior byproduct from nickel, gold, and platinum mines, the price incentive from palladium alone isn’t enough to generate the needed investments in new mine production. According to Nornickel, this is slowly changing, palladium is an increasingly large part of mining companies’ revenues, making the metal a valuable co-product. This could improve mines investments’ responsiveness to movement in palladium prices over the medium term. 4    According to Eskom, “Load shedding is aimed at removing load from the power system when there is an imbalance between the electricity available and the demand for electricity. If we did not shed load, then the whole national power system would switch off and no one would have electricity.” The company’s load-shedding program includes 8 stages, where each stage represents the removal of 1000MW of demand – e.g., stage 5 removes 5000MW. This is done by shutting down specific sections of the grid.  5    The PGMs are ruthenium, rhodium, palladium, osmium, iridium, and platinum. 6    Things got worse after the December load-shedding event.  Less than a month later, Reuters noted more than two times the power shed in December went “offline because of plant breakdowns. 7    This can be seen in the close to 12mm oz. decline in UK and Switzerland – home of the largest secured vaults of Palladium and Platinum – net imports. 8    Technological improvement in palladium catalysts has made the metal more efficient in for gasoline-powered engines vs. platinum. It has superior properties in terms of thermal durability and NOx reduction. Thus, the conversion could be greater than 1-to-1 and would imply a smaller share of palladium autocatalyst substitution could be absorbed by existing platinum supplies.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights In the past week, it is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery. Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016. As manufacturers in regions other than Hubei are returning to work and their production capacity continues to rise, the outbreak-induced economic shock may be smaller than investors currently fear. Hence, the odds are rising that the upcoming “insurance stimulus” may end up overshooting the short-term economic shock. As such, we maintain a constructive view on Chinese stocks over the next 6-12 months. Feature A surge in the number of COVID-19 infections outside of China (including South Korea, Japan, Iran, and Italy) risks delaying a global economic recovery, and has cast doubt on the outlook for the global economy beyond Q1 (Chart 1). Chart 1Pandemic Threats Expanding Globally Despite the sharp uptick in global investor concern, our constructive view on Chinese stocks remains unchanged for the next 6-12 months. Our view on Chinese risk assets is based on a simple arithmetic framework that we described last year when the trade war tensions between the US and China were escalating. In short, when gauging the net impact of an economic shock, investors should determine which of the following two scenarios is most likely: Scenario 1 (Bearish): Stimulus – Shock ≤ 0 Scenario 2 (Bullish): Stimulus – Shock > 0 While this framework is quite simplistic, the point is to underscore that economic shocks are almost always met with a policy response, and the goal is to determine whether this response is sufficient enough to offset the impact of the shock. If the Chinese leadership underestimates the severity of the shock and undershoots on the stimulus, this would be bearish for Chinese stocks (Scenario 1). In the current situation, however, even if the near-term economic outlook is deeply negative, investors should maintain a bullish cyclical (i.e. 6-12 month) outlook for China-related assets as long as the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand (Scenario 2). Major Stimulus Around The Corner? It is becoming evident that the Chinese policymakers, when dealing with an unprecedented public health crisis, are returning to aggressive fiscal and monetary easing. In fact, the odds are rising that the magnitude of the upcoming stimulus may resemble that of 2015/2016, and has an increasing possibility to overshoot in the next 6-12 months. In the past week, there has been a clear shift of policy focus from “financial de-risking” to “mitigating the economic damage from shocks at all costs”, as indicated by high-profile policy announcements. In an unprecedented large-scale teleconference on February 23,1 President Xi stated that China will not lower its economic growth target for this year, and that fiscal policy will be “more proactive” while monetary policy was upgraded from “prudent” to “flexible and moderate". Chart 2PBoC Looks Set For Massive Stimulus Xi also pledged to “introduce new policy measures in a timely manner”. China’s central bank, the PBoC, issued a statement signaling further cuts ahead in the bank reserve requirement ratio rate and interest rate.2 The PBoC has already aggressively eased monetary conditions in the past two weeks, and both the central bank policy and average lending rates are now lower than they were during the last massive easing cycle in 2015/2016 (Chart 2).  Other policy initiatives also suggest the Chinese authorities are stepping up coordinated efforts to boost the economy, beyond short-term and targeted financial support. The stimulative measures now span from infrastructure to housing and automobile sectors, the exact “three prongs” that supported a V-shaped economic recovery in 2016.3 This is in sharp contrast with last year, when Chinese policymakers largely resisted resorting to large-scale stimulus, despite immense pressure from the US-China trade war and tariff impositions.4 The ongoing COVID-19 epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. The ongoing epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. As we predicted in November last year,5 China was to frontload additional fiscal stimulus in Q1 this year to secure an economic recovery, which started to bud in Q4 last year. The increase in January’s credit numbers confirms our projection: local government bond issuance picked up significantly from last year while the contraction in shadow bank lending continued to ease, signaling a less restrictive policy bias on both the monetary and fiscal fronts (Chart 3).  Chart 3Stronger Fiscal Support Likely To Soon Follow The exact economic and monetary expansion growth targets will be officially set at the National People’s Congress meeting, which has been postponed from its usual schedule on March 5. Compared with the 6.1% real GDP growth achieved in 2019, we now think a growth target of 5.6% would be conservative for this year. According to an estimate by BCA’s Global Investment Strategy,6 China’s real GDP growth in Q1 could slow to 3.5% on a year-over-year basis. To achieve 5.6% growth, China would need at least 6.3% average real growth (year-over-year) for the next three quarters, 0.3 percentage points higher than in the second half of 2019. The growth in credit expansion, infrastructure spending and government expenditures will need to significantly outpace last year in the next 6-12 months. Bottom Line: The government appears to be willing to abandon its financial de-risking agenda to secure economic recovery. There is an increasing possibility that the stimulus may overshoot the economic shock this year. China’s Economic Engine Warms Up There are increasing signs that the scale of the upcoming stimulus may match that of the 2015/2016 cycle. The likely magnitude of the shock, on the other hand, might be smaller than investors fear as the evidence is mounting that production is returning to normality in China. Despite a lack of employees and raw materials, industrial activity in regions outside of Hubei is resuming. Chart 4…Small Companies Are Not Far Behind A survey of China’s 500 top manufacturers by China Enterprise Confederation7 indicated that most of the 342 respondents had resumed production as of February 20. They also reported that more than half of their employees had returned to work and the average capacity utilization rate had reached nearly 60% (Table 1). Furthermore, the China Association of Small and Medium Enterprises8 survey of 6,422 small businesses showed that as of February 14, more than half of the companies have resumed operations (Chart 4). By February 21, the daily coal consumption in China’s six largest power plants has reached 62% of the consumption from the same period last year (adjusted for Lunar Year calendar), 14 percentage points higher than February 10 - the first day officially scheduled for people to return to work.9 Table 1Large Manufacturers Have Reached More Than Half Of Their Production Capacity… The resurgence in the number of new infections has not slowed those regions down from reopening businesses, particularly along the manufacturing belt in China’s coastal regions (Chart 5). China’s leadership has repeatedly urged local governments to relax aggressive containment measures to allow production to resume. Unless the number of new cases in China picks up again, we expect business operations in regions outside of Hubei to continue re-opening in the coming weeks. Chart 580% Of China’s Coastal Regions Are Back To Work Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. Bottom Line: The aggressive containment measures seem to be effective inside China. Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. We expect the rate to improve. This will mitigate the impact of the virus outbreak on the Chinese economy.  “Scenario 2” Implies An Upturn In The Corporate Earnings Cycle The impact of the COVID-19 outbreak on China’s economy may be smaller than investors currently fear. The country is also in a better economic condition than in 2015/2016. If the Chinese leadership believes an “insurance stimulus” is warranted and allows credit growth in 2020 to reach near 28% of GDP, as in 2015-2016, then the stimulus will more than offset the outbreak-induced economic shock from Q1 and lead to a meaningful rise in this year’s corporate earnings (Chart 6): China’s households and corporates are actually more willing to spend now than in 2015-2016. We agree that China’s households and companies are both highly leveraged, and re-leveraging may further diminish their debt-servicing ability and willingness to invest or spend. Debt as a share of Chinese household disposable income has climbed by 33 percentage points compared with five years ago (Chart 7). The increase in debt load makes Chinese households particularly vulnerable to income reductions. But this supports our view that policymakers will make every reflationary effort to avoid massive layoffs. Additionally, the willingness to spend among Chinese households is not less than during the down cycle in 2015-2016 (Chart 7 bottom panel). Chart 6A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks Chart 7Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 The debt-to-GDP ratio and debt-servicing cost-to-income ratio in China’s non-financial private sector have trended sideways in the past five years (Chart 8). The corporate cash flow situation is only slightly worse than in 2015 (Chart 9). The virus outbreak and drastic containment measures will temporarily weaken the corporates’ cash positions, but this negative situation can be partially offset by tax, fee and interest relief measures.10 Chart 8Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chart 9...And Their Cash Flow Situation Is Only Slightly Worse   Furthermore, China’s non-financial corporates’ marginal propensity to spend is actually higher than in 2015-2016 (Chart 10). This may be due to the more accommodative monetary backdrop than in 2015-2016. If Chinese authorities are to significantly step up their reflationary efforts, the easy monetary policy stance may be here to stay throughout 2020. Prior to the COVID-19 outbreak, the mild deflation in China’s PPI growth was already turning slightly positive on the heels of an improving economy. The historical relationship between China’s producer prices and industrial profits suggests that profit growth for both China’s onshore and offshore markets is highly linked to fluctuations in producer prices (Chart 11). An ultra-easy monetary policy, a weak RMB, and a more forceful boost to domestic demand will provide strong reflationary support to producer prices and industrial profits. Chart 10Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chart 11A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits   Bottom Line: Despite a short-term economic shock, China’s economy is at a better starting point than in 2015-2016. If monetary and fiscal easing in 2020 reaches the same magnitude as five years ago, then the economy and corporate profits will likely begin to respond to the stimulus. Investment Conclusions The clear sign of policy shift to shoring up the economy suggests that, our Scenario 2 is the most likely outcome. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016. The short-term outbreak-induced economic shock, on the other hand, looks to be smaller than the market anticipates. Manufacturers in China continue to resume production in regions outside of Hubei, a trend we believe will go on unless there is a significant threat that the virus will break out again in these Chinese regions. This supports our constructive view on China-related assets over a 6-12 month time horizon. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016, and will likely overshoot the short-term economic shock. There is a risk to our constructive view, though, that the more forceful policy response from the Chinese leadership may imply a greater than anticipated short-term economic shock from the outbreak. This would challenge our bullish stance on Chinese stocks in the next three months. Substantially weaker economic data in Q1 would likely trigger a selloff in Chinese risk assets, both onshore and offshore. However, a severe short-term economic shock, followed by a burst of stimulus, would create strong investment opportunities. If the scale of Chinese policymakers’ reflationary measures ramps up significantly in the coming months, they will likely overshoot the short-term economic shock. Another reflationary cycle would certainly have a positive impact on global investors’ sentiment and Chinese financial assets. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://english.www.gov.cn/news/topnews/202002/23/content_WS5e5286cdc6d0… 2   http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3975864/index.html 3   Please see China Investment Strategy Weekly Report "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 4   Please see China Investment Strategy Weekly Reports "Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10, 2019, "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, "Don’t Bottom-Fish Chinese Assets (Yet)," dated August 14, 2019 and "Mild Deflation Means Timid Easing," dated October 9, 2019. available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 6   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at cis.bcaresearch.com 7   http://www.cec-ceda.org.cn/view_sy.php?id=42633 8   http://www.ce.cn/xwzx/gnsz/gdxw/202002/18/t20200218_34298844.shtml 9   http://www.21jingji.com/2020/2-21/wOMDEzNzhfMTUzNjAwOA.html 10  China has announced targeted measures to defer or lower taxes and administrative fees. It will also provide interest rate subsidies to affected businesses. Cyclical Investment Stance Equity Sector Recommendations