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Highlights Since 2004, Sweden’s private sector leverage trend can be explained using a simple Taylor rule approach. The approach clearly highlights three distinct monetary policy phases, and underscores the singular role of inflation (not systemic risk from rising indebtedness) as a driving factor for Riksbank policy. Since 2015, the Riksbank has maintained interest rates well below what a Taylor rule approach would suggest, owing to the desire to raise inflation expectations and Sweden’s high trade exposure to the euro area. This highlights strong similarities between the experience of Sweden and Canada: both countries are in the orbit of a major neighboring central bank, which has created serious distortions in both economies. Given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, our assessment of the Riksbank’s reaction function suggests the odds appear to be high that the repo rate will move back into negative territory at some point this year (despite their reluctance to do so). Over the near-term, Swedish policy easing suggests that investors should avoid the krona versus both the US dollar and euro. Over a medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends, potentially to the benefit of Swedish consumer durable and apparel stocks. Finally, over the long-term, Sweden is very likely to face a period of domestic economic stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. The co-ordinated global response to the pandemic suggests that this is not the end of Sweden’s debt supercycle, but timing the transition from reflation to stagnation will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Feature One of the worrying legacies of the global financial crisis has been a substantial buildup in private sector debt in many economies around the world. This has most famously occurred in China, but private indebtedness is also very high in many developed economies. Among advanced countries, Sweden stands out as being particularly exposed to elevated private sector debt. Chart I-1 highlights that Sweden’s private sector debt-to-GDP ratio has ballooned to a massive 250% of GDP over the past 15 years, from a starting point of roughly average indebtedness. Chart I-1Sweden's Extremely Indebted Private Sector In this report we explore why Sweden has seen an explosion in private sector debt-to-GDP, and highlight that Sweden’s experience can be compared closely with that of Canada – both countries are in the orbit of a major neighboring central bank, which has created distortions in each economy. We also summarize what this implies for Riksbank policy, and what investment recommendations can be drawn from our analysis. We conclude that while the Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, it appears likely that they will forced to do so unless the negative economic impact from the COVID-19 pandemic abates very soon. Over the short-term, this suggests that investors should avoid the Swedish krona, versus either the US dollar or the euro. Why has Sweden seen such an explosion in private-sector debt? Over the medium-term, easy Riksbank policy and the probable absence of any additional macroprudential measures is likely to spur a renewed increase in Swedish house prices and household debt, which will likely benefit consumer durables and apparel stocks relative to the broad Swedish equity market.  But this will reinforce Sweden’s existing credit bubble, and similar to Canada will set the stage for domestic economic stagnation over the very long-term. Riksbank Policy and Sweden’s Private Sector Debt: A Tale Of Three Phases Much of the investor attention on Sweden's extremely high private sector debt load has occurred following the global financial crisis. But Chart I-1 clearly highlights that the process of private sector leveraging began in 2004, arguing that the Riksbank’s easy monetary policy stance following the global financial crisis is not the only cause of Sweden’s extremely elevated private debt-to-GDP ratio. In a previous Special Report for our Global Investment Strategy service,1 we investigated a similar experience in Canada and used a simple Taylor rule approach to show that the Bank of Canada’s decision to maintain interest rates below equilibrium levels for nearly two decades has contributed to a substantial buildup in private sector leverage. A similar approach for Sweden highlights similar conclusions, albeit with some complications: Chart I-2 shows our Taylor rule estimate for Sweden alongside the policy rate, and shows the deviation from the rule in the second panel. Chart I-2Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Compared with Canada’s experience, which has maintained too-low interest rates consistently for the past 20 years, Chart I-2 shows that the stance of Sweden’s monetary policy since 2000 falls into three distinct phases: Persistently easy policy from 2000 to 2008 A period of less easy and then relatively tight policy from 2009 to early-2014 A period of extremely easy policy from 2015 until today. The first phase noted above closely resembles the experience of Canada: policymakers in both countries simply kept interest rates too low during the last global economic expansion. In the second phase, the stance of monetary policy in Sweden became progressively less easy: the Taylor rule collapsed in 2009/2010, and trended lower again during the euro area sovereign debt crisis as well as its aftermath. In fact, Chart I-2 suggests that Sweden’s monetary policy stance was outrightly tight from 2012-2014, and in early-2014 the Taylor rule recommended negative policy rates while the actual policy rate was above 1%. In the third phase, the Riksbank appears to have overcompensated for the second phase of relatively less easy and eventually tight monetary policy. The Riksbank pushed policy rates into negative territory in late-2014, as had been recommended by the Taylor rule a year before, at a time when the rule was rising sharply. Roughly 2/3rds of the rise in the rule from early-2014 to late-2018 occurred due to the significant rise in Swedish inflation, with the rest due to a rise in Sweden’s output gap – which turned positive in late-2016 according to the OECD (Chart I-3). It is this third phase, featuring a massive and glaring gap between Swedish policy rates and a monetary policy rule that correctly recommended easy policy from 2010 – 2014, that has attracted global investor attention over the past few years. But Chart I-4 presents Sweden’s Taylor rule gap alongside its private sector debt-to-GDP ratio, and highlights that over 80% of the rise in the latter since 2000 actually occurred in the first phase described above – a period of persistently easy monetary policy as defined by our Taylor rule approach. The behavior of Sweden’s private sector debt-to-GDP ratio in the second and third phases also seems to validate our approach, as gearing essentially stopped during the second phase and restarted in the third phase. Chart I-3Since 2014, Sweden’s Rising Taylor Rule Has Been Driven Mostly By Inflation Chart I-4Sweden’s Monetary Policy Phases Explain Its Private Sector Leveraging The Riksbank: “Talk To Us About Inflation, Not Debt” Chart I-5During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates It is crucial to understand the motivations of Sweden’s central bank during each of these phases in order to be able to forecast the likelihood of a return to negative interest rates this year, as well as the Riksbank’s likely policy response once the COVID-19 pandemic subsides. In the first monetary policy phase that we have described, Sweden was not the only country to maintain persistently easy monetary policy. Given the relative scarcity of private sector deleveraging events in the post-war era, most policy makers, academic economists, and market participants were regrettably unconcerned about rising private sector indebtedness during this period, and only came to understand the consequences during the crisis and its aftermath. Most advanced economies leveraged during the first of Sweden’s monetary policy phases, and Sweden really only stands out as a major outlier from 2007 – 2009 when nearly 60% of the country’s total 2000-2019 private sector leveraging occurred (most of which, in turn, occurred before the collapse of Lehman Brothers in September 2008). In essence, by the time that Swedish policymakers were given a vivid and painful demonstration of the dangers of elevated private sector debt, it was too late to prevent most of the increase in debt-to-GDP that is facing the country today. In the second phase of Sweden's modern monetary policy, our Taylor rule framework highlights that the Riksbank largely acted as appropriate. One complication, however, is the difference in the leverage trend between Sweden's nonfinancial corporate and household sectors. Chart I-5 clearly highlights that Sweden's household sector took advantage of low interest rates during the country’s second monetary policy phase. Household sector leveraging began to rise again starting in late-2011, whereas it was completely absent for the corporate sector during the period. A crucial reason why the Riksbank ignored this renewed household sector leveraging is also part of the reason that it has maintained extremely low policy rates in the third phase noted above. The Riksbank’s monetary policy strategy, which is published in every monetary policy report, includes the following: “According to the Sveriges Riksbank Act, the Riksbank’s tasks also include promoting a safe and efficient payment system. Risks linked to developments in the financial markets are taken into account in the monetary decisions. With regard to preventing an unbalanced development of asset prices and indebtedness however, well-functioning regulation and effective supervision play a central role. Monetary policy only acts as a compliment to these.” In other words, the Riksbank has been very clear that preventing excessive leveraging is not its responsibility, and that the job ultimately falls to the Swedish government. But if the Taylor rule was recommending meaningfully higher interest rates during phase 3, then why did the Riksbank continue to lower interest rates into negative territory until last year? In our view, their behavior can be explained by the confluence of three factors: 1. Sweden’s deflation scare in 2014: Sweden’s underlying inflation rate had been trending lower for four years by the time that it dipped briefly into negative territory in March 2014. By this point, the Riksbank appears to have become increasingly concerned about inflation expectations rather than the trend in actual inflation. Chart I-6 presents Sweden’s underlying inflation rate and an adaptive-expectations based estimate of inflation expectations alongside the repo rate, and shows that inflection points in the repo rate match inflection points in expectations. Specifically, the repo rate continued to fall until inflation expectations stabilized in early-2016, and the Riksbank did not raise the repo rate until expectations crossed above 1.5%, a level that was reasonably close to the central bank’s 2% target. Chart I-6During Phase 3, The Riksbank Focused On Low Inflation Expectations 2. Sweden’s high trade sensitivity: Chart I-7 highlights that Sweden’s economy, like Canada and other Scandinavian countries, is highly exposed to exports to top trading partners. The euro area accounts for a large portion of Sweden’s exports, and Chart I-8 highlights that nominal euro area imports from Sweden remained very weak from 2012-2016. In addition, Sweden’s import sensitivity is also very high, with total imports of goods and services accounting for over 40% of Sweden’s GDP. By our calculations, roughly 2/3rds of Swedish imports are for domestic consumption,2 and Chart I-9 highlights how closely (inversely) correlated imported consumer and capital goods prices are to Sweden’s trade-weighted currency index. By pushing the repo rate into negative territory, the Riksbank reinforced rising inflation expectations by supporting exports and importing inflation from its trading partners via a weaker krona. Chart I-7Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Chart I-8Euro Area Demand For Swedish Goods Remained Weak For Several Years Chart I-9To 'Import' Inflation, The Riksbank Had To Weaken The Krona 3. The euro area’s persistently weak inflation and extremely easy monetary policy: While this is related to Sweden's overall trade sensitivity, the fact that the euro area had to combat persistently weak inflation with negative interest rates and asset purchases from late-2014 to late-2018 has had a particularly strong impact on Riksbank policy given the latter’s goal of boosting Swedish inflation via higher import prices. Chart I-10 highlights the strong link between the SEK-EUR exchange rate and the real interest rate differential between the two countries, and in particular shows that the Riksbank had to lower the differential into negative territory in order to bring the krona below “normal” levels (defined here as the average of the past global economic expansion). When faced with a real euro area policy rate of roughly -1.5% during the period (Chart I-11), the only way to achieve a negative real rate differential was to maintain the repo rate at an extremely low level as Swedish inflation rose. Chart I-10To Weaken The ##br##Krona... Chart I-11…Deeply Negative Real Policy Rates Were Required Where Next For The Repo Rate? In February 2019 the Riksbank was forecasting that the repo rate would return into positive territory by the end of this year, and would rise as high as 80 basis points by mid-2022. They downgraded this assessment in April, and again in October, highlighting that they expected a 0% repo rate for essentially the entire three-year forecast period. In other words, the Riksbank had been moving in a dovish direction even before the COVID-19 pandemic began. Prior to the outbreak, we would have been inclined to argue that the Riksbank’s forecast of a 0% repo rate beyond 2020 was suspect, given the budding recovery in global growth. Chart I-12 highlights that the global PMI had been improving for several months prior to the outbreak, and the Swedish PMI and consumer confidence index had recently rebounded sharply. A negative repo rate was essential to “import” inflation. But, given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, and our description of the Riksbank mandate and reaction function, the odds appear to be high that the repo rate will move back into negative territory at some point this year. Besides the very negative direct impact to global trade from the pandemic, Chart I-13 highlights that Swedish inflation is now falling, and that our measure of inflation expectations has now peaked. Chart I-12Swedish Economic Momentum Was Building Prior To The Pandemic... Char I-13...But Inflation Is Falling And The Unemployment Rate Is Rising In addition, the Swedish unemployment rate has been trending higher since early-2018 (Chart I-13, second panel), in response to several factors: a shock to household wealth in late-2015/early-2016 due to sharply falling equity prices, a meaningful decline in house prices driven by newly introduced macroprudential policies, and a sharp albeit seemingly one-off decline in the contribution to Swedish economic growth from government expenditure (Chart I-14). These trends would have likely reversed at some point this year given the building economic momentum that was evident in January and early-February, but it is now clear that the pandemic will more than offset the budding improvement in economic activity. Chart I-14Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Over the past week the Riksbank has announced two policies: it will provide cheap loans to the country’s banks (500 billion SEK) to bolster credit supply to Swedish small & medium-sized enterprises, and it will increase its asset purchase program by 300 billion SEK. The Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, and has argued that strong liquidity support and stepped up asset purchases are more likely to be effective measures in the current environment. However, Charts I-10 & I-11 underscored the link between real interest rate differentials and the currency, and the Riksbank will risk having the krona appreciate versus the euro and other currencies if inflation continues to fall and the policy rate is kept unchanged. Chart I-15 shows that market participants have already begun to price in cuts to the repo rate, and our sense is that the Riksbank will be forced to act in a way that is consistent with the market’s view. Chart I-15The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. Investment Conclusions Over a cyclical (i.e. 6-12 month) time horizon, the Swedish krona is the asset with the clearest link to our discussion of Riksbank policy, and investors should recognize that the krona call is now a binary one based on the evolution of the COVID-19 pandemic. It is one of the cheapest currencies in the G10 space, but foreign exchange markets have recently ignored fundamentals such as interest rate differentials and valuation. This is particularly true in the face of a spike in US dollar cross-currency basis swaps, which have started to send the dollar higher even against the safe haven currencies. In such an a environment, selling pressure could continue to push SEK lower, especially if the Riksbank is pushed to reduce the repo rate sooner rather than later. The SEK is one of the most procyclical currencies in the FX space, suggesting that investors should stand aside until markets stabilize (Chart I-16). Right now, the Swedish krona is the clearest play on Riksbank policy. As for the EUR/SEK cross, any renewed ECB stimulus suggests that Sweden will act accordingly to prevent the SEK from appreciating too far, too fast. EUR/SEK will top out after global growth is in an eventual upswing, and the Riskbank has eased policy further. Over the medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends. House prices will likely decelerate in the near term given the shock to household wealth from falling equity prices, but we showed in Chart I-5 that Sweden’s household sector ultimately took advantage of low interest rates during Sweden’s second monetary policy phase. We expect a similar dynamic to unfold beyond the coming 6-9 months, and Chart I-17 highlights that overweighting Swedish consumer durable and apparel stocks within the overall Swedish equity market is likely the best way to eventually play a resumption of household leveraging and rising house prices. Chart I-16Avoid Krona Exposure ##br##For Now Chart I-17Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand With the exception of a selloff in 2013, the relative performance of the industry group has closely correlated with house price appreciation, and is now deeply oversold. The companies included the industry group earn a significant portion of their revenue from global sales, but the close correlation of relative performance with Swedish house prices and limited correlation with the global PMI suggests that domestic economic performance matter in driving returns for these stocks (Chart I-17, bottom panel). We are not yet prepared to recommend a long relative position favoring this industry group, but we are likely to view signs of policy traction and a relative performance breakout as a good entry point. Finally, the key long-term implication of our research is that Sweden will at some point likely face a period of stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. While regulators had begun to combat excessive debt with macroprudential measures, further measures to restrict household sector debt are extremely unlikely to occur until after another substantial reacceleration in Swedish house prices and another nontrivial rise in household sector leverage. This will be cyclically positive for Sweden coming out of the pandemic, but will ultimately make Sweden’s underlying debt problem meaningfully worse. Macroprudential control of rising nonfinancial corporate debt has not and is not likely to occur, and no regulatory control measure will be able to significantly ease the existing debt burden facing the private sector. Chart I-18 highlights that while Sweden’s private sector debt service ratio (DSR) is not the highest in the world, is it extremely elevated compared to other important DM countries such as the US, UK, Japan, and core euro area. Several other countries with higher private sector DSRs, such as Canada and Hong Kong, are also at serious risk of long-term stagnation. Chart I-18Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' We have not yet identified a specific list of assets that will be negatively impacted by Swedish domestic economic stagnation over the longer term. Our European Investment Strategy service recently argued that Swedish stocks are attractive over the very long term versus Swedish bonds, based on valuations and the fact that the Swedish equity market as a whole is heavily driven by the global business cycle. We plan on revisiting the question of which equity sectors are most vulnerable to domestic stagnation in a future report, as the onset of stagnation draws nearer. As we noted in our report on Canada,3 it is difficult to identify precisely when Sweden’s high debt load will meaningfully and sustainably impact Swedish economic activity and related equity sectors. The acute shock to global activity from the COVID-19 pandemic is an obvious potential trigger, but the fact that policymakers around the world are responding forcefully to the pandemic suggests that this is not the end of Sweden’s debt supercycle. In this regard, the prospect of globally co-ordinated fiscal spending is especially significant. Our best guess is that Sweden’s true reckoning will come once US and global activity contracts for conventional reasons, instigated by tight monetary policy to control rising and above-target inflation. This may mean that Sweden will avoid a balance sheet recession for some time, but investors exposed to domestically-linked Swedish financial assets should take heed that the eventual consequences of such an event are likely to grow in magnitude the longer it takes to arrive. In short, beyond the acute nearer-term impact of the pandemic, Sweden is likely to experience short-term gain for long-term pain. The short- to medium-term focus of investors should be on the former, but with full recognition that the latter will eventually occur. Timing the transition between these two states will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com 2 We assume that all services imports are consumed domestically. Among goods exports, we assume domestic consumption of all imports of food & live animals, beverages & tobacco, mineral fuels, lubricants, and related materials, miscellaneous manufactured articles, road vehicles, and other goods. 3 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com

Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis.  One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect.  As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.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

Dear Client, In addition to this week’s report, BCA Research will hold webcasts over the coming days to discuss the economic and financial outlook amid the myriad of uncertainties gripping global markets. I will take part in a roundtable discussion alongside my fellow BCA Strategists Arthur Budaghyan, Mathieu Savary, and Caroline Miller for a live webcast on Friday, March 13 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). In addition, I will hold a webcast on Monday, March 16 at 12:00 PM EDT (4:00 PM GMT). Best regards, Peter Berezin, Chief Global Strategist Highlights A global recession is now a fait accompli. The only question is whether there will be a technical recession lasting a couple of quarters, or a more prolonged downturn that produces a sizeable increase in unemployment rates. We lean towards the former outcome. Unlike during most recessions, the decrease in labor demand will be mitigated by a decline in labor supply, as potentially millions of workers are confined to their homes. This will limit the rise in unemployment, at least initially. The pandemic is likely to prompt firms to increase inventory levels for fear of further disruptions to their supply chains. This should provide a short-term boost to output. While it is possible that spending will remain broadly depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis, while ultra-low government bond yields will incentivize increased fiscal outlays. Spending on leisure travel and public entertainment will remain subdued well into 2021, but much of this demand will be redirected to other categories of discretionary consumer purchases, particularly in the online realm. Health care expenditures will also increase. The collapse in oil prices following the breakdown of OPEC 2.0 represents a positive supply shock for the global economy, albeit one that will have negative consequences for oil-extraction sectors. We tactically upgraded stocks on the morning of Friday, February 28. That was obviously a major mistake: While global equities did rally 7% higher after our upgrade, they have since given up all their gains (and then some). For now, we are maintaining a modest overweight recommendation to equities. However, this is a low-conviction view, and we would not dissuade more conservative investors from reducing risk exposure. We would only consider upgrading stocks to a high-conviction overweight if the S&P 500 dropped to 2250, or the number of new infections outside of China peaked. In the meantime, we are downgrading high-yield credit tactically, as the odds of earnings weakness prompting a near-term rise in default expectations warrant caution. What A Way To Start The Decade So far, the 2020s may not be roaring, but they are certainly not boring. At the outset of the crisis, there were three scenarios for the COVID-19 outbreak: 1) A regional epidemic largely confined to China; 2) a series of global outbreaks, successfully short-circuited by a combination of government intervention and voluntary “personal distancing” measures; 3) A full-blown pandemic that exposes a significant proportion of the planet to the virus. Unfortunately, the first scenario has been ruled out. Policymakers are now trying to achieve the second scenario. Successful containment would “flatten the curve” of new infections, while allowing the sick to receive better treatment than they would otherwise. It would also buy precious time to develop a vaccine and increase the output of face masks, hand sanitizers, and other products that could slow the spread of the disease. Health Versus Growth Ironically, while the second scenario is clearly preferable to a full-blown pandemic from a health perspective, it may be more damaging from the very narrow, technical perspective of GDP accounting. It all depends on how severe the measures to quash each outbreak need to be. If simple hygiene measures and social distancing turn out to be enough, the economic fallout will be minimal. If ongoing mass quarantines and business closures are necessary, the damage will be severe. History suggests that containment efforts can work. During the Spanish flu, US cities such as St. Louis, which took early action to slow the spread of the disease, ended up with far fewer deaths than cities such as Philadelphia which did not (Chart 1). Western Samoa did not impose any travel restrictions and lost a quarter of its population. American Samoa closed its border and suffered no deaths. Chart 1Containment Efforts Can Be Effective: The Case Of The Spanish Flu Recent experience suggests that COVID-19 can be stopped, even after community contagion has set in. The number of new Chinese cases has fallen from 3,892 on February 5 to 31 on March 11. South Korea seems to be getting the virus under control. The number of new cases there has declined from 813 on February 29 to 242 (Chart 2). Japan and Singapore also appear to be succeeding in preventing the virus from spreading rapidly. Chart 2Coronavirus: The Authorities In East Asia Seem To Be In Control Of The Situation What remains unclear is whether other countries can replicate East Asia’s experience. A recent Chinese study estimated that R-naught – the average number of people someone with the virus ends up infecting – fell from 3.86 at the outset of the outbreak to 0.32 following interventions (Chart 3).1 In other words, China was able to lower R-naught to one-third of what was necessary to stabilize the number of new infections. If one wanted to be optimistic, one could argue that other countries could get away with less heavy-handed measures, even if it is at the expense of a somewhat slower decline in the infection rate. Chart 3Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak Unfortunately, given how contagious the virus appears to be, it is unlikely that simple measures such as regularly washing one’s hands, avoiding large gatherings, and wearing a face mask in public when sick will suffice. Trade-offs will have to be made between growth and health. Moreover, if the virus becomes endemic in a few countries that do not have the institutional capacity to contain it, this could create a viral reservoir that produces repeated outbreaks in the wider world. The result could feel like a ghastly game of whack-a-mole. The Fatality Rate The degree to which countries pursue costly containment measures depends on how deadly the virus turns out to be. On the one hand, there is some evidence that the fatality rate from COVID-19 is lower than the 2%-to-3% that has been widely reported once mild or asymptomatic cases, which often go undetected, are taken into account. This may explain why South Korea, which has arguably done a better job of testing suspected patients than any other country, has reported a fatality rate of only 0.7%. Like the seasonal flu, the death rate from COVID-19 appears to be heavily tilted towards the elderly. In Italy, 89% of COVID-19 deaths have occurred among those who are 70 and older. On the ill-fated Diamond Princess cruise liner, not a single person under the age of 70 has died. The fatality rate for passengers on the ship older than 70 is 2.4%. The seasonal flu kills about 1% of those it infects over the age of 70. Based on this simple calculation, COVID-19 is more lethal, but not light-years more lethal, than the typical flu (and possibly less lethal than the flu is for young children). Unfortunately, these optimistic estimates assume that patients with COVID-19 can continue to receive appropriate care. As we saw in Wuhan, where the official death rate stands at 4.5% compared to 0.9% in the rest of China, and as we are now seeing in Italy, once the health care system becomes overwhelmed, death rates can rise sharply. Bottom Line: Containing the virus will be economically costly, but given the potentially large death toll from a full-blown pandemic, most countries will be willing to pay the price. A Global Recession Even before the virus became endemic outside China, we estimated that global growth would fall to zero on a quarter-over-quarter basis in Q1. As we cautioned back then, the risk to our forecast was tilted to the downside, and that has proven to be the case. We now expect the global economy to shrink not just in the first quarter but in the second quarter as well, as country after country experiences a surge in new infections. Two consecutive quarters of negative growth constitute a technical recession. Despite the drop in new cases in China over the past two weeks, most high-frequency measures of economic activity such as property sales, railway-loaded coal volumes, and traffic congestion have yet to return anywhere close to normal levels (Chart 4). In the US, hotel occupancy rates, movie ticket sales, and attendance at sporting events were all close to normal levels as of last week. However, that is changing quickly. Already, automobile traffic in Seattle, one of the cities most hard-hit by the virus, has fallen sharply (Chart 5). Chart 4China: It Will Take Time For Life To Return To Normal Chart 5US: Staying Home More In Seattle Due To The Virus? Qualitatively Different While a recession in the first half of 2020 is now unavoidable, the nature of this recession is likely to be quite different than in the past. To understand why, it is useful to review what causes most recessions. A typical recession involves a prolonged loss of aggregate demand. Such a loss of demand can result from either financial market overheating or economic overheating. Financial market overheating can occur if a credit-fueled asset bubble bursts, leaving people with less wealth struggling to pay off debt. For example, US residential investment fell from 6.6% of GDP in 2005 to 2.5% of 2010. Thus, even after the credit markets thawed, there was still a large hole in aggregate demand that needed to be filled. A similar, though less severe, loss of demand occurred when the bursting of the dotcom bubble led to severe cutbacks in IT spending. Economic overheating occurs when a lack of spare capacity puts upward pressure on inflation. Wary of accelerating prices, central banks slam on the brakes, raising interest rates into restrictive territory. This often results in a recession. In both types of recessions, there are usually second-round effects that can swamp the initial shock to aggregate demand. As spending falls, firms start to lay off workers. The resulting loss in household income leads to less spending. Even those who retain their jobs are apt to feel less confident, leading to an increase in precautionary savings. For their part, businesses tend to cut production as inventory levels swell. Things only return to normal once enough pent-up demand has accumulated and/or policy has become sufficiently stimulative to revive spending. Framed in this way, one can see that the current downturn differs from past downturns in at least three important respects. First, unlike during most recessions, the decrease in labor demand this time around will be partly mitigated by a decline in labor supply, as potentially millions of workers are confined to their homes. While this will not prevent many workers from temporarily losing income, it will limit the increase in unemployment, at least initially. We have already seen this in China, where GDP growth collapsed but companies are complaining about a shortage of migrant labor. Second, rather than falling, inventory levels may actually rise. Since companies will have to deal with pervasive supply shocks of unknown frequency, duration, and magnitude, their natural inclination will be to increase inventory levels for fear that they will not be able to access their supply chains when they need them. If recent reports of hoarding of toilet paper and bottled water are any guide, the same sort of behavior will show up among consumers. Again, in the short term, this additional demand will help to keep unemployment from rising as much as it would otherwise. Third, and perhaps most importantly, the ongoing crisis is the result of an exogenous shock rather than an endogenous slowdown. In fact, a variety of economic indicators such as US payrolls, the Chinese PMI, and German factory orders were all pointing to an acceleration in global growth before the crisis began. This suggests that growth could recover quickly once the panic subsides. While it is impossible to say with any degree of certainty how long it will take for the panic to end, it may not last as long as many fear. Investors should particularly pay attention to the situation in Italy. If the number of new cases peaks there, it could create a sense that other western countries will be able to get the virus under control. Second-Round Effects? Although it is possible that economies will remain depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis. The private-sector financial balance – the difference between what companies and households earn and spend – is in surplus in most countries, including China (Chart 6). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7Lower Oil Prices Eventually Lead To Higher Growth Granted, not all sectors are likely to prove equally resilient. Spending on leisure travel and public entertainment will remain subdued well into 2021. The collapse in oil prices following the breakdown of OPEC 2.0 will also wreak havoc on oil producers. In both cases, however, there will be offsetting benefits. Much of the demand for travel and entertainment will be redirected to other categories of discretionary consumer purchases, particularly in the online realm. And while lower oil prices will hurt producers, they represent a boon for consumers and companies that use petroleum as an input. In general, as Chart 7 illustrates, global growth usually accelerates following declines in oil prices. Fiscal Policy Will Turn More Stimulative Even before the crisis began, we argued that most governments should permanently increase fiscal deficits in order to raise the neutral rate of interest. At the current juncture, with a recession upon us and government bond yields at ultra-low levels, the failure to enact meaningful fiscal stimulus would be economic malpractice of the highest order. In addition to easing measures being rolled out by central bankers, our sense is that we will get a lot of fiscal stimulus, sooner rather than later. During most recessions, there is always a chorus of voices from people whose own jobs are secure about how a downturn is necessary to cleanse the system. This time around, it is obvious that the victims are not to blame. Politicians will not endear themselves to voters by denying the need for fiscal support to households struggling with medical bills and lost time from work and businesses facing bankruptcy. President Trump’s pledge this week to cut payroll taxes and increase transfers to those affected by the virus is just a taste of what’s to come. Investment Conclusions Chart 8Stock-To-Bond Ratio: A Lot Of The Bad News Has Already Been Priced In We tactically upgraded stocks on the morning of Friday, February 28. That was obviously a major mistake: While global equities did rally 7% higher after our upgrade, they have since given up all their gains (and then some). In retrospect, we should have paid more attention to our own analysis in our report “Markets Too Complacent About The Coronavirus.” For now, we are maintaining a modest overweight recommendation to equities. The total return ratio between stocks and bonds has fallen by a similar magnitude as in the run-up to prior recessions, suggesting that much of the bad news has already been priced in (Chart 8). Nevertheless, significant downside risks remain, which is why we would characterize our equity overweight as a fairly low-conviction view. We would not dissuade more conservative investors from reducing risk exposure. As discussed above, containing the virus could lead to significant economic disruptions. We would only consider upgrading stocks to a high-conviction overweight if the S&P 500 dropped to 2250, or the number of new infections outside of China peaked. In the meantime, we are downgrading high-yield credit tactically, as the odds of earnings weakness prompting a near-term rise in default expectations warrant caution. Safe-haven government bond yields will probably not rise much from current levels, at least in the near term. The Fed cut rates by 50 basis points last week and will cut rates by another 50 basis points next week. Looking further out, however, bonds are massively overvalued and will suffer mightily as life returns to normal.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

  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 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 An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Clients, In our final publication of the year, we bring you a recap of this past week’s significant events in Sino-US relations and the key messages from the Central Economic Work Conference. Accordingly, we are upgrading our tactical stance towards Chinese stocks from neutral to overweight.  Our publishing schedule will resume on January 9, 2020 with our monthly Macro and Market Review. Our China Investment Strategy team wishes you a happy holiday season and a prosperous New Year! Best regards, Jing Sima, China Investment Strategist Highlights We are upgrading our tactical call on Chinese stocks from neutral to overweight. Recent developments in the Chinese investable equity market point to a risk-on sentiment. The fact the US and China have reached an agreement likely marks the beginning of a truce, which could potentially last through the US presidential election in November 2020. The CEWC statement from last week reinforces our view that China's leadership feels the urgency to stabilize the economy now outweighs the desire to continue financial deleveraging.  Feature Signals from the Chinese investable equity market have titled in a bullish direction. This shift is accompanied by two modestly bullish developments:  First, the annual China Economic Work Conference (CEWC) concluded on December 12 with support for a more reflationary stance for the coming year. Then, a day later, the US and Chinese officials confirmed they have agreed on a Phase One trade deal.  The combination of these developments provides a sufficient basis to upgrade our tactical (0-3 month) stance on Chinese stocks from neutral to overweight (within a global equity portfolio), to be consistent with our bullish cyclical (6-12 month) stance. Equity Market Signals Have Become Bullish In our previous reports, we highlighted that the relative performance of some sectors in the Chinese investable equity market reflects China’s policy direction and financial market conditions, supporting our bullish/bearish calls on Chinese stocks. Recently, two of the three equity market telltale signs that we have been watching have turned favorable for a bullish view on Chinese stocks (Chart 1A and 1B): Chart 1ACountercyclical Sector Stock Performance Points To Improvement In Economic Activity Chart 1BThe Breakdown Of Defensive Stocks Suggests A Return Of Risk-On Sentiment Chart 1A (top panel) shows that the relative performance of investable utility stocks have broken down, signifying that market participants anticipate the slowdown in China’s economy will soon bottom.  Investable healthcare stocks have not breached their 200-day trend, but are headed in that direction (Chart 1A, bottom panel). Key equity market signs have turned supportive for a bullish tactical call on Chinese stocks. Cyclical stocks are outperforming defensives in both China’s onshore and offshore markets, reflecting improved investor sentiment towards China’s economic outlook (Chart 1B). Bottom Line: Key equity market signs have turned supportive for a bullish call on Chinese stocks for the next 0 to 3 months. Phase One Trade Deal: Unimpressive But Pragmatic Adding to this bullish shift in equity market signals was the first of two positive fundamental improvements over the past week. The US and China reached agreement on a Phase One deal just a few days before the 15% tariff increase on $160 billion of Chinese export goods to the US was scheduled to come into effect. Reportedly, the two sides agreed to pause the 15% tariff scheduled for December 15 and lower the tariff on about $120 billion of Chinese imports to 7.5%.  However, the 25% tariffs on the first $250 billion of Chinese imports will remain in place (Chart 2). Chart 2Tariff Rollbacks Unimpressive... Chart 3...But China's Promise To Buy American Goods Helps Trump Claim Victory In return, China agrees to, in the next two years, boost imports of American goods and services by a total of $200 billion from their levels in 2017 (Chart 3).  While no specific number has been confirmed from the Chinese side, in a news conference, Chinese officials said that China “will expand imports of some agriculture products currently in urgent need, such as pork and poultry.” Given that both sides picked low hanging fruit in the Phase One deal, the tougher issues to be discussed in Phase Two could lead to a breakdown in negotiations, which potentially could unravel the Phase One tariff rollbacks. Nevertheless, the agreement serves an interim purpose for both President Trump and President Xi: it allows Trump to claim a short-term political victory on his trade negotiations with China, and gives Xi some breathing space to focus on domestic economic challenges.  Bottom Line: While the Phase Two negotiations, when commencing, will be a risk to the Phase One trade deal, the current agreement likely marks the beginning of a truce, which could potentially last through the November’s presidential election in 2020. CEWC: Reinforcing Reflationary Bias For 2020 In addition to the trade deal, another bullish factor for stocks is the fact that Chinese policymakers will proactively fine-tune economic policy to mitigate the impact from the US tariffs that remain in effect and to ensure stable economic growth in the coming year. President Xi at last week’s Central Economic Work Conference (CEWC) urged that Chinese policymakers must “make contingency plans” to combat challenges from both domestic and external environment. At the three-day annual CEWC this year, Chinese central and local government officials set the direction and strategy of China’s economic policy for the coming year. The meeting also reveals the challenges Chinese policymakers are facing, and the areas they will likely mobilize monetary resources to tackle. Investors can therefore benefit from insights into both the direction and constraints of China’s near-term policy framework. We highlight four investment-relevant messages from this year’s CEWC: A Greater Emphasis On Growth Stability The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The statement from the meeting mentioned “stability” 31 times, compared with 22 in 2018.1  The statement also reiterated the importance of doubling GDP and per capita income by 2020. This suggests that a growth imperative remains the top priority and reinforces the leadership’s reflationary policy stance for next year. We previously projected that the Chinese government would allow a lower GDP growth target for 2020, between 5.5 and 6.0%. However, we think growth targets to be set at next March’s National People’s Congress (NPC) are more likely to be in a “reasonable range” (verbiage used in the CEWC statement) between 5.8 and 6.2%. As noted in our December 11 report,2 the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms. While China’s real GDP statistics are suspiciously smooth and largely invalid when it comes to equity market pricing, the deviation between market expectations and the actual GDP growth target range set at NPC can help investors gauge how much more (or less) ammunition Chinese policymakers are willing to deploy to support the economy in that year. China is falling short of its target to double real urban per capita income next year from 10 years ago (Chart 4). Nominal wage and salary per capita growth has experienced a sharp drop since the third quarter of 2018 and probably contributed to the subdued appetite for consumption (Chart 5). Chart 4Household Income: Rural Overshooting; Urban Falling Short Chart 5Wage Growth Only Started Stabilizing Recently   To meet the target, urban per capita income will need to grow at an above-real GDP rate of 10% in 2020, almost doubling the growth in 2018 and 2019.  Given the still weak domestic economic conditions, we are not optimistic that China will be able to double the growth rate of urban income per capita in 2020 from 2019. Additionally, income typically lags economic activity. Even if China’s economic slowdown bottoms in the first quarter of 2020, it is unlikely we will see significant improvement in income until a few quarters later. Therefore, we think policymakers will likely focus on overall economic and employment growth stability, and poverty reduction through improving rural income in 2020 (Chart 4, top panel). A Shift In Policy Priorities The new year marks the final year of the “Three Major Battles” against financial deleveraging, poverty elimination, and pollution. In this year’s CEWC statement, for the first time in three years, the order of the battles has been rearranged with financial deleveraging ranked behind poverty reduction and environment protection. The PBoC will stay on a mild rate-cutting cycle throughout next year. The shift in policy priorities suggests that the pressure to deleverage has greatly eased. Banks’ asset balance sheets will expand at a faster rate, while the pace of reduction in shadow banking will likely continue to moderate (Chart 6). The description of monetary policy stance was amended to “maintaining a flexible and appropriate monetary policy” from last year’s “appropriately loose or tight.” The change points to a more dovish tone, confirming our assessment that the PBoC will stay on a mild rate-cutting cycle to lower corporate funding costs throughout the next year3 (Chart 7). Chart 6In 2020, Expect Faster Bank Balance Sheet Expansion Chart 7The PBoC's Rate-Cutting Cycle Will Continue Next Year   At this stage, we do not anticipate the Chinese policymakers will entirely abandon financial risk containment or significantly loosen financial regulations. Rather, we think the reduced pressure on deleveraging and lowering of funding costs will provide moderate support for the private sector, specifically small- and medium-sized enterprises.  A slew of new policies announced before the CEWC, including an adjustment to some of the parameters in the Macro-Prudential Assessment (MPA) framework to encourage lending to the private sector,4 will help strengthen the impact of PBoC’s countercyclical measures. A Bigger Fiscal Push This year’s CEWC statement indicated policymakers will continue to fine-tune a proactive fiscal policy, but unlike last year, the meeting did not specify further cuts to taxes. The statement suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year. Chart 8Local Governments Have Borrowed More Than They Spent In 2019, infrastructure investment was subdued, despite increased quotas for local government special-purpose bond issuance. Our research shows that local government infrastructure expenditures in 2019 have consistently lagged behind their borrowing (Chart 8). The gap between local government infrastructure funding deficit and borrowing has only started flattening in the third quarter of this year. The delayed conversion from borrowing to spending means local governments have accumulated more spending power for 2020. In order to encourage local governments to speed up spending, the central government is also likely to further loosen up project restrictions. A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019.5  More robust fiscal stimulus will lead to an increase in the debt load of local governments, but Chinese policymakers are caught between a rock and a hard place and therefore must choose the least risky tools to stimulate the economy.  In our view, local government bonds are still a better option over local government financing vehicles (LGFVs) or other illicit channels. Social Housing Gets Another Boost Surprisingly,6 last week’s CEWC statement again emphasized the importance of shantytown renovation (Chart 9). While this implies there would likely be a significant monetary boost to social housing in the coming year, the statement also indicated that policymakers would not want property prices to dramatically change in either direction. Even though local governments have been granted more flexibility to fine-tune their local housing policies, we think the possibility of a broad-based regulatory easing in the housing market remains low in 2020. Therefore, government subsidies in social housing in 2020 will unlikely to lead to another property market boom like that of 2016. Chart 9Social Housing Gets Another Fiscal Boost If the scale of the cyclical policy support in 2020 is still moderate, then we think the stimulus may delay, but not entirely derail China’s progress in structural rebalancing, particularly if the current financial regulations remain in place. The CEWC statement also mentioned deepening reforms of state-owned enterprises (SOEs), and a “three-year SOE reform executive plan”, which we will be closely monitoring in the coming year. Last year’s reference to “striving for stronger, better and larger state assets” was replaced this year by “accelerating the reform of SOEs and optimization of SOE resource allocation”, implying there will be a greater emphasis on the quality and efficiency of SOEs’ assets. These plans can potentially impact SOE profit margins and accelerate the pace of industry consolidation among SOEs. The statement also dedicated a lengthy and detailed segment to "promoting high-quality development", covering topics ranging from the reform of the agricultural supply side to accelerating the implementation of regional development strategies. Further details are expected after next March’s NPC in Beijing. At that time, we will have a Special Report to consider some of the strategic and regional planning initiatives discussed at the meeting and their market implications. Bottom Line: The past week’s CEWC reinforces our view, that the Chinese leadership’s urgency to stabilize the economy has shifted to overweigh the desire to continue financial deleveraging.  Monetary policy will only moderately loose further, but fiscal stimulus may overshoot in the first half of 2020.  Investment Conclusions We have been cyclically overweight Chinese stocks on the basis of a bottoming in the economy in the first quarter of 2020, and the likelihood of an eventual trade deal.  Tactically however, we have been more cautious because of the potential for further near-term downside in the economic data, and the uncertainty surrounding the timing and nature of a trade deal. While the tariff reduction in the trade deal announced last week is somewhat disappointing, the combination of a trade agreement, bullish equity market signals, and the positive messages from last week’s CEWC warrant an upgrade to our tactical stance on Chinese stocks from neutral to overweight. As such, our cyclical and tactical calls are now both aligned in favor of Chinese stocks within a global equity portfolio. As a final point, we noted in last week's report that there are decent odds that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. In the new year, we look forward to providing an ongoing assessment of whether Chinese economic growth has more or less potential upside than we currently expect, along with the attendant investment implications of our analysis. Stay tuned!   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1   http://www.gov.cn/xinwen/2019-12/12/content_5460670.htm http://www.xinhuanet.com/english/2019-12/12/c_138626531.htm 2   Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com 3, 5 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 4   http://www.gov.cn/premier/2019-12/14/content_5461147.htm 6   In our last week’s China Investment Strategy 2020 Outlook report, we had projected less monetary support to this sector in 2020. Cyclical Investment Stance Equity Sector Recommendations

Highlights 2019 was a good year for our constraint-based method of political analysis. Trump was impeached, the trade war escalated, and China (modestly) stimulated – all as predicted. Nevertheless Trump caught us by surprise in Q2, with sanctions on Iran and tariffs on China. Our best trades were long defense stocks, gold, and Swiss bonds. Our worst trade was long rare earth miners. Feature Jean Buridan’s donkey starved to death because, faced with equal bundles of grain on both sides, it could not decide which to eat. So the legend goes. Investors face indecision all the time. This is especially the case when a geopolitical sea change is disrupting the global economy. Two or more political outcomes may seem equally plausible, heightening uncertainty. What is needed is a method for eliminating the options that require the farthest stretch. That’s what we offer in these pages, but we obviously make mistakes. The purpose of our annual report card is to identify our biggest hits and misses so we can hone our ability to combine fundamental macro and market analysis with the “art of the possible,” delivering better research and greater returns for clients. This is our last report for 2019. Next week we will publish a joint report with Anastasios Avgeriou of BCA Research’s US Equity Strategy. We will resume publication in early January. We wish all our clients a merry Christmas, happy holidays, and a happy new year! American Politics: Unsurprising Surprises Chart 1Our 2019 Forecast Held Up On the whole our 2019 forecast held up very well. We argued that the global growth divergence that began in 2018 would extend into 2019 with the Fed hiking rates, a lack of massive stimulus from China, and an escalation in the US-China trade war. The biggest miss was that the Fed actually cut rates three times – addressed at length in our BCA Research annual outlook. But the bulk of the geopolitical story panned out: the US dollar, US equities, and developed market equities all outperformed as we expected (Chart 1). Geopolitical risk in the Trump era is centered on Trump himself. Beginning in 2017, we argued that the Democrats would take the House of Representatives in the midterm elections and impeach the president. Congress would not be totally gridlocked: while we argued for a government shutdown in late 2018, we expected a large bipartisan budget agreement in late 2019 and always favored the passage of the USMCA trade deal. Still, Congress would encourage Trump to go abroad in pursuit of policy victories, increasing geopolitical risks. We also argued that, barring “smoking gun” evidence of high crimes, the Republican-held Senate would acquit Trump – assuming his popularity held up among Republican voters themselves (Chart 2). These views either transpired or remain on track. The implication is that Trump-related risk continues and yet that Trump’s policies are ultimately constrained by the guardrails of the election. The latter factor helped propel the equity rally in the second half of the year. We largely sat out that rally, however. We overestimated the chances that Senator Bernie Sanders would falter and Senator Elizabeth Warren would swallow his votes, challenging former Vice President Joe Biden for the leading position in the early Democratic Party primary. We expected a significant bout of equity volatility via fears of a sharp progressive-populist turn in US policy (Chart 3). Instead, Sanders staged a recovery, Warren fell back, Biden maintained his lead, and markets rallied on other news. Chart 2Trump Will Be Acquitted Chart 3Fears Of A Progressive Turn Did Not Derail The H2 Rally Warren could still recover and win the nomination next year. But the Democratic Primary was not a reason to remain neutral toward equities, as we did in September and October. China’s Tepid Stimulus In recent years China first over-tightened and then under-stimulated the economy – as we predicted. But we misread the credit surge in the first quarter as a sign that policymakers had given up on containing leverage. In total this year’s credit surge amounts to 3.4% of GDP, about 1.2% short of what we expected (based on half of the 9.2% surge in 2015-16) (Chart 4). China’s credit surge was about 1.2% short of what we expected, but the direction was correct. While the government maintained easy monetary policy as expected, its actions combined with negative sentiment to snuff out the resurgence in shadow banking by mid-year (Chart 5). Chart 4China's Credit Surge Was Underwhelming Still, China’s policy direction is clear – and fiscal policy is indeed carrying a greater load. The authorities are extremely unlikely to reverse course next year, so global activity should turn upward (Chart 6). Our “China Play Index” – iron ore prices, Swedish industrials, Brazilian stocks, and EM junk bonds, all in USD terms – has appreciated steadily (Chart 7). Chart 5China's Shadow Banking Remained Under Pressure   Chart 6Global Activity Should Turn Upward In 2020 Chart 7Our 'China Play Index' Performed Well US-China: Underestimating Trump’s Risk Appetite We have held a pessimistic assessment of US-China relations since 2012. We rejected the trade truces agreed at the G20 summits in December 2018 and June 2019 as unsustainable. Our subjective probabilities of Trump achieving a bilateral trade agreement with China have never risen above 50%. Since September we have expected a ceasefire but not a full-fledged deal. Nevertheless we struggled with the timing of the trade war ups and downs (Chart 8). In particular we accepted China's new investment law as a sufficient concession and were surprised on May 5 when talks collapsed and Trump increased the tariffs. The lack of constraints on tariffs prevailed in 2019 but in 2020 the electoral constraint will prevail as long as Trump still has a chance of winning. Our worst trade recommendation of the year emerged from our correct view that the June G20 summit would lead to trade war escalation. We went long rare earth miners based outside of China. We expected China to follow through on threats to impose a rare earth embargo on the US in retaliation for sanctions against Chinese telecom giant Huawei. Not only did the US grant Huawei a reprieve, but China’s rare earth companies outperformed their overseas rivals. The trade went deeply into the red as global sentiment and growth fell (Chart 9). Only with global growth turning a corner have these high-beta stocks begun to turn around. Chart 8Expect A Ceasefire, Not A Full-Fledged Trade Agreement Chart 9Our Worst Call: Long Rare Earth Miners Chart 10North Korean Diplomacy Has Not Collapsed (Yet) Our sanguine view on North Korea was largely offside this year. Setbacks in US negotiations with North Korea have often preceded setbacks in US-China talks. This was the case with the failed Hanoi summit in February and the inconsequential summit at the demilitarized zone in June. This could also be the case in 2020, as Washington and Pyongyang are now on the verge of breaking off talks with the latter threatening a “Christmas surprise” such as a nuclear or missile test. It is not too late to return to talks. Beijing is the critical player and is still enforcing crippling sanctions on North Korea (Chart 10). Beijing would benefit if North Korea submitted to nuclear and missile controls while the US reduced its military presence on the peninsula. We view this year as a hiccup in North Korean diplomacy but if talks utterly collapse and military tensions break out then it would undermine our view on US-China talks, Trump’s reelection odds, and US Treasuries in 2020. Hong Kong, rather than Taiwan, became the site of the geopolitical “Black Swan” that we expected surrounding Xi Jinping’s aggressive approach to domestic dissent. We have never downplayed Hong Kong. The loss of faith in the governing arrangement with the mainland began with the Great Recession and shows no sign of abating (Chart 11). We shorted the Hang Seng after the protests began, but closed at the appropriate time (Chart 12). The problem is not resolved. Also, Taiwan can test its autonomy much farther than Hong Kong and we still expect Taiwan to become ground zero of Greater China political risk and the US-China conflict. Chart 11Hong Kong Discontent Is Structural Chart 12Our Hang Seng Short Is Done Chart 13Trump Needs A Trade Ceasefire Trump is unlikely to seek another trade war escalation given the negative impact it would have on sentiment and the economy (Chart 13). He could engage in another round of “fire and fury” saber-rattling against North Korea, as the economic impact is small, but he will prefer a diplomatic track. Taiwan, however, cannot be contained so easily if tempers flare. As we go to press it is not clear if Trump will hike the tariff on China on December 15. Some investors would point to his tendency to take aggressive action when the market gives him ammunition (Chart 14). We doubt he will, as this would be a policy mistake – possibly quickly reversed or possibly fatal for Trump. Trump’s electoral constraint is more powerful in 2020 than it was in 2019. Chart 14Trump Ceasefire Will Last As Long As Economy Is At Risk Chart 15Our 'Doomsday Basket' Captured Trump's First Three Years Our best tactical trade of the year stemmed from the geopolitical risk in Asia (and the Fed’s pause): we recommended a long gold position this summer that gained 16%. We also closed out our “Doomsday Basket” of gold and Swiss bonds, initiated in Trump’s first year, for a gain of 14% (Chart 15). Now that the market has digested Trump’s tactical retreat, we have reinitiated the gold trade as a long-term strategic hedge against both short-term geopolitical crises and the long-term theme of populism. Iran: Fool Me Once, Shame On You … This is the second year in a row that we are forced to explain our analysis of Iran – we were only half-right. Our long-held view is that grand strategy will push the US to pivot to Asia to counter China while scaling back its military activity in the Middle East. Two American administrations have confirmed this trend. That said, there is still a risk that President Trump will get entangled in Iran and that risk is growing. Global oil volatility – which spiked during the market share wars of 2014 – declined through the beginning of 2018, until the Trump administration took clearer steps toward a policy of “maximum pressure” on Iran. The constraints on Trump are obvious: the US economy is still affected by oil prices, which are set globally, and Iran can damage supply and push up prices. Therefore Trump should back down prior to the 2020 election. Yet Trump imposed sanctions, waivered on them, and then re-imposed them in May 2019 – catching us by surprise each time (Chart 16). Chart 16Trump Flip-Flopped On Iran Policy Chart 17Iran Tensions Backwardated Oil Markets This saga is not resolved – we are witnessing what could become a secular bull market in Iran tensions. True, a Democratic victory in 2020 could lead to an eventual restoration of the 2015 nuclear deal. True, the Trump administration could strike a deal with the Iranians (especially after reelection). But no, it cannot be assumed that the US will restore the historic 2015 détente with Iran. Within Iran the regime hardliners are likely to regain control in advance of the extremely uncertain succession from Supreme Leader Ali Khamenei and this will militate against reform and opening up. We went long Brent crude Q1 2020 futures relative to Q1 2021 to show that tensions were not resolved (Chart 17) – the attack on Saudi Arabia in September confirmed this view. And yet the oil price shock was fleeting as global supply was adequate and demand was weak. Our current long Brent spot trade is not only about Iran. Global growth is holding up and likely to rebound thanks to monetary stimulus and trade ceasefire, OPEC 2.0 has strong incentives to maintain production discipline (driven by both Saudi Arabian and Russian interests), and the Iranian conflict has led to instability in Iraq, as we expected. The UK: Not Dead In A Ditch British Prime Minister Boris Johnson proclaimed this year that he would "rather be dead in a ditch” than extend the deadline for the UK to leave the EU. The relevant constraint was that a disorderly “no deal” exit would have meant a recession, which we used as our visual illustration of why Johnson would not actually die in a ditch (Chart 18). The test was whether parliament could overcome its coordination problems when it reconvened in September, which it immediately did, prompting us to go long GBP-USD on September 6 (Chart 19). This trade was successful and we remain long GBP-JPY. Chart 18The Reason We Rejected Chart 19UK Parliament Voted Down No-Deal Brexit Populism faltered in Europe, as expected. As we go to press, the UK Christmas election is reported to have produced a whopping Conservative majority. This year Johnson mounted the most credible threat of a no-deal Brexit that we are ever likely to see and yet ultimately delayed Brexit. The Conservative victory will produce an orderly Brexit. The trade deal that needs to be negotiated next year will bring volatility but it does not have a firm deadline and is not harder to negotiate than Brexit itself. The UK has passed through the murkiest parts of Brexit uncertainty. Moreover, our high-conviction view that more dovish fiscal policy would be the end-result of the Brexit saga is now becoming consensus. Europe: Not The Crisis You Were Looking For The European Union was a geopolitical “red herring” in 2019 as we expected. Anti-establishment feeling remained contained. Italy remains the weakest link in the Euro Area, but the political “turmoil” of 2018-19 is the populist exception that mostly proves the rule: Europeans are not as a whole rebelling against the EU or the euro. On France, Italy, and Spain our views were fundamentally correct. Even in the European parliament, where anti-establishment players have a better chance of taking seats than in their home governments, the true Euroskeptics who want to exit the union only make up about 16% of the seats (Chart 20). This is up from 11% prior to the elections in May this year. Chart 20Euroskepticism Was Overstated Yet the European political establishment is losing precious time to prepare for the next wave of serious agitation, likely when a full-fledged recession comes. Chart 21Trump Did Not Pile Tariffs Onto Auto Sector Germany is experiencing a slow transition from the long reign of Angela Merkel, whose successor has plummeted in opinion polls. The shock of the global slowdown – particularly heavy in the auto sector (Chart 21) – hastened Germany’s succession crisis. Chart 22Overstated EU Political Risk, Understated Chinese Risk There is a silver lining: this shock is forcing the Germans to reckon with de-globalization. Attitudes across the country are shifting on the critical question of fiscal policy. Even the conservative Christian Democrats are loosening their belts in the face of the success of the Green Party and a simultaneous change in leadership among the Social Democrats to embrace bigger spending. The Trump administration refrained from piling car tariffs onto Europe amidst this slowdown in the automobile sector and overall economy. We expected this delay, as there is little support in the US for a trade war with Europe, contra China, and it is bad strategy to fight a two-front war. But if the US economy recovers robustly and Trump is emboldened by a China deal then this risk could reignite in future. With European political risk overstated, and Chinese mainland risk understated, we initiated a long European equities relative to Chinese equities trade (Chart 22), as recommended by our colleagues at BCA Research European Investment Strategy. And now we are initiating the strategic long EUR/USD recommendation that we flagged in September with a stop at 1.18. Japan: Shinzo Abe Has Peaked Japanese Prime Minister Shinzo Abe is still in power and still very popular, whether judged by the average prime minister in modern memory or his popular predecessor Junichiro Koizumi. But he is at his peak and 2019 did indeed mark the turning point – it is all downhill from here. First, he lost his historic double super-majority in the Diet by falling to a mere majority in the upper house (Chart 23). He is still capable of revising the constitution, but now it is now harder – and the high water mark of his legislative power has been registered. Chart 23Abe Lost His Double Super Majority Chart 24Consumption Tax Hike Shows Limits Of Abenomics Second, he proceeded with a consumption tax from 8% to 10% that predictably sent the economy into a tailspin given the global slowdown (Chart 24). We thought the tax hike would be delayed, but Abe opted to hike the tax and then pass a stimulus package to compensate. This decision further supports the view that Abe’s power will decline going forward. It is now incontrovertible that the Liberal Democrats are eschewing a radical plan of debt monetization in which they coordinate ultra-dovish fiscal policy with ultra-dovish monetary policy. “Abenomics” has not necessarily failed but it is a fully known quantity. Abe will next preside over the 2020 summer Olympics and prepare to step down as Liberal Democratic party leader in September 2021. It is conceivable he will stay longer, but the likeliest successors have been put into cabinet positions, including Shinjiro Koizumi, son of the aforementioned, whom we would not rule out as a future prime minister. Constitutional revision or a Russian peace deal could mark the high point of his premiership, but the peak macro consequences have been felt. Japan suffered a literal and figurative earthquake in 2011. Over the long run Tokyo will resort to more unorthodox economic policies and redouble its efforts at reflation. But not until the external environment demands it. This suggests that the JPY-USD is a good hedge against risks to the cyclically bullish House View in 2020 and supports an overweight stance on Japanese government bonds. Emerging Markets: Notable Mentions India: We were correct that Narendra Modi would be reelected as prime minister, but we did not expect that he would win a single-party majority for a second time (Chart 25). The risk is that this result leads to hubris – particularly in foreign policy and domestic social policy – rather than accelerating structural reform. But for now we remain optimistic about reform. Chart 25 East Asia: We are optimistic on Southeast Asia in the context of US-China competition. But we proved overly optimistic on Malaysia and Indonesia this year, while we missed a chance to close our long Thai equity trade when it would have been very profitable to do so. Turkey: Domestic political challenges to President Recep Tayyip Erdoğan have led to a doubling down on unorthodox monetary policy and profligate fiscal policy, as expected. Early in the year we advised clients that Erdoğan would delay deployment of the Russian S-400 air defense system in deference to the US but it quickly became clear that this was not the case. Thus we correctly anticipated the sharp drop in the lira over the autumn (Chart 26). The US-Turkey relationship continues to fray and additional American sanctions are likely. Russia: President Vladimir Putin focused on maintaining domestic stability amid tight fiscal and monetary policy in 2019. This solidified our positive relative view of Russian currency and equities (Chart 27). But it also highlighted longer-term political risks. We expect this trend to continue, but by the same token Russia is a potential “Black Swan” risk in 2020. Chart 26The Lira's Autumn Relapse Chart 27Russia's Eerie Quiet In 2019 Venezuela: Venezuela’s President Nicolas Maduro eked out another year of regime survival in 2019 despite our high-conviction view since 2017 that he would be finished. However, the economy is still collapsing and Russian and Chinese assistance is still limited (Chart 28). Before long the military will need to renovate the regime, even if our global growth and oil outlook for next year is positive for the regime on the margin. Chart 28Maduro Clung To Power Chart 29Our 2019 Winner: Global Defense Stocks Brazil: We were late to the Brazilian equity rally. While we have given the Jair Bolsonaro administration the benefit of the doubt, a halt to structural reforms in 2020 would prove us wrong. Our worst trade of the year was long rare earth miners, mentioned above. Our best trade was long global defense stocks (Chart 29), a structural theme stemming from the struggle of multiple powerful nations in the twenty-first century. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Jingnan Liu Research Associate jingnan@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com

  Dear Client, In lieu of our regular report next week, I will be hosting a webcast on Wednesday, December 18th at 10:00 AM EST, where I will discuss the major investment themes and views I see playing out for 2020. This will be the last Global Investment Strategy report of 2019, with publication resuming early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist   Overall Investment Strategy: Global growth should accelerate in 2020. Favor stocks over bonds. A more defensive stance will be appropriate starting in late 2021. Equities: Upgrade non-US equities to overweight at the expense of their US peers. Cyclical stocks, including financials, will outperform defensives. Fixed Income: Central banks will stay dovish, but bond yields will nevertheless rise modestly thanks to stronger global growth. Favor high-yield corporate credit over investment grade and sovereigns. Currencies: The US dollar will weaken in 2020 against EUR, GBP, CAD, AUD, and most EM currencies. The dollar will be flat against the yen and the Swiss franc. Commodities: Oil and industrial metals prices will move higher. Gold prices will be range-bound next year, but should rally in 2021 once inflation finally breaks out. GIS View Matrix   I. Global Macro Outlook Stronger Global Growth Ahead We turned bullish on global equities last December after temporarily moving to the sidelines in the summer of 2018. Last month, we increased our procyclical bias by upgrading non-US stocks within our recommended equity allocation at the expense of their US peers. The decision to upgrade non-US equities stems from our expectation that global growth will strengthen in 2020. Global financial conditions have eased sharply this year, largely due to the dovish pivot by many central banks. Monetary policy affects the economy with a lag. This is one reason why the net number of central banks cutting rates has historically led global growth by about 6-to-9 months (Chart 1). Chart 1The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy In addition, there is mounting evidence that the global manufacturing cycle is bottoming out (Chart 2). The “official” Chinese PMI produced by the National Bureau of Statistics rose above 50 in November for the first time since May. The private sector Caixin manufacturing PMI has been improving for five consecutive months. The euro area manufacturing PMI increased over the prior month, led by gains in Germany and France. Chart 2A Fairly Regular Three-Year Manufacturing Cycle Chart 3The Auto Sector Is Showing Signs Of Life (I)   The PMI data for the US has been mixed. The ISM manufacturing index weakened in November. In contrast, the Markit PMI rose to a seven-month high. Despite its shorter history, we tend to give the Markit PMI more credence. It is based on a larger sample of companies and has sector weights that closely match the actual composition of US output. As such, the Markit PMI is better correlated with hard data on manufacturing production, employment, and factory orders. The auto sector has been particularly hard hit during this manufacturing downturn. Fortunately, the industry is showing signs of life. The Markit euro area auto sector PMI has rebounded, with the new orders-to-inventory ratio moving back into positive territory for the first time since the autumn of 2018. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In China, vehicle production and sales are improving on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies, suggesting further upside for sales (Chart 5). Chart 4The Auto Sector Is Showing Signs Of Life (II) Chart 5China: Structural Outlook For Autos Is Bright     Trade War Uncertainty The trade war remains the biggest risk to our sanguine view on global growth. As we go to press, rumors are swirling that the US and China have reached a “Phase One” trade deal that would cancel the scheduled December 15th tariff hike and roll back as much as half of the existing tariffs. If this were to occur, it would be consistent with our expectation of a trade truce. Nevertheless, it is impossible to be certain about how things will unfold from here. The best we can do is think through the incentives that both sides face and assume they will act in their own self-interest. For President Trump, the key priority is to get re-elected next year. Trump generally gets poor grades from voters on most issues. The one exception is the economy. Rightly or wrongly, the majority of voters approve of his handling of the economy (Chart 6). An escalation of the trade war would hurt the US economy, especially in a number of Midwestern states that Trump needs to win to remain president (Chart 7). Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 7Economic Health Of The US Midwest Matters For Trump A resurgence in the trade war would also hurt Trump’s credibility. The point of the tariffs was not simply to raise revenue; it was to get China to the negotiating table. As a self-described master negotiator, President Trump now has to produce a “great” deal for the American people. If he had finalized an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than face him after the election when he will no longer be constrained by re-election pressures. China would also like to avoid facing someone like Elizabeth Warren or Bernie Sanders, who may insist on including stringent environmental and human rights provisions in any trade deal. At least with Trump, the Chinese know that they are getting someone who is focused on commercial issues. Contrary to most media reports, there is a fair amount of overlap between what Trump wants and what the Chinese themselves would like to achieve. For example, as China has moved up the technological ladder, many Chinese companies have begun to complain about intellectual theft by their domestic rivals. Thus, strengthening intellectual property protection has become a priority for Chinese officials. Along the same vein, China aspires to transform the RMB into a reserve currency. A country cannot have a reserve currency unless it also has an open capital account. Hence, financial market liberalization must be part of China’s long-term reform strategy. These mutual interests between the US and China could provide the basis for a trade truce. The Changing Nature Of Chinese Stimulus Chart 8China: Credit Growth Is Only A Few Percentage Points Above Nominal GDP Growth If a détente in the trade war is reached, will this prompt China to go back to its deleveraging campaign? We do not think so. For one thing, there can be no assurance that a trade truce will last. Thus, China will want to maintain enough stimulus as an insurance policy. In addition, credit growth is currently running only a few percentage points above nominal GDP growth (Chart 8). With the ratio of credit-to-GDP barely rising, there is little need to bring credit growth down much from current levels. This does not mean that the Chinese authorities will allow credit growth to increase significantly further. Instead, the authorities will continue shifting the composition of credit growth from the riskier shadow banking sector to the safer formal banking sector, while increasingly leaning on fiscal policy to buttress growth. One of the developments that has gone largely unnoticed by investors this year is that China’s general government deficit has climbed from around 3% of GDP in mid-2018 to 6.5% of GDP at present (Chart 9). Some of this stimulus has been used to finance tax cuts for households. Some of it has also been used to finance infrastructure spending, which requires imports of raw materials and capital goods. As a result of this fiscal easing, the combined Chinese credit/fiscal impulse has risen to a two-year high. It leads global growth by about nine months (Chart 10). Chart 9China Has Been Stimulating, Fiscally Chart 10Chinese Stimulus Should Boost Global Growth   Europe On The Upswing Chart 11Euro Area Growth: The Good, The Bad, And The Ugly Chart 12German Economy: Some Green Shoots The weakness in euro area growth this year has been concentrated in Germany and Italy. France and Spain have actually grown at a trend-like pace (Chart 11). Germany should benefit from stronger global growth and a recovery in automobile production next year. The recent rebound in the German PMI, as well as improvements in the expectations components of the IFO, ZEW, and Sentix surveys are all encouraging in this regard (Chart 12). Italy should also gain from an easing in financial conditions and receding political risks (Chart 13). The Italian 10-year government bond yield has fallen from a high of 3.69% in October 2018 to 1.23% at present. Chart 13Easing Financial Conditions And Less Political Uncertainty Will Help Italy Chart 14Euro Area Fiscal Thrust   Fiscal policy across the euro area is also turning more stimulative. The fiscal thrust in the euro area rose to 0.4% of GDP this year mainly due to a somewhat larger budget deficit in France (Chart 14). The thrust should remain positive in 2020. Even in Germany, fiscal policy should loosen. Faster wage growth in Germany is eroding competitiveness relative to the rest of the euro area (Chart 15). That could force German policymakers to ratchet up fiscal stimulus in order to support demand. Already, the Social Democrats are responding to poor electoral performance by adopting a more proactive fiscal policy, hoping to stop the loss of votes to the big spending Greens. Chart 15Germany: Faster Wage Growth Eroding Competitiveness Relative To The Rest Of The Euro Area Chart 16Boris Johnson Won't Pursue A No-Deal Brexit   The UK economy should start to recover next year as Brexit uncertainty fades and fiscal policy turns more stimulative. Exit polls suggest that the Conservatives will command a majority government following today's election. There is not enough appetite within the Conservative party for a no-deal Brexit (Chart 16). As such, today's victory will allow Prime Minister Boris Johnson to push his proposed deal through Parliament. It will also allow him to fulfill his pledge to pass a budget that boosts spending.   Japan: Own Goal Japan has been hard hit by the global growth slowdown, given its close ties to its Asian neighbors, namely China. Add on a completely unnecessary consumption tax hike, and it is no wonder the economy has been faltering. Despite widespread weakness, there have been some very preliminary signs of improvement of late: The manufacturing PMI ticked up in November, while the services PMI rose back above 50. Consumer confidence also moved up to the highest level since June. Furthermore, Prime Minister Abe announced a multi-year fiscal package worth approximately 26 trillion yen. The headline number grossly overstates the size of the stimulus because it includes previously announced measures as well as items such as land acquisition costs that will not directly benefit GDP. Nevertheless, the package should still boost growth by about 0.5% next year, offsetting part of the drag from higher consumption taxes.  US: Chugging Along Despite the slowdown in global growth, a stronger dollar, and the trade war, US real final demand is on track to grow by 2.5% this year (Chart 17). This is above the pace of potential GDP growth of 1.7%-to-2%. Chart 17Underlying US Growth Remains Above Trend The Fed’s 75 basis points of rate cuts has moved monetary policy even further into accommodative territory. Not surprisingly, residential housing – the most interest rate-sensitive part of the economy – has responded favorably (Chart 18). While the tailwind from lower mortgage rates will dissipate by next summer, we do not anticipate much weakness in the housing market. This is because the inventory levels and vacancy rates remain near record-low levels (Chart 19). The shortage of homes should buttress both construction and prices. Chart 18US Housing: On Solid Ground (I) Chart 19US Housing: On Solid Ground (II)   Strong labor and housing markets will support consumer spending, which represents nearly 70% of the economy. Business capital spending should also benefit from lower rates, receding trade tensions, and rising wages which are making firms increasingly eager to automate. II. Financial Markets Global Asset Allocation We argued in the section above that global growth should rebound next year thanks to easier financial conditions, an upturn in the global manufacturing cycle, a detente in the trade war, and modest Chinese stimulus. Chart 20 shows that stocks usually outperform bonds when global growth is accelerating. This occurs partly because corporate earnings tend to rise when growth picks up. BCA’s US equity strategy team expects S&P 500 EPS to increase by 5% next year if global growth merely stabilizes. An acceleration in global growth would surely lead to even stronger earnings growth. On the flipside, investors also tend to price out rate cuts (or price in rate hikes) when growth is on the upswing, resulting in lower bond prices (Chart 21). Chart 20Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 21Improving Global Growth Boosts Earnings Growth...And Expectations Of Rate Hikes Relative valuations also favor stocks over bonds. Despite the stock market rally this year, the MSCI All-Country World Index currently trades at a reasonable 15.8-times forward earnings. This is below the forward PE ratio of 16.7 reached in January 2018 and even below the forward PE ratio of 16.4 hit in May 2015. Analysts expect global EPS to increase by 10% next year, below the historic 12-month expectation of 15% (Chart 22). In contrast to most years when analyst forecasts prove to be wildly overoptimistic, the current EPS forecast is likely to be met. Chart 22Analyst Expectations Are Not Wildly Optimistic Chart 23Equity Risk Premium Remains Quite Elevated   If one inverts the PE ratio, one can calculate an earnings yield for global equities of 6.3%. One can then calculate the implied equity risk premium (ERP) by subtracting the real long-term bond yield from the earnings yield. As Chart 23 illustrates, the ERP remains quite elevated by historic standards. Some observers might protest that the ERP is elevated mainly because bond yields are so low. If low bond yields are discounting very poor economic growth prospects, perhaps today’s PE ratio should be lower than it actually is? The problem with this argument is that growth prospects are not so bad. The IMF estimates that global growth will be slightly above its post-1980 average over the next five years (Chart 24). While trend growth is falling in both developed and emerging economies, the rising share of faster-growing emerging markets in global GDP is helping to prop up overall growth. Chart 24The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Sector And Regional Equity Allocation US stocks have outperformed their overseas peers by 10% year-to-date and by 137% since 2008. About half of the outperformance of US equities since the Great Recession was due to faster sales-per-share growth, a third was due to stronger margin growth, and the rest was due to relative PE expansion (Chart 25). Chart 25Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade It is worth noting that the outperformance of US stocks is a fairly recent phenomenon. Between 1970 and 2008, European equity prices and EPS actually rose slightly faster than in the US (Chart 26). EM stocks also outperformed the US in the decade leading up to the Global Financial Crisis. Chart 26US Earnings Have Not Always Outpaced Their Peers We expect US stocks to rise in 2020 by about 5%-to-10%, but to lag their foreign peers in common-currency terms. There are four reasons for this: Sector skews favor non-US equities. Cyclical stocks tend to outperform defensives when global growth is strengthening and the US dollar is weakening (Chart 27). Cyclical sectors are overrepresented outside the US. We would include financials in our definition of cyclicals. Faster global growth next year will lift long-term bond yields. Since central banks are unlikely to raise rates, yield curves will steepen. Steeper yield curves will boost net interest margins, thus helping bank shares (Chart 28). European banks are more dependent on the spread between lending and borrowing rates than US banks, since the latter derive more of their profits from fees. Non-US stocks are quite a bit cheaper than their US peers. The forward PE for US equities currently stands at 18.1, well above the forward PE of 13.6 for non-US equities. Other valuation measures reveal an even bigger premium on US stocks (Chart 29). Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world. The rest of the gap is due to cheaper valuations within sectors. Financials, for example, are notably less expensive in the rest of the world, particularly in Europe (Chart 30). The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is significantly higher for non-US stocks. Profit margins have less scope to rise in the US than in the rest of the world. According to MSCI data, net operating margins currently stand at 10.3% in the US compared to 7.9% abroad. Unlike in the US, margins in Europe and EM are still well below their pre-recession peaks (Chart 31). While US margins are unlikely to fall next year thanks to stronger global growth, rising wage growth will negatively impact profits in some labor-intensive industries. Labor slack is generally greater abroad, which should limit cost pressures. Uncertainty over the US election is likely to limit the gains to US equities. All of the Democratic frontrunners have pledged to roll back the 2017 Tax Cuts and Jobs Act to one degree or another. A full repeal of the Act would reduce S&P 500 EPS by about 10%. While such a dramatic move is far from guaranteed – for starters, it would require that the Democrats gain control of both the White House and the Senate – it does pose a risk to investors. The same goes for increased regulatory actions, which Senators Sanders and Warren have both vocally championed. Chart 27Cyclicals Do Well Versus Defensives When Global Growth Is Strengthening And The US Dollar Is Weakening Chart 28Steeper Yield Curves Help Financials   Chart 29US Equities Are More Expensive Than Stocks Abroad Chart 30European Financials Trade At A Substantial Discount To Their US Peers     Chart 31Profit Margins Have Less Scope To Rise In The US Than In The Rest Of The World Within the non-US universe, euro area stocks have the most upside potential. In contrast, we see less scope for Japanese stocks to outperform the global benchmark because of uncertainties over the impact of the consumption tax hike on domestic demand. In addition, a weaker trade-weighted yen next year will annul the currency translation gains that unhedged equity investors can expect to receive from other non-US stock markets. Lastly, the passage of a new investment law that requires investors wishing to “influence management” to receive prior government approval could cast a pall over recent efforts to improve corporate governance in Japan. Fixed Income Chart 32Inflation Excluding Shelter Has Been Muted Chart 33Long-Term Bond Yields Will Move Higher As Faster Growth Pushes Up Estimates Of The Neutral Rate Central banks will remain on the sidelines next year. Inflation is still running well below target in most economies. Even in the US, where slack has largely been absorbed and wage growth has risen, core inflation excluding housing has averaged only 1.2% over the past five years (Chart 32). Nevertheless, long-term bond yields will still move higher next year as investors revise up their estimate of the neutral rate in response to faster growth (Chart 33). On a regional basis, BCA’s fixed-income experts favor low-beta bond markets (Chart 34). Japanese bonds have a very low beta to the overall Barclays Global Treasury index because inflation expectations are quite depressed and the Bank of Japan will actively intervene to prevent yields from rising. On a USD currency-hedged basis, the Japanese 10-year yield stands at a relatively decent 2.38%, above the yield of 1.79% on comparable maturity US Treasurys (Table 1). Chart 34Favor Lower-Beta Government Bond Markets In 2020 Table 1Bond Markets Across The Developed World In contrast to Japan, the beta of US Treasurys to the overall global bond index is relatively high, implying that Treasurys will underperform other sovereign bond markets in a rising yield environment. The beta for Germany, UK, Australia, and Canada lie somewhere between Japan and the US. Consistent with our bullish view on global equities, we expect corporate bonds to outperform sovereign debt in 2020 (Chart 35). Despite the weakness in manufacturing, US banks further eased terms on commercial and industrial loans in Q3, according to the Fed’s Senior Loan Officer Survey. Chart 35Stronger Growth Causes Corporate Spreads To Tighten At the US economy-wide level, neither interest coverage nor debt-to-asset ratios are particularly stretched (Chart 36). Admittedly, the picture looks less flattering if we focus solely on high-yield issuers (Chart 37). That said, a wave of defaults is very unlikely to occur in 2020, so long as the Fed is on hold and economic growth is on the upswing. Chart 36Corporate Debt: A Benign Top-Down View Chart 37Corporate Debt: More Concerning Picture Among High-Yield Issuers Chart 38US Corporates: Focus On High-Yield Credit Moreover, despite narrowing this year, high-yield spreads still remain above our fixed-income team’s estimate of fair value (Chart 38). They recommend moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year largely because of technical factors such as their large exposure to the energy sector and relatively short duration. As oil prices rise next year, energy sector issuers will feel some relief. Moreover, unlike this year, rising long-term government bond yields in 2020 should also make shorter-duration credit more attractive. In contrast to high-yield spreads, investment-grade spreads have gotten quite tight. Investors seeking high-quality bond exposure should shift towards Agency MBS, which still carry an attractive spread relative to Aa- and A-rated corporate bonds. European IG bonds should also outperform their US peers thanks to faster growth in Europe next year and ongoing support from the ECB’s asset purchase program. Looking beyond the next 12-to-18 months, there is a strong chance that inflation will increase materially from current levels. The unemployment rate across the G7 has fallen to a multi-decade low, while the share of developed economies reaching full employment has hit a new cycle high (Chart 39). Chart 39ADeveloped Markets: Unemployment Rates Keep Trending Lower... And Full Employment Reaching New Cycle Highs Chart 39BDeveloped Markets: Unemployment Rates Keep Trending Lower... And Full Employment Reaching New Cycle Highs Chart 40The Phillips Curve Is Alive And Well   For all the talk about how the Phillips curve is dead, wage growth remains well correlated with labor market slack (Chart 40). Rising wages will boost real disposable incomes, leading to more spending. If economies cannot increase supply to meet higher demand, prices will rise. It simply does not make sense to argue that the price of apples will increase if the demand for apples exceeds the supply of apples, but that overall prices will not increase if the demand for all goods and services exceeds the supply of all goods and services. It will take at least until mid-2021 for inflation to rise above the Fed’s comfort zone. It will take even longer for rates to reach restrictive territory, and longer still for tighter monetary policy to make its way through the economy. However, at some point in 2022, the interest-rate sensitive sectors of the US economy will buckle, setting off a global economic downturn and a deep bear market in equities and credit. Enjoy it while it lasts. Currencies And Commodities The US dollar is a countercyclical currency, meaning that it usually moves in the opposite direction of the global business cycle (Chart 41). This countercyclicality stems from the fact that the US, with its large service sector and relatively small manufacturing base, is a “low beta economy.” Strong global growth does help the US, but it benefits the rest of the world even more. Thus, capital tends to flow out of the US when global growth strengthens, which puts downward pressure on the dollar. As global growth picks up in 2020, the dollar will weaken. EUR/USD should increase to around 1.15 by end-2020. GBP/USD will rise to 1.40. USD/CNY will move to 6.8. The Australian and Canadian dollars, along with most EM currencies, will strengthen as well. However, the Japanese yen and Swiss franc are likely to be flat-to-down against the dollar, reflecting the defensive nature of both currencies. Today's rally in the pound has raised the return on our short EUR/GBP trade to 10.5%. For now, we would stick with this position. Chart 42 shows that the pound should be trading near 1.30 against the euro based on real interest rate differentials, which is still well above the current level of 1.20. Chart 41The Dollar Is A Countercyclical Currency Chart 42Interest Rate Differentials Suggest More Upside For The Pound   The trade-weighted dollar will continue to depreciate until late-2021, and then begin to strengthen again as the Fed turns more hawkish and global growth starts to falter. Commodity prices tend to closely track the global growth/dollar cycle (Chart 43). Industrial metal prices will fare well next year. Oil prices will also move up. Globally, the last of the big projects sanctioned prior to the oil-price collapse in late 2014 are coming online in Norway, Brazil, Guyana, and the US Gulf. Our commodity strategists expect incremental oil supply growth to slow in 2020, just as demand reaccelerates. Gold is likely to be range-bound for most of next year reflecting the crosswinds from a weaker dollar on the one hand (bullish for bullion), and receding trade war risks and rising bond yields on the other hand. Gold will have its day in the sun starting in 2021 when inflation finally breaks out. Our key market charts are shown on the following page. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 43Dollar Weakness Is A Boon For Commodities   Key Financial Market Forecasts   MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades