Asia

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 Contagion Contagion 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 Contagion Contagion 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 Contagion Contagion 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 Contagion Contagion Chart 5US: Staying Home More In Seattle Due To The Virus? Contagion Contagion 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 Contagion Contagion Chart 7Lower Oil Prices Eventually Lead To Higher Growth Lower Oil Prices Eventually Lead To Higher Growth Lower 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 Stock-To-Bond Ratio: A Lot Of The Bad News Has Already Been Priced In Stock-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 Contagion Contagion MacroQuant Model And Current Subjective Scores Contagion Contagion 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" A Black Monday Triggered By A "Perfect Storm" A 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 The Chinese Economy Is Much Less Reliant On Exports The Chinese Economy Is Much Less Reliant On Exports Chart 3Global Economy Showing Reflation Signs Before COVID-19 Global Economy Showing Reflation Signs Before COVID-19 Global 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 Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chart 5Chinese Demand Likely To Pick Up Sharply In Q2 Chinese Demand Likely To Pick Up Sharply In Q2 Chinese 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 Substantial Acceleration In Infrastructure Investment Likely In 2020 Substantial 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 Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Chart 8Monetary Conditions Are Ripe For Major Money Base Expansion Monetary Conditions Are Ripe For Major Money Base Expansion Monetary 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 More Room To Widen Government Budget Deficit More 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? Too Much Too Fast? Too Much Too Fast? Chart 11A Strong RMB Will Choke Off PBoC's Easing Efforts A Strong RMB Will Choke Off PBoC's Easing Efforts A 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 PBoC Likely To Rapidly Expand Its Balance Sheet Again PBoC 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 Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Chinese 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

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 China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review 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 Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand Inventory 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 Corporates Are Short On Cash Corporates Are Short On Cash Chart 3Land And Home Sales Likely To Pick Up In 2020 Land And Home Sales Likely To Pick Up In 2020 Land 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 Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chart 5Onshore Market Trading Does Not Seem Overly Leveraged Onshore Market Trading Does Not Seem Overly Leveraged Onshore 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 Monetary Policy Now More Accommodative Than 2015-2016 Monetary Policy Now More Accommodative Than 2015-2016 Chart 7Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chinese 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 The RMB Likely To Continue Outperforming Other EM Currencies The 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

Feature “Bayesian: …statistical methods that assign probabilities or distributions to events…based on experience or best guesses before experimentation and data collection and that apply Bayes' theorem to revise the probabilities and distributions after obtaining experimental data.” — Merriam-Webster Dictionary Markets have reacted pretty rationally to the outbreak of the COVID-19 virus. Equities initially rebounded a few days ahead of the peak of new cases in China (Chart 1). But then, once the number of cases in the rest of the world started to accelerate, stock markets sold off again sharply. The MSCI All Country World Index is now down 13% from its peak on February 12. Recommended Allocation Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 1Markets Have Reacted In Line With New COVID-19 Cases Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic No one knows whether this episode will turn into an unprecedented pandemic, which will kill millions worldwide, last for months, and trigger a global recession. So it is the sort of environment in which Bayesian analysis becomes useful. Our “prior” for the probability of a full pandemic would be around 10-20%. If it doesn’t happen, an attractive buying opportunity for risk assets should present itself soon. But there could be further downside first, especially if the number of cases in major countries such as the US, Germany, and the UK were to accelerate significantly. There are some sign that Chinese activity is beginning to recover. There are some signs that Chinese activity is beginning to recover, as new cases of COVID-19 slow, thanks to the draconian measures taken by the authorities. Big Data can help analyze this. For example, live traffic statistics from TomTom show that by February 28, weekday road congestion in Shanghai was back to 50% of its normal level, compared to 19% on February 14 (Chart 2). The Chinese authorities have relaunched fiscal and monetary stimulus, causing short-term rates to fall to their lowest level since 2010 (Chart 3). Monetary policy has been upgraded from “prudent” to “flexible and moderate.” BCA Research’s China strategists believe there is even an increasing possibility of a stimulus overshoot in the next 6-12 months, as the authorities plan for the worst-case scenario but the economy rebounds.1 Chart 2Chinese People Getting Back On The Roads Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 3Chinese Stimulus Pushing Down Rates Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic In the short-term, it is clear that global growth will weaken, though quantifying this is hard. A 1% quarter-on-quarter decline in Chinese GDP in Q1 would bring growth down to 3.5% year-over-year. Our colleagues in BCA’s Global Investment Strategy estimate this would cause global growth to fall 0.8% below trend in Q1, mainly from a contraction in tourism, but that this would be largely made up in Q2, assuming that the epidemic is over by then (Chart 4).2 Could even a limited epidemic tip the world into recession? We doubt it. Consumer confidence remains strong in developed economies (Chart 5) and the virus is not yet serious enough to stop most consumers going out to spend. The global economy was in the process of bottoming out before COVID-19 hit (Chart 6) and there is little reason to think that we will not return to the status quo ante. Chart 4Global Growth To Slow In Q1, But Rebound In Q2 Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic   Chart 5Consumers Remain Confident Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 6Before COVID-19, Growth Was Bottoming Out Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic We see the two biggest risks being: 1) a rise in defaults in China, especially among smaller companies, that the government is unable or unwilling to prevent (Chart 7); and 2) a deterioration in the jobs market in the US, as companies start to postpone hiring, or lay off staff (Chart 8). We will watch these carefully over coming weeks. Chart 7Are Chinese Companies Vulnerable? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 8Is The US Job Market Starting To Wobble? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 9Markets Believe Trump Would Beat Sanders Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic There is one other risk that might give equity markets an excuse for a further sell-off: November’s US presidential election. The probability that Bernie Sanders wins the Democratic nomination has risen to 60% from 15% over the past two months. The consensus believes that Trump can easily defeat Sanders, which is why the President’s probability of being reelected has risen in tandem (Chart 9). But, if the economy starts to weaken and Trump’s approval rating slips, investors could become nervous about the likelihood of a market-unfriendly Sanders administration. We would not recommend long-term investors sell out of risk assets at this point. There could be an attractive buying opportunity over the next few weeks, and investors who have derisked should be looking for a reentry point. With US 10-year bonds yields at 1.2% and German yields at -60 basis points, it is hard to see much further upside for risk-free bonds. Equities should be able to outperform over the next 12 months, as growth rebounds following the COVID-19 episode. We have been recommending overweights in cash and gold, as hedges, since December, and these still make sense. However, if events over the coming weeks point to the risk of global pandemic being higher than we currently think, then investors should Bayesianally adjust and move more risk-off. Otherwise, a peak in COVID-19 cases ex-China should be a strong signal to buy risk assets again. Chart 10Why Should Long-Run Inflation Expectations Fall? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Fixed Income: US Treasurys have become investors’ safe haven of choice over the past few weeks. A marked drop in long-run inflation expectations (Chart 10), in particular, has pushed the 10-year yield to a record low. This seems somewhat illogical, since the Fed will announce this summer the results of its review of monetary policy, which is likely to lead to a more dovish long-term inflation target (perhaps a commitment to achieve 2% on average over the cycle). The market has also priced in at least three Fed rate cuts by year-end (Chart 11). The Fed will certainly cut rates if US growth falters as a result of COVID-19, but this is by no means a certainty. History shows that Treasury yields jumped sharply once previous viral outbreaks ended (Chart 12). We expect yields to be significantly higher in 12 months, and so are underweight duration and prefer TIPS over nominal bonds. Credit will continue to underperform in the risk-off phase, but some interesting opportunities should arise soon, especially among the lowest-rated credits and in the Energy sector. Chart 11Will The Fed Really Be This Accommodating? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 12After Previous Virus Outbreaks, Rates Leapt Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Equities: The sell-off has already put on fire sale some stocks most affected by the epidemic. For example, cruise lines are down by 40% over the past month or so, European oil stocks 25%, some luxury goods makers 30%, and airlines 30%. Opportunistic investors might want to buy a basket of the most oversold quality names. Our overweight on euro area stocks has not worked in the sell-off. But, as a cyclical, export-oriented market, we continue to expect Europe to outperform when global growth rebounds. Euro area banks, in particular, represent the best call option on a rise in bond yields, since their performance is highly correlated to the shape of the yield curve. We continue to have a somewhat cyclical tilt among our sector weightings (with overweights on, for example, Energy and Industrials), but may adjust this in our Quarterly Portfolio Outlook in early April if we decide to reduce risk. The sell-off has already put on fire sale some stocks most affected by the epidemic. Currencies: The dollar is a safe-haven currency and so, unsurprisingly, has benefitted from the rush to safety in recent weeks. However, it remains overvalued (Chart 13), and interest rate differentials would move further against it if the Fed does cut rates, since other major developed central banks have much less room to move (Chart 14). This suggests that it will probably resume the weakness it experienced from August to December last year as soon as global growth rebounds. Chart 13Dollar Is Overvalued... Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 14...And Interest Differentials Have Moved Against It Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 15Metals Prices Stabilized In Recent Weeks Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Commodities: Industrial metals fell sharply on the outbreak of COVID-19 in China, but have bottomed in line with the stabilization of the situation in that country (Chart 15). Gold has worked predictably as the best hedge in the sell-off. While it is starting to look technically overbought and would be hurt by a rise in bond yields (Chart 16), for prudent investors it remains a useful hiding place amid heightened risk and ultra-low interest rates. Oil is the commodity that has fallen the most surprisingly, with Brent close to the low it reached during the sell-off in December 2018 (Chart 17).  It is much less dependent on Chinese demand than metals are, and so is maybe pricing in a global recession – as well as questioning the commitment of OPEC to cut production further. This would suggest upside to the oil price if global growth turns out not to be so bad, oil demand continues to pick up, and supply remains constrained.   Chart 16How Much Could Gold Overshoot? Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Chart 17Oil Discounting A Global Recession Monthly Portfolio Update: A Classic Bayesian Dynamic Monthly Portfolio Update: A Classic Bayesian Dynamic Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?” dated 26 February 2020, available at cis.bcaresearch.com 2   Please see Global Investment Strategy Weekly Report, “Market Too Complacent About The Coronavirus,” dated 21 February 2020, available at cis.bcaresearch.com GAA Asset Allocation  

Highlights It is too soon to bottom feed with fears of a global pandemic and “socialist” boom in the United States. China’s government will do “whatever it takes” to stimulate the economy – but animal spirits need to revive for it to work. European political risk and policy uncertainty are clearly on the rise, albeit from low levels. Bernie Sanders could become the presumptive nominee for president on Super Tuesday – if Biden fails to make a comeback. The market is underrating the Sanders risk to US equities – particularly tech and health. Assuming pandemic fears subside, the Fed put, the China put, and the Trump reflation put will fuel risk-on sentiment in H2 2020. Feature Chart 1Risk-Off Mood Dominates Markets... Risk-Off Mood Dominates Markets... Risk-Off Mood Dominates Markets... Financial markets awoke to the confluence of negative news this year on February 20. The S&P 500 has fallen 8.0% from this year’s peak while the 10-year US Treasury yield dove to 1.33%. Gold reached the highest level since 2013. The yield curve inverted again (Chart 1). It is too soon to buy into the equity selloff. Fear of the coronavirus is spreading, not abating, while Vermont Senator Bernie Sanders – a democratic socialist who would turn the regulatory pen against corporations – is running away with the Democratic Party’s nomination for US president. Chart 2...Amid Fears Over Coronavirus And Sanders ...Amid Fears Over Coronavirus And Sanders ...Amid Fears Over Coronavirus And Sanders The market selloff is well correlated with fear of the coronavirus, but there is also some correlation with Sanders’s success (Chart 2). This should intensify if Sanders becomes the presumptive nominee following “Super Tuesday,” March 3, by which time 39% of the Democratic Party delegates will have been chosen. Sanders poses a more systemic risk to corporate profits than the virus as he emblematizes a generationally driven sea change looming over US national policy: a shift from capital to labor. A greater tightening of financial conditions would prompt the Federal Reserve to cut interest rates, possibly as soon as its meeting on March 17-18. But the Fed is not yet signaling cuts. Also, cuts may not pacify the market as easily this time as in the last major pullback in Q4 2018. Tightening monetary policy was the culprit for that selloff and therefore the Fed’s policy reversal on January 4, 2019 gave the market just what it needed to rally. Today the Fed has no control over the causes: virus fears and “socialism.” President Trump is manifestly uneasy as the virus spreads. Anything that weakens the US manufacturing sector is a direct threat to his reelection, regardless of how he spins it. The statewide coincident indicators provided by the Philadelphia Fed show that Pennsylvania’s economy is deteriorating, while a relapse in Michigan will push it into the Democratic camp according to our quantitative election model. This would leave Trump with only Wisconsin standing between him and the shame of a one-term presidency (Chart 3). Chart 3Trump’s Narrow Victory At Risk Of Virus-Induced Slowdown GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? What can Trump do to feed the markets and economy some good news? Not much. The Democrats control the House of Representatives and will refuse any fiscal stimulus unless a total collapse is occurring, in which case Trump is doomed anyway. Given the strong dollar, the Fed’s reluctance to cut rates, and Trump’s paternalist proclivities, we can fully envision him attempting to strong-arm the Treasury Department into intervening against the dollar. But intervention would have a fleeting impact without Fed cooperation – and again, the economic crisis required for the Fed to intervene decisively would likely seal Trump’s fate regardless. What remains for Trump is his ability to enact surprise “rate cuts” of his own via tariff rollback on China. This is fully within his power. All he has to do is hold a phone conference with Xi Jinping and then declare that China is complying with the “phase one” trade deal in good faith and therefore deserves assistance amid the coronavirus economic shock. But the impact of a positive tariff surprise would be limited. And such rate cuts are likely to be reactive rather than proactive, as with the Fed. We shifted to a cautious, neutral stance on global risk assets on January 24 and we maintain that position. China is stimulating the economy, meaning that the dominant trend in H2 should be a global “risk on.” Thus we are keeping our China and emerging market trades open. But volatility will likely remain elevated through March, at minimum, given the toxic combination of a slowing global economy and an increasingly likely Sanders nomination. China Stimulus: "Whatever It Takes" Chart 4Xi Administration Is Getting Out The Big Guns Xi Administration Is Getting Out The Big Guns Xi Administration Is Getting Out The Big Guns One near certainty of the coronavirus outbreak is that it will catalyze greater economic stimulus in China. Last year we argued that the trade war had derailed Beijing’s financial deleveraging agenda and hence that the risk of a stimulus overshoot was greater than an undershoot. The Xi Jinping administration limited the degree of reflation for most of the year, but by autumn it was incontrovertible: stabilizing growth and the labor market had taken priority over deleveraging. Local government bond issuance picked up and the government relaxed its grip on informal lending and the shadow banks (Chart 4). Now, with the coronavirus outbreak, the Xi administration is getting out the big guns. The People’s Bank of China has cut key interest rates below where they stood in 2015-16, the last major bout of stimulus (Chart 5), as our China Investment Strategy has noted. Beijing officials have announced they will dial up fiscal policy to build infrastructure and boost purchases of homes and cars. President Xi Jinping has personally assured the world that China will meet its economic growth target for the year. Compared with the 6.1% real GDP growth achieved in 2019, our China Investment Strategy believes a conservative estimate is 5.6% for 2020. Assuming China’s real GDP growth slows to 3.5% in Q1 on a year-over-year basis, China would need at least 6.3% average real growth year-over-year for the next three quarters to hit its target. This growth rate would be 0.3 percentage points higher than in the second half of 2019. Credit expansion and government spending in the next six-to-12 months would need to outpace that of last year. Will the government succeed in firing up demand? If getting back to work results in further outbreaks, then China may see greater difficulty in using its old-fashioned stimulus tools. Moreover Chinese households and corporates are more indebted than ever and have suffered a series of blows in recent years that have weighed on animal spirits: a political purge, slowing trend growth, corporate deleveraging, trade war, and now the virus. It is essential for consumer confidence and the velocity of money to keep recovering (Chart 6). Our Emerging Markets Strategy rightly insists that without a revival in animal spirits, stimulus will be pushing on a string. Chart 5Key Chinese Interest Rates Now Below 2015-16 Levels Key Chinese Interest Rates Now Below 2015-16 Levels Key Chinese Interest Rates Now Below 2015-16 Levels Chart 6Animal Spirits A Precondition For Chinese Recovery Animal Spirits A Precondition For Chinese Recovery Animal Spirits A Precondition For Chinese Recovery Yet it is also true that most of the negative shocks were policy decisions, especially deleveraging and trade war. With these decisions reversed – and likely to stay that way for at least this year – there is no reason to assume a priori that animal spirits will remain depressed. Furthermore, we see little room for the Xi administration to revert to tightening measures until a general economic recovery is well advanced. As we highlighted in our annual strategic outlook, it is necessary to stabilize the economy ahead of the 100th anniversary of the Communist Party in 2021 and – more importantly – the leadership reshuffle to take place in 2022. Chinese consumer confidence and the velocity of money need to recover for stimulus to have an impact. On a side note, Hong Kong is also implementing stimulus measures. This is positive for the city-state in the short run but it is unlikely to revive its fortunes over the long run. What made Hong Kong special was its position as a well-governed ally of the West during the heyday of globalization and the backdoor to mainland China during its rapid, catch-up phase of industrialization. Now globalization is slowing, Beijing is tightening central control, and the West has lost the appetite to defend its influence in Hong Kong. This influence is part and parcel with Hong Kong’s freedoms and privileges. This means that while the country’s equities can see a cyclical improvement we are structurally negative. Bottom Line: We are maintaining our cyclically constructive outlook on global growth and risk assets, as our view on China’s “Socialism Put” has been reinforced. We are keeping open our China Play Index and other EM trades. However, near-term risks are extremely elevated and our cyclical view could change quickly if the virus fear factor proves insurmountable for China and the global economy. China Sneezes, Europe Catches A Cold … And Its Immune System Is Weak Chart 7Our European GeoRisk Indicators Are Springing Back Our European GeoRisk Indicators Are Springing Back Our European GeoRisk Indicators Are Springing Back The European economy was on track to rebound in 2020 prior to the coronavirus, but only tentatively, as sentiment and manufacturing were fragile. The virus struck at the heart of demand for European exports, China, and now is hitting European demand directly via the outbreak in Italy and across the continent. As fear of the virus spreads country by country, households and corporations will cut back on activity. It could take weeks or even months to resume business as usual. And it will take 6-12 months for China’s stimulus to kick in fully and lift demand for European goods. European political risk is thus no longer slated to remain subdued. Our indicators already show it is springing back. The most significant player is Germany, but Italy is the weakest link in the Euro Area, and non-negligible risks are affecting France, Spain, and the United Kingdom (Chart 7). German political risk will be highly market-relevant between now and the federal election slated for October 2021. De-globalization is a structural headwind for the German economy and Chancellor Angela Merkel’s attempt to stage manage a smooth succession has collapsed. The Christian Democratic Union is now plunging into a truly competitive leadership contest that will keep uncertainty elevated, at least until the aftermath of the election. Friedrich Merz is the leading contender (Chart 8) and is attempting to rope more conservative voters back into the Christian Democratic fold so that they do not stray into the populist Alternative für Deutschland (AfD). While a similar dynamic led the British Conservative Party into Brexit, German politics are less polarized than British politics. The Christian Democrats are nowhere near being overtaken by the far right. First, the CDU is still the most popular party and its closest competitors are the Green Party and the Social Democrats, while the AfD polls at 13.3% support and is opposed by all other parties. The AfD’s popularity, while growing, is still very small. Second, a majority of the public still approves of Merkel (Chart 9), signaling a tailwind for centrists within and without her party. Chart 8Merz Is The Top Contender In Germany’s Leadership Contest GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Third, the German public is still the most supportive of the euro and EU, for the obvious reason that its economic success is integrally bound up in the union (Chart 10A). Nor is Germany alone, since the only country that looks truly concerning by these measures is Italy and even Italy’s populists remain engaged in the European project (Chart 10B). Chart 9Merkel's Popularity A Sign Of German Centrism Merkel's Popularity A Sign Of German Centrism Merkel's Popularity A Sign Of German Centrism   Chart 10ASupport For The Euro Still Strong (But Watch Italy) (I) Support For The Euro Still Strong (But Watch Italy) (I) Support For The Euro Still Strong (But Watch Italy) (I) Chart 10BSupport For The EU Still Strong (But Watch Italy) (II) Support For The EU Still Strong (But Watch Italy) (II) Support For The EU Still Strong (But Watch Italy) (II) Immediate economic challenges favor Merz’s bid to lead the party. However, if they do not give way to an economic rebound by fall 2021 (i.e. if Chinese and global growth worsen in the lead-up to the general election), then these challenges will undercut the Christian Democrats’ bid to remain in power regardless of whether Merz or a more dovish chancellor-candidate emerges from Merkel’s exit. The Green Party offers a viable alternative to lead the next government. Chart 11Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity In the short run, Germany can ease fiscal policy marginally to help offset the current slowdown. But a game changer in fiscal policy will require either for the current economy to collapse or a resolution to the succession crisis. Finance Minister Olaf Scholz, of the Social Democrats, has just proposed a significant revision to the schuldenbremse, or “debt brake,” which keeps budget deficits pinned above -0.35% of GDP. He would allow Germany’s state and local governments to suspend the debt brake temporarily so as to boost fiscal spending to mitigate the slowdown. A formal suspension requires a constitutional change that would in turn require a two-thirds vote in both houses of the legislature. There are enough votes in the Bundestag and possibly in the Bundesrat but it requires the economic shock to get bigger first so as to force the conservatives to capitulate and court the help of smaller parties. Otherwise Scholz is making an election gambit to distinguish the Democratic Socialists from the fiscally conservative Christian Democrats. In the meantime, limited moves to loosen the belt are perfectly countenanced by existing law which allows for deviations from the debt brake during recessions and emergencies. France is also seeing a spike in political risk. President Emmanuel Macron has slogged through the massive labor strikes against his pension reform, as we expected. The reform would streamline a complex web of pension programs into a single national program, providing incentives for workers to work longer without making spending cuts. It will likely pass into law through his En Marche party’s control of the National Assembly. However, Macron’s political capital is spent and his party is expected to sustain heavy losses in municipal elections from March 15-22. The service-oriented economy will also suffer a blow from reduced tourism amid the coronavirus scare (Chart 11), further eroding Macron’s already low popularity. The loss of influence at home will reinforce Macron’s pivot to foreign policy. Macron can play the leader of Europe at a time when the UK is leaving and Germany is consumed with a leadership contest. In this role he will clash with the UK over Brexit and the US over trade – but this can only go so far given the need to sustain the French economy. Negotiations with the UK will involve brinkmanship but will result in a delay of the end-of-year deadline, or a deal, given the fragile economic backdrop affecting all players. Economic constraints also imply that negotiations with the US will not spiral into a major confrontation unless and until Trump is reelected. Therefore Macron’s gaze will turn to security and immigration, challenges that have the potential to fuel anti-establishment sentiment that could hurt him in the French election of 2022 and undermine his vision of a more integrated Europe. While terrorism has abated for the time being (Chart 12), the trend cannot be guaranteed. The Middle East is extremely unstable amid the global slowdown, virus, drop in oil prices, and general destabilization emanating from the underlying US-Iran conflict. Immigration is also starting to rise again, particularly along the western North African route into Spain and France that bypasses the fighting in Libya (Chart 13). Chart 12A Pickup In Terrorism Would Fuel Populist Sentiment... A Pickup In Terrorism Would Fuel Populist Sentiment... A Pickup In Terrorism Would Fuel Populist Sentiment... Turkey’s foreign policy confrontation with the West threatens an increase in immigration in the east as well as a Turkish client-state in western Libya that France fears could become a militant safe haven. Chart 13...As Would An Increase In Immigration ...As Would An Increase In Immigration ...As Would An Increase In Immigration France is therefore taking a harder line with Turkey and providing maritime assistance to Greece (see Chart 13 above). The Mediterranean is becoming a geopolitical hot spot that could lead to negative surprises – and not only for Turkish assets. European populism is under control for now but a new wave of immigration would spark a new wave of populism that would increase policy uncertainty and the risk premium in equities. Italy has shifted from being an overstated to an understated political risk. Chart 14Italian Right-Wing Parties Are Gaining Strength Italian Right-Wing Parties Are Gaining Strength Italian Right-Wing Parties Are Gaining Strength Politically, Italy remains the weakest link in Europe – and this long-term risk is now becoming more pressing. Support for the euro and EU is among the weakest (see Chart 10 above). The ruling coalition is rickety and groping toward an election, with a popular referendum on the electoral law dated March 29. The country is poorly equipped to handle the virus outbreak. The virus will also call attention to the porous borders, fueling anti-establishment sentiment – after all the anti-establishment League is still the top party in polls while the right-wing Brothers of Italy’s support is surging (Chart 14). This is the case even though immigration into Italy is under control at the moment, particularly with renewed fighting in Libya discouraging flows through the central North African route. In short a full-fledged recession will unleash the furies in Italian politics and the country has shifted from being an overstated to an understated political risk. Bottom Line: The UK-EU trade talks threaten volatility for the pound this year, on top of the key continental risks: succession crisis in Germany, the potential for Macron’s centrist political movement to falter in France, and the possible election of a right-wing anti-establishment government emerging in Italy. Populist sentiment can emerge from the economic slowdown even if terrorism and immigration remain contained, but the recent uptick in immigration and new sources of instability in the Middle East, North Africa, and the Mediterranean show clouds gathering on the horizon. The Euro Area’s fiscal thrust is expected to be a measly 0.015% of potential GDP in 2020. The trends above suggest that this number could increase substantively, albeit reactively, due to fiscal easing in Germany and several other states along with France’s lack of real cuts in its pension reform. United States: Can A Northern Progressive Win In The South? In February 1980, Democratic presidential contender Jimmy Carter won the New Hampshire primary with 51% of the vote. Carter would go on to become the first Democrat from the Deep South to win the presidency since Woodrow Wilson. His triumph in New Hampshire proved, as he said, “that a progressive southerner can win in the North.” Fast forward to February 2020 and Vermont Senator Bernie Sanders, the most left-wing candidate vying for the nomination, is attempting to perform the equally dazzling feat of winning a primary election in the conservative southern state of South Carolina. If Sanders pulls it off then it will trigger an earthquake. For a progressive who can win in the South is likely to score big on Super Tuesday, March 3, and if Sanders pulls that off then he will become the country’s first “socialist” presumptive nominee for president (Chart 15). This would be a huge upset, primarily for former Vice President Joe Biden, who has long led the opinion polls in South Carolina and recently has even rebounded. Biden expects strong support from the African American community – which is staunchly Democratic, moderate in ideology, and favorable toward Biden due to his close association with former President Barack Obama. The problem is that Biden’s latest rebound in the polls may be too little, too late. He made more gaffes in the debate performance and, most importantly, Sanders’s polling has improved among African Americans (Chart 16). Chart 15A Sanders Win In The South Will Help Him Score Big On Super Tuesday GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Chart 16Sanders’s Polling Has Improved Among African-Americans GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Sanders performed well with almost every demographic in Nevada – if he can do well among blacks, and in the south as well as the north and west, then his ability to unify the party will be incontrovertible and moderate Democratic primary voters looking for a winner will start to resign themselves to his nomination. What is more likely is that Biden wins in South Carolina, declares himself the “comeback kid,” and prolongs the uncertainty regarding the Democratic nomination. Chart 17A Biden Win In Texas Would Reenergize The Establishment GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? If South Carolina propels Biden to a strong performance on Super Tuesday, particularly a win in Texas, it could usher in a new phase of the primary election since it would suggest the possibility that the establishment has not lost the nomination and is striking back against Sanders (Chart 17). Failing that, any “Never Sanders” movement will face an uphill battle. After March 3, about 39% of the Democratic Party’s delegates will be “pledged,” or committed, to one of the candidates. Two weeks later, fully 61.5% of delegates will be chosen. Which means that the best chance for a conservative counter-revolution against Sanders comes over the next three weeks. Regardless of South Carolina, Biden’s structural limitation on Super Tuesday is the well-known phenomenon of vote-splitting. Five centrist candidates are dividing the moderate vote, leaving Sanders to engross the 40%-45% of the vote that is progressive all to himself.1 This is a compelling reason to believe that Sanders will continue to amass the most delegates. What would change the equation would be a mustering of the centrists under a single competitive candidate. The latter requires candidates to be forced out of the race through defeat or to drop out of the race willingly for the good of the party. If Mayor Pete Buttigieg or Senator Amy Klobuchar should fall short of the 15% to qualify for delegates in South Carolina, they would need to bow out of the race (they might be persuaded by promises of high appointments). Most importantly, if Biden should squander South Carolina then he would need to take one for the team and drop out, passing the baton to Bloomberg. It will be hard for any one of these politicians to quit unless it is coordinated with the others; he or she would have to forgo any hopes of emerging at the top of the ticket at a contested Democratic National Convention in July. If coordination fails, the centrist vote will become even more fragmented when Mayor Michael Bloomberg finally appears on the ballot on March 3. Last week we argued that if Sanders cannot clinch the nomination by winning a majority of the delegates by June, then he needs to win a commanding plurality of the delegates so that moderate unpledged delegates are forced to capitulate and vote for him at the Democratic National Convention. We argued that for this to happen he needs, at minimum, to improve upon his score in 2016, which was 43% of the popular vote and 40% of the delegate count. Otherwise, a sequential voting procedure among roughly equally weighted blocs will likely lead to his defeat, as the two other factions of the party (establishment Washington insiders like Biden and centrist Washington outsiders like Bloomberg) view Sanders-style socialism as their least preferred option. Is this 40%+ threshold enough? Nobody knows. Clearly it is harder to win the nomination with 40% of the delegates than with 49%, even if you are in first place. But if Sanders leads by double digits in terms of the share of delegates, has captured 43%+ of the popular vote, and has won the big swing state primaries across regions, then it will be hard for Democratic delegates to conclude that he is not the most competitive in the general election. Currently Sanders is slated to win California, Michigan, Wisconsin, Pennsylvania, Ohio, and possibly Texas. This is a strong argument for moderate unpledged delegates to swing behind him. It is even compelling for some of the Democratic Party’s “super delegates,” at least those who are wavering. Otherwise these party elders would break up an enormous amount of momentum in the name of a less popular Democratic candidate – and strengthen Trump. Bottom Line: Super delegates will vote as political actors facing constraints inherent in their situation. If the situation is that Sanders has won 43% of the vote, leads the next candidate by double digits, has won the most primary elections, and has won in the major states, including the swing states, then it will be a compelling constraint on voting against him. Investment Conclusions The daily new cases of the coronavirus outside China continues to surge, creating near-term headwinds for global risk assets. Ultimately the negative shock of the virus may be overstated, but we remain on the sidelines of any near-term equity rally due to the confluence of a global demand shock and a US socialism boom. With manufacturing already vulnerable, the coronavirus, insofar as it causes a harder hit to global and hence American manufacturing, is a threat to Trump’s reelection odds. This is true regardless of who takes the Democratic nomination. It is also true notwithstanding that pandemic risks may ultimately fuel xenophobic sentiment. Trump cannot argue his way out of rising unemployment in the Rust Belt. The market is underrating the Sanders risk to health care and technology stocks. This means that Sanders has a greater chance of winning the White House than the consensus holds. Financial markets should continue to discount his rising odds, at least until it becomes clear either that he is falling short of a strong plurality or that the global economy is shaking off its jitters. As the financial market stumbles Sanders will get more steam than other candidates, while Trump’s odds will suffer, which is a potentially self-reinforcing dynamic. Looking at the correlations between different candidates and US equity sectors, the market is underrating the Sanders risk to health care and technology stocks (Table 1). Sanders poses a threat to regulation in these spheres even if the Democrats do not take a majority in the Senate. And they are likely to take the Senate and have a one-seat majority in the event that they prove capable of ousting Trump (via the vice president). Table 1The Market Is Underrating The Sanders Risk To US Equities GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Ultimately Trump’s reelection also represents a threat to the tech sector, due to a “Phase Two” trade war, but the initial market reaction is likely to be risk-on. Assuming our base case that the virus fear eventually subsides, people get back to work, the world economy regains its footing, and monetary and fiscal stimulus get pumping (especially in China), the swing state economies may well be banging by November. In that context, the three pillars of our bullish 12-month view will be restored: the Fed put, the China put, and Trump’s reelection as a “buy the rumor, sell the news” phenomenon.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 This assumes Senator Elizabeth Warren of Massachusetts continues to fall short of the 15% threshold qualifying a candidate to receive pledged delegates to the Democratic National Convention. Appendix Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Section III: Geopolitical Calendar

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

Dear Client, I participated in a webinar earlier this week with my fellow BCA Research strategists to discuss the coronavirus outbreak and other timely issues. A replay can be accessed from this link. In lieu of our regular report next week, we will be sending you a Special Report from Matt Gertken, BCA’s Research Chief Geopolitical Strategist. Matt will discuss the state of the Democratic Party’s presidential nomination process in the wake of “Super Tuesday” and address the market implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The decline in the number of new infections in China suggests that the coronavirus can be contained, provided that governments are both able and willing to impose severe quarantine measures on their own citizens. It is far from clear whether all countries can introduce such measures. And even among those who can, the economic damage from prolonged work stoppages could end up being too much to bear. The spike in supplier delivery times in various purchasing manager indices suggests that the global supply chain is already showing signs of strain. If the outbreak morphs into a global pandemic, a recession on the scale of the 2008/09 downturn would likely ensue. The only economic consolation from such an outcome is that once everyone is in the same boat, the need for mass quarantines and business shutdowns will diminish. While stock valuations have improved markedly over the past week, we would still recommend that investors refrain from significantly adding to equity positions at the moment. Once COVID-19 cases start popping up all over the US, stocks could come under further pressure. That said, we would only become more constructive on the near-term outlook for global equities if prices were to fall another 5%-to-8% from current levels or if the risks of a pandemic recede. The Power Of Exponential Change Humans tend to think in linear rather than exponential terms. Thus, it is easy to forget that when dealing with exponential growth, what appears exceedingly slow at first can become exceedingly fast later on. Take the example of the COVID-19 outbreak. Suppose that R0 is 2, meaning that someone who contracts the virus will spread it to two other people on average. Also suppose that it takes one week to pass it on to someone else. In week 1, one person is infected; in week 2, two new people are infected; in week 3, four new people; in week 4, eight new people, and so on. If only a small percentage of people who are infected get sick enough to have to go to the hospital, it might not be until after the end of week 8, when 128 new people have been infected, that the authorities become aware of the epidemic. Once we reach this stage, the only two options left are to impose extreme quarantine measures in an effort to drive Ro below 1, or stand back and let the outbreak run its natural course. Not surprisingly, most governments have chosen the first approach in the hopes of limiting the outbreak to a few regional clusters. A vigilant approach also buys some time to develop a vaccine. Time will tell if this strategy succeeds. On the positive side, the number of new infections in China continues to trend lower. Outside of Hubei, only 66 new cases have been reported since February 22nd. This has allowed an increasing number of Chinese companies to resume operations. It is also encouraging that a few countries such as Japan, Singapore, and Thailand, which at one point seemed on track to experience major epidemics, have gotten the problem under some degree of control. Chart 1The Number Of New Cases Has Declined In China, But Has Jumped In South Korea, Italy, And Iran Health Versus Growth Health Versus Growth On the negative side, the number of cases in South Korea, Iran, and Italy has surged (Chart 1). In South Korea, there are now 1261 confirmed cases, up from 31 early last week. South Korea’s population is less than 4% of China’s. If the current trend continues, the infection rate in Korea could surpass that of China over the next two weeks. The situation in Iran appears to be out of control. Two people from Iran have already tested positive in Canada. Bahrain has recorded 33 cases linked to Iran. In perhaps one of the most surreal moments of the crisis, Iranian deputy health minister Iraj Harirchi, who had been charged with leading the nation’s efforts to stem the epidemic, was filmed wiping his brow one day before it was confirmed he had contracted the virus. None of this prevented President Rouhani from declaring that Iran must “not allow enemies to convert the coronavirus into a weapon in their hand in order to disrupt work and production in Iran”. He went on to denounce the US for failing to “pay attention to the 16,000 American victims who died after having the influenza virus.” Worse Than The Swine Flu? Looking at the global data in aggregate, the number of confirmed cases is increasing in a manner more similar to the swine flu (H1N1) outbreak in 2009/10 than the SARS outbreak in 2003 (Chart 2). The H1N1 virus ended up infecting 61 million people in the US and between 700 million-to-1.4 billion globally. Chart 2COVID-19: More Like Swine Flu Than SARS? Health Versus Growth Health Versus Growth Unlike SARS, the COVID-19 coronavirus appears to be extremely contagious and can be spread by people who show few or no symptoms. SARS was generally spread only by people who were already visibly ill. In terms of fatality rates, COVID-19 is not as lethal as SARS, but appears to be at least ten times as fatal as H1N1. At present, there are no effective vaccines for coronaviruses. While concerted efforts are underway to develop a vaccine for COVID-19, most medical professionals agree that it will take at least a year before one is widely available. Unfortunately, given the exponential dynamic described above, most of the people on the planet could be infected by then. Pandemic Risk No one knows what the probability of a pandemic is, but it is clearly not zero. As workers return to their jobs in China, the outbreak may flare up again, leading to a new wave of business closures. Countries that do not have the will or the means to quarantine their citizens on a massive scale may find themselves unable to keep the virus at bay. Investors are finally waking up to this reality. As we discussed in last week’s report entitled “Markets Too Complacent About The Coronavirus,” even in a best-case scenario where the virus is successfully corralled over the next month or so, sequential global growth will still fall to zero in the first quarter. If the outbreak is not contained and a full-fledged pandemic ensues, the world is likely to experience a recession on the scale of the 2008/09 downturn. Table 1COVID-19 Fatality Rates By Age Health Versus Growth Health Versus Growth The only economic consolation from such an outcome is that once everyone is in the same boat, the need for mass quarantines and business shutdowns will diminish. Table 1 shows preliminary age-specific estimates of the fatality rate from the COVID-19 virus, provided by the Chinese Center for Disease Control and Prevention (China CDC).1 The results are based on 44,672 confirmed cases.   Stocks Won’t Get Much Relief From Bonds Given that investors have known about the risks from the coronavirus for some time, why did it take so long for stocks to buckle? Part of the answer has to do with the sigh of relief investors breathed after the number of new COVID-19 cases peaked in China. As in the SARS episode, the peak in new cases marked a bottom in risk assets (Chart 3). Unfortunately, now that the number of cases has accelerated outside of China, this sanguine narrative has been dashed. Chart 3AJust As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked... Health Versus Growth Health Versus Growth Chart 3B… But The Number Of New Cases Outside China Has Surged Health Versus Growth Health Versus Growth While the news flow about the coronavirus has been the dominant driver of stocks, there has also been another important factor at work. As Chart 4 shows, global bond yields have dropped sharply since the start of the year. Up until this week, equity investors clung to the hope that falling yields would cushion the blow to growth and earnings. They also figured that a decline in the discount rate applied to future cash flows would boost equity valuations. Not surprisingly, growth stocks, which are most sensitive to changes in the discount rate, led the charge higher (Chart 5).   Chart 4Global Bond Yields Are Back Near Record Lows Health Versus Growth Health Versus Growth Chart 5Growth Stocks Have Outperformed On Falling Yields Health Versus Growth Health Versus Growth           These rosy expectations could still be realized if the global outbreak is quickly contained. If it is not, there is not much more central banks can do. Easier monetary policy can help offset demand shocks. However, it cannot do much about supply shocks. Stocks sold off in late 2018 because investors concluded that the Fed had erred in raising interest rates four times over the course of nine months. As soon as the Fed pivoted in a more dovish direction, equities rallied. This time is different. The Fed is not responsible for the current sell-off; the virus is. Thus, while the Fed would almost certainly cut rates if the outbreak turns into a pandemic, this would have less of a soothing effect than it did in early 2019. Supply Chains At Risk The modern global economy is powered by an intricate division of labor. Widespread work stoppages across many countries would eviscerate the global supply chain. Ironically, investors were worried at the start of the year that manufacturing inventories were too high. As it turned out, excess inventories have proven to be a blessing rather than a curse because they have allowed companies to weather the supply shock longer than they could have otherwise. The grace period will expire soon. According to the latest PMI data, supplier delivery times have soared in the major economies. The latest Markit Flash Eurozone PMI noted “a marked lengthening of supplier delivery times, with delays for inputs the most widespread since December 2018, attributed in many cases to supply chain issues arising from the COVID-19 outbreak.”  In the UK, Markit reported that UK manufacturers had disclosed the “the largest month-on-month slide in supply chain performance since the survey began in 1992, exceeding the previous record seen during the UK fuel protests in September 2000.” Monetary policy will come in handy only after the outbreak subsides. The dislocations caused by the virus could push many businesses towards the brink of bankruptcy. This could trigger a feedback loop of reduced spending, less hiring, and even lower spending. Timely stimulus would short-circuit this vicious cycle. That said, given that interest rates are already close to zero in most countries, much of the burden of preventing an extended downturn will have to fall on fiscal policy. It's Not Just About The Risk-Free Rate Chart 6Risk-Off Has Been On Fire Health Versus Growth Health Versus Growth What about the valuation boost to stocks from falling bond yields? It is certainly true that, all things equal, lower bond yields are good for stocks. However, all things are rarely equal. We need to ask why yields have fallen. The value of the stock market does not just depend on the risk-free rate. It also depends on the additional return investors demand to hold stocks – the so-called equity risk premium – as well as expected earnings growth. If bond yields decline because skittish investors pile into safe-haven US Treasuries, while simultaneously cutting their earnings projections, this will almost certainly result in lower equity prices. What we have seen this past week is a classic risk-off event (Chart 6). Gold has surged to the highest level since 2013. Term premia in government bond markets have plunged. Tech stocks have underperformed other sectors despite the ostensible support from lower bond yields. The US dollar has rallied, even as interest rate differentials have moved against the greenback (Chart 7).   Chart 7The Dollar Has Rallied, Even As Interest Rate Differentials Have Moved Against The Greenback Health Versus Growth Health Versus Growth What are investors to do? While stock valuations have improved markedly over the past week, we would warn against deploying significant fresh capital to equities at the moment. Stocks were technically overbought going into this correction. Some degree of profit taking was likely no matter what transpired. Once COVID-19 cases start popping up all over the US, stocks could come under further pressure. Hence, we would only become more constructive on the near-term outlook for global equities if prices were to fall another 5%-to-8% from current levels or if the risks of a pandemic recede. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1The Novel Coronavirus Pneumonia Emergency Response Epidemiology Team, "The Epidemiological Characteristics of an Outbreak of 2019 Novel Coronavirus Diseases (COVID-19) — China, 2020[J]," China CDC Weekly, 2020, 2(8): 113-122. Global Investment Strategy View Matrix Health Versus Growth Health Versus Growth MacroQuant Model And Current Subjective Scores Health Versus Growth Health Versus Growth Strategic Recommendations

Highlights Global growth will quickly recover if the Covid-19 outbreak is soon controlled. If the virus's spread doesn't slow, a worldwide recession will take hold in 2020. BCA remains cyclically bullish, but tactical caution is warranted as long as uncertainty around Covid-19 remains high. A strong dollar is generally good for the US, except for exporters. The dollar possesses greater cyclical upside, a trend that will affect global asset allocation. The dollar will correct in 2020, which could allow cyclical stocks and value stocks to outperform growth equities in the short term. Foreign equities will also temporarily outperform US stocks this year. Feature 10-year Treasury yields hit an all-time low of 1.26% this morning, and the S&P 500 finally buckled under the pressure. Meanwhile, the US dollar seems unstoppable and commodity prices are still hobbling near recent lows. The economic and financial outlook for 2020 is unusually divided. On the positive front, economic momentum slowly turned the corner after a soft 2019. Liquidity aggregates have been improving, economic sentiment is bottoming and inventories are melting away. However, if Covid-19 morphs into a global pandemic, then these nascent positives will disappear. Faced with mounting uncertainty, the S&P 500 could still face additional tactical downward pressure. However, if Covid-19 does not turn into a global pandemic, then equities should recover in the second quarter. Additionally, the dollar’s strength remains a great concern, and for 2020, it too will depend on Covid-19's continued spread. While the next 12 months are likely to be painful for the dollar, its cyclical highs still lie ahead. The dollar’s trend will affect relative sector and regional performance. Covid-19 Under Control? The Covid-19 outbreak is key to the 2020 outlook. If Covid-19 is contained, then global growth can recover after a dismal first quarter. However, if the recent uptick in cases outside of China continues to increase beyond the coming two to three weeks, 2020 will witness a quick but painful recession as governments will impose quarantines and consumer confidence will collapse. If Covid-19 is contained, then global growth can recover after a dismal first quarter. Our colleagues from BCA Research’s Global Investment Strategy service estimate that Covid-19 could easily curtail global growth by more than 1% this quarter. China’s economy is experiencing a severe contraction, which should result in negative seasonally adjusted quarterly growth in Q1.1 Live indicators, such as the number of traffic jams in Shanghai streets or daily coal consumption are very weak, standing 20% and 32% below last year’s levels. Moreover, China accounts for 19.3% of global GDP, and its imports account for 12.5% of the rest of the world’s exports. China’s weak domestic activity has a ripple effect around the world. Making matters worse, the recent factory closings are scuttling global supply chains, which further lowers non-Chinese output. Finally, Chinese tourism accounts for 4.7% of global service exports, which will be deeply negatively impacted by the current immobility of Chinese citizens. As severe as the impact of Covid-19 will be in Q1, it will be fleeting. Epidemics and natural disasters may stop economic activity for a finite time, but they create pent-up demand that boosts economic growth in the following quarters. In the case of SARS, the lost output was recovered over the subsequent two quarters. Excess money is expanding at a brisk pace, which confirms that both the quantity and price of global output can rebound quickly (Chart I-1). The same is true of various liquidity measures, such as BCA Research’s US Financial Liquidity Index, which has an excellent record of forecasting the Global Leading Economic Indicator, the US ISM, and EM export prices. Most importantly, deleveraging is a tertiary concern for Chinese policymakers for the next two years. PMIs show that inventory levels are rapidly falling around the world. A purge in inventory allows pent-up demand to boost economic activity. Nowhere is this trend more powerful than in Sweden. Manufactured goods, especially intermediate and capital goods, represent a large percentage of Sweden’s output and exports. Thus, Sweden sits early in the global supply chains. Today, the decline in Swedish inventories is so deep that the country’s new orders-to-inventories ratio is surging, which historically indicates increases in our Global Industrial Activity Nowcast as well as US and global capital expenditures (Chart I-2). Chart I-1Ample Liquidity Will Cushion The Blow Ample Liquidity Will Cushion The Blow Ample Liquidity Will Cushion The Blow Chart I-2Positive Signal From Inventories Positive Signal From Inventories Positive Signal From Inventories   Improving liquidity and purged inventory bode very well for global economic activity. Our Global Growth Indicator, a variable mainly based on commodity prices and the bond yields of cyclical economies, has already predicted an improvement in global industrial production (Chart I-3). Our models showed that even Germany’s economy, which is largely driven by global economic gyrations, will experience a turnaround despite abysmal industrial production readings (Chart I-4). Chart I-3The Global Growth Indicator Continues To Rebound The Global Growth Indicator Continues To Rebound The Global Growth Indicator Continues To Rebound Chart I-4There's Hope Even For Germany There's Hope Even For Germany There's Hope Even For Germany The Federal Reserve is prepared to nurture the recovery. Falling job ads in the US, along with the New York Fed Underlying Inflation Gauge and BCA Research’s Pipeline Inflation Indicator point to a slowdown in core CPI (Chart I-5). Additionally, the FOMC wants to see inflation expectations recover toward the 2.3% to 2.5% zone reached when economic agents believe in the Fed’s capacity to sustain core PCE near 2%. BCA Research’s US Bond Strategy service’s adaptive expectations models show that based on current realized inflation trends, it would take a substantially long time for inflation expectations to move back into that zone. Chart I-5Disinflationary Pressures In The US Disinflationary Pressures In The US Disinflationary Pressures In The US The current health crisis is unleashing a wave of global stimulus. EM central banks, particularly in the Philippines and Indonesia, are cutting rates, thanks to low global and domestic inflation. Fiscal stimulus is expanding. Singapore has announced an SGD 800 million package aimed at fighting the impact of Covid-19; South Korea, Malaysia and Indonesia are also boosting spending. Even Germany is considering fiscal stimulus to support its economy. In China, the PBoC has injected RMB 2.3 trillion so far this year and cut rates. Most importantly, deleveraging is a tertiary concern for Chinese policymakers for the next two years. Factions opposed to President Xi will use his handling of the virus crisis to capitalize on discontent and gain more seats on the Politburo and Central Committee at the 2022 Communist Party Congress. To combat this opposition, President Xi is abandoning the deleveraging campaign and is generously stimulating the economy to generate greater income gains. The news is not all positive however, as the risk of a global pandemic remains elevated. There is no consensus in the medical community as to whether or not the pandemic is in remission. Chinese factories are re-opening and people are on the move, which is giving the virus an opportunity to spread again. Worryingly, new clusters of cases have popped up in South Korea, Iran, and Italy. In the US too, an individual without any links to previously known cases has fallen ill. These developments must be monitored closely. As BCA Research’s Global Investment Strategy service recently showed, the 2009/10 H1N1 outbreak (known as swine flu) affected between 700 million and 1 billion people worldwide.2 According to the Lancet, it resulted in 151,700 to 575,400 deaths or a fatality rate of 0.01% to 0.08%, well below current estimates of 2.3% for Covid-19. Thus, if Covid-19 spreads as much as H1N1, it could kill between 16 and 23 million people worldwide in a short amount of time. If such an outcome comes to pass, then we are looking at a global recession. Factory closures will grow in length and prevalence, which will paralyze global supply chains. International tourism will collapse and consumers around the world will shun crowded public places, which will hurt consumption substantially. Prudence forces us to not be cavalier and protect ourselves against what would be an extremely adverse outcome if Covid-19 were to spread much further. The uncertainty around such binary outcomes is hard to price for markets. As we argued last month, investors must input large risk premia in asset prices to compensate for this lack of visibility. When we last wrote, we saw no such margin of safety in the S&P 500, but its 11.5% collapse since February 19 has gone a long way in adjusting this mispricing. In fact, some bargains in the industrial, energy or transport sectors have emerged. Bottom Line: Investors should continue to hedge their exposure to risk assets until the situation becomes clearer. For now, our central scenario remains that new cases will soon peak and economic activity will recover. In this case, stocks and bond yields now have very limited downside, and they will recover later this year. Equities will ultimately reach new highs. However, prudence forces us to not be cavalier and protect ourselves against what would be an extremely adverse outcome if Covid-19 were to spread much further. The US Benefits From A Strong Dollar Looking beyond Covid-19, BCA Research expects the US dollar to correct in 2020. However, we increasingly view this downdraft as a temporary phenomenon. The dollar’s cyclical highs remain ahead in the next two to three years. Ultimately, the US is a consumer-driven economy and households benefit from a firm currency. A higher dollar also acts as a tax cut for consumers. Surprisingly, the dollar does not have a negative impact on employment. The unemployment rate and the dollar are negatively correlated (Chart I-6). The 27% dollar rally since 2011 is not antithetical with a US unemployment rate at a 51-year low of 3.6%. Less than 10% of US jobs are in the manufacturing sector, compared with 14.4% and 15.8% in Europe and Japan respectively (Chart I-7). Moreover, 93.6% of jobs created since the labor market troughed in 2010 have been in the service sector. Given that the service sector is domestically driven and is immune to the deflationary impact of a stronger dollar, the low share of manufacturing in the US’s GDP means that the labor market is resistant to a firm USD. Chart I-6The Labor Market Does Not Abhor A Strong Dollar... The Labor Market Does Not Abhor A Strong Dollar... The Labor Market Does Not Abhor A Strong Dollar... Chart I-7...Because The US Is Manufacturing Light ...Because The US Is Manufacturing Light ...Because The US Is Manufacturing Light   A higher dollar also acts as a tax cut for consumers. A dollar rally leads to a rapid decline in the share of disposable income spent on food and energy (Chart I-8). As a result, households have more discretionary disposable income to spend on services that generate domestic jobs. A strong dollar makes job creation less inflationary and permits the Fed to keep monetary policy easier for longer. A strengthening dollar redistributes income to the middle class, which supports consumption. When the dollar rallies, the share of salaries in national income increases because the dollar creates a headwind for profit margins (Chart I-9). Rich households garner more than 50% of their income from profits and rents. Therefore, if a stronger dollar increases the share GDP accounted for by wages, then a rising greenback redistributes income to middle-class households away from the rich. This redistribution is positive for consumption because middle-class households have a marginal propensity to consume of 90%, compared with 60% for households in the top decile of the income distribution. Furthermore, the more consumption can grow as a share of GDP, the more the economy can withstand a rallying currency. Chart I-8A Firm Dollar Cut "Taxes" A Firm Dollar Cut "Taxes" A Firm Dollar Cut "Taxes" Chart I-9The Dollar Is A Redistributor The Dollar Is A Redistributor The Dollar Is A Redistributor   Chart I-10A Strong Dollar Boosts Real Incomes A Strong Dollar Boosts Real Incomes A Strong Dollar Boosts Real Incomes A strong dollar also weighs on inflation, which has positive ramifications for consumers and the economy. By mid-2015, the dollar had rallied by an impressive 13.8%. While nominal wages grew at 2.2%, well below today’s rate of 3.8%, real wages were expanding at their highest rate in this cycle, courtesy of low inflation. Real consumption was also enjoying its largest gain in this cycle, expanding at 4.6% per annum (Chart I-10). A firm dollar also dampens inflation expectations (Chart I-11), allowing a flattening of the Phillips Curve, which links inflation to the unemployment rate. In other words, a strong dollar makes job creation less inflationary and permits the Fed to keep monetary policy easier for longer, delaying the inevitable date when the Fed kills the business cycle. Moreover, the disinflationary impact of a rising dollar puts downward pressure on interest rates (Chart I-12). In turn, lower rates keep financial conditions easier than would have otherwise been the case, which supports growth. Chart I-11A Hard Currency Dampens Inflation Expectations A Hard Currency Dampens Inflation Expectations A Hard Currency Dampens Inflation Expectations Chart I-12A Strong Dollar Depresses Interest Rates A Strong Dollar Depresses Interest Rates A Strong Dollar Depresses Interest Rates   A counterargument to the view that a strong US dollar is good for the business cycle is that it will hurt capex. While true, it is easy to overestimate this impact on growth. Not only does capex represent a much lower share of GDP than consumption, it most often contributes less to changes in GDP than consumer spending (Chart I-13). Moreover, lower interest rates triggered by a firm dollar support residential activity, which in turn mitigates some of the drag created by lower corporate capex. Finally, as Chart I-14 illustrates, 74.7% of the US’s capex emanates from sectors that are minimally affected by the dollar, creating greater resilience to a stronger currency than many realize. Chart I-13Consumption Dominates Capex Consumption Dominates Capex Consumption Dominates Capex Chart I-14Even Within Capex, The Dollar Is Not As Dominant As Believed Even Within Capex, The Dollar Is Not As Dominant As Believed Even Within Capex, The Dollar Is Not As Dominant As Believed   Chart I-15Symptoms Of US Resilience Symptoms Of US Resilience Symptoms Of US Resilience The US economy is indeed robust in the face of the strong dollar. If the dollar was hurting the US, then Germany should benefit from a falling euro. However, German net exports are weakening. Moreover, US profits are not lagging European ones as US firms continue to benefit from stronger global pricing power than their European counterparts. Finally, capex intentions in the US are surprisingly resilient (Chart I-15). Three forces increase the US’s economic capacity to withstand a strong dollar this cycle. First, the structural improvement in the US’s energy trade balance allows the US current account to remain stable at -2.5% of GDP despite a widening non-oil trade deficit. Secondly, the Trump Administration’s profligate spending boosts demand and insulates the economy from a rising dollar. BCA Research’s Geopolitical Strategy service expects President Trump to win the election, albeit with a conservative probability of 55%, but also believes a Democratic victory would lead to larger spending increases than tax hikes. The current expansive fiscal policy set up will thus remain in place going forward. Finally, the Sino-US Phase One deal will provide a welcome relief valve for US manufacturers, who are victims of the stronger dollar. While economic reality probably will not allow the deal to boost China’s purchases of US goods by $200 billion vis-à-vis the higher water mark of $186 billion of 2017 (Chart I-16), nonetheless it will force China to substitute goods purchases away from Europe and Japan in favor of the US. A hard dollar can feed on itself by widening the gap between US and foreign growth, a trend currently underway. Our favorite structural valuation measure also does not suggest that the dollar is currently a major hurdle for the US economy. BCA Research's Foreign Exchange Strategy service’s Long-Term Fair Value models, which account for differences in the productivity and neutral rate of interest of the US and its trading partners, show that the dollar is still roughly fairly valued and that its equilibrium is trending up (Chart I-17). Chart I-16The Phase One Deal Is Ambitious March 2020 March 2020 Chart I-17The Dollar Is Not Expensive Enough To Cause Pain The Dollar Is Not Expensive Enough To Cause Pain The Dollar Is Not Expensive Enough To Cause Pain   In this context, the US dollar has further cyclical upside. A strong dollar may not be as negative to the US economy as investors believe, but it hurts emerging economies. According to the Bank for International Settlements, there is more than US$12 trillion of USD-denominated foreign currency debt in the world. Therefore, a firm dollar tightens financial conditions outside the US. A hard dollar can feed on itself by widening the gap between US and foreign growth, a trend currently underway. Investment Implications For The Remainder Of The Cycle… Chart I-18The S&P 500 Likes A Firm Dollar The S&P 500 Likes A Firm Dollar The S&P 500 Likes A Firm Dollar The dollar’s additional cyclical upside is good news for US capital markets over the next few years. The S&P 500 performs better when the dollar is firm (Chart I-18). US stocks generated average annual returns of 12% during the 53% dollar rally of 1978 to 1985, 12% during the 33% dollar rally of 1995 to 2002, and 11% as the USD appreciated 27% during the past nine years. This compares well to an annualized return of 4% when the dollar suffers cyclical bear markets. The following observations explain why the US stock market performs better when the dollar appreciates: A strong dollar allows interest rates to remain lower than would have been the case otherwise, which also allows stock multiples to remain elevated. A strong dollar elongates the US business cycle by delaying the Fed’s tightening of monetary conditions. A longer business cycle dampens volatility and invites investors to bid down the equity risk premium. A strong dollar supports the US corporate bond market. A robust dollar may negatively impact bonds issued by energy or natural resources companies, but it also keeps the Fed at bay, which prevents a generalized increase in volatility and spreads. Lower rates allow for easy financial conditions and plentiful buybacks, a helpful combination for equities. Chart I-19The Dollar Holds The Key To Growth Vs Value The Dollar Holds The Key To Growth Vs Value The Dollar Holds The Key To Growth Vs Value A hard dollar is fundamental to the outperformance of US equities relative to global stocks. Global investors usually not do not hedge the currency component of equity returns. A firm USD automatically creates a powerful advantage for US stocks that invites greater inflows. In addition, a climbing dollar hurts value stocks (Chart I-19). Value stocks overweight cyclical sectors such as financials, industrials, materials and energy, sectors which depend on higher inflation, expanding EM economies and higher yields to outperform, three variables that suffer from an appreciating USD. An underperformance of value stocks also causes a poor outcome for foreign markets, which heavily overweight value over growth (Table I-1).   Table I-1Key Overweights By Market March 2020 March 2020 Chart I-20A Strong Dollar Fuels Tech Multiples A Strong Dollar Fuels Tech Multiples A Strong Dollar Fuels Tech Multiples The tech sector also benefits from a firm dollar. Tech stocks generate long-term earnings growth and they are generally not as sensitive to the global business cycle as traditional cyclical equities are. When the global business cycle weakens, yields decline and the dollar appreciates, then earnings growth becomes scarce. In this environment, investors willingly bid up assets that can generate a structural earning expansion. Tech multiples become the prime beneficiary of that phenomenon (Chart I-20), which allows US stocks to meaningfully outperform the rest of the world when the dollar hardens. Bottom Line: A firm dollar will allow the business cycle to expand for longer, which suggests that the dollar will make greater highs over the coming two to three years. Within this time frame, US stocks will likely continue to outperform their global counterparts, despite their valuations disadvantage. … And For 2020 In 2020, the dominant driver for the US dollar will be global growth. The pickup in BCA’s Global Growth Indicator and the elevated chance of a rising Chinese combined credit and fiscal impulse will lift global activity and thus, force down the USD (Chart I-21). Additionally, existing trends in global money supply growth reinforce the near-term downside risk to the dollar, assuming Covid-19 does not become a global pandemic (Chart I-22). Chart I-21China Stimulus Will Lift Growth chart 21 China Stimulus Will Lift Growth China Stimulus Will Lift Growth Chart I-22Bearish Monetary Dynamics For The Dollar In 2020 Bearish Monetary Dynamics For The Dollar In 2020 Bearish Monetary Dynamics For The Dollar In 2020   Chart I-23The Euro Is Not The Best Anti-Dollar Bet For 2020 The Euro Is Not The Best Anti-Dollar Bet For 2020 The Euro Is Not The Best Anti-Dollar Bet For 2020 The euro is unlikely to be the main beneficiary from a dollar correction. EUR/USD does not yet trade at a discount to our fair value estimates consistent with an intermediate-term bottom (Chart I-23). Moreover, the euro lags pro-cyclical currencies such as the AUD, CAD, NZD, or SEK, when global growth starts to recover but inflation remains weak. Finally, the Phase One Sino-US trade deal will create a drag on the positive impact of a Chinese recovery on European exports for machinery.3 Bottom Line: A dollar correction in 2020 is congruent with a period of underperformance for tech stocks relative to industrials, financials, materials and energy stocks. The correction also supports value relative to growth equities this year, as well as foreign bourses relative to the S&P 500. Investors who elect to bet against the dollar in 2020 should only do so with great caution as they will be betting against the broader cyclical trend. A correction in the dollar, by definition, is transitory. Thus, the aforementioned equity implications will also likely be temporary. Ultimately, the US economy remains the global growth leader in the post-2008 environment. Mathieu Savary Vice President The Bank Credit Analyst February 27, 2020 Next Report: March 26, 2020 II. Labor Strikes Back The balance of power in US labor negotiations has shifted infrequently in the industrial age. Successful strikes beget strikes. Key factors that have bolstered management for decades are poised to reverse. Public opinion has a significant impact on labor-management outcomes. Elections have consequences. Organized labor isn’t dead. Where will inflation come from, and when will it arrive? An investor who answers these questions will have advance notice of the end of the expansion and the bull markets in equities and credit. Per our base-case scenario, the expansion won’t end until monetary policy settings become restrictive, and the Fed won’t pursue restrictive policy unless inflation pressures force its hand. The fur flies when each party thinks the other should make the bulk of the concessions: labor negotiations over the next couple of years could be interesting. Inured by a decade of specious warnings that “money printing” would let the inflation genie out of the bottle, investors are skeptical that inflation will ever re-emerge. The inflation backdrop has become much more supportive in the last few years, however, upon the closing of the output gap, and the stimulus-driven jolt in aggregate demand. Output gaps in other major economies will have to narrow further (Chart II-1) for global goods inflation to gain traction, and mild inflation elsewhere in the G7 (Chart II-2) suggests that goods prices are not about to surge. Chart II-1There's Still Enough Spare Capacity ... March 2020 March 2020 Chart II-2... To Restrain Global Goods Inflation ... To Restrain Global Goods Inflation ... To Restrain Global Goods Inflation Services are not so easily imported, though, and services inflation is a more fully domestic phenomenon. Rising wages could be the spur for services inflation, and the labor market is tight on several counts: the unemployment rate is at a 50-year low; the broader definition of unemployment, also encompassing discouraged workers and the underemployed, reached a new all-time (25-year) low in December; the JOLTS job openings and quits rates at or near their all-time (19-year) highs; and the NFIB survey and a profusion of anecdotal reports suggest that employers are having a hard time finding quality candidates. With labor demand exceeding supply, wages for nonsupervisory workers have duly risen (Chart II-3). Gains in other compensation series have been muted, however, and investors have come to yawn and roll their eyes at any mention of the Phillips Curve. Chart II-3Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Perhaps it’s not the Phillips Curve that’s broken, but workers’ spirits. A supine organized labor movement could explain why the Phillips Curve itself is so flat. As the old saying goes, if you don’t ask, you know what you’re going to get, and beleaguered unions and their memberships, cowed by two decades of woe coinciding with China’s entry into the WTO (Chart II-4), have been afraid to ask. Strikes are the most potent weapon in labor’s arsenal; if it can’t credibly wield them, it is sure to be steamrolled. Chart II-4Globalization Has Been Unkind To Labor Globalization Has Been Unkind To Labor Globalization Has Been Unkind To Labor Two years of high-profile strike victories by public- and private-sector employees may suggest that the sands have begun to shift, however, and inspired our examination of labor’s muscle. An Investor’s Guide To US Labor History Let's begin our exercise with a review of US labor relations. The Colosseum Era (1800-1933) We view US industrial labor history as having three distinct phases. We label the first, which lasted until the New Dealers took over Washington, the Colosseum era (Figure II-1), because labor and management were about as evenly matched as the Christians and the lions in ancient Rome. Uprisings in textile mills, steel factories, and mines were swiftly squelched, often violently. Management was able to draw on public resources like the police and state National Guard units to put down strikes, or was able to unleash its own security or ad hoc militia forces on strikers or union organizers without state interference. The public, staunchly opposed to anarchists and Communists, generally sided with employers. Figure II-1Significant Events In The Colosseum Era March 2020 March 2020 Unions won some small-bore victories during the period, but they nearly all proved fleeting as companies regularly took back concessions and public officials and courts failed to enforce the loose patchwork of laws aimed at ameliorating industrial workers’ plight. Labor inevitably suffered the brunt of the casualties when conflicts turned violent. Workers were hardly choir boys, and seem to have initiated violence as often as employers’ proxies, but they were inevitably outgunned, especially when police, guardsmen or soldiers were marshaled against them. Societal norms have changed dramatically since the Colosseum era, but the lore of past “battles” encourages an us-versus-them union mentality that occasionally colors negotiations. Employees and employers need each other, and their tether can only be stretched so far before it starts pulling them back together. The UAW Era (1933-1981) Established presumptions about the employer-employee relationship were upended when FDR entered the White House. Viewing labor organization as a way to ease national suffering, New Dealers passed the Wagner Act to grant private-sector workers unionization and collective bargaining rights, and created the National Labor Relations Board to ensure that employers respected them. The Wagner Act greatly aided labor organization, enabling unions to build up the heft to engage with employers on an equal footing. Unionized workers still fought an uphill battle in the wake of the Depression, but tactics like the sit-down strike (Box II-1) produced some early labor victories that paved the way for more. BOX II-1 David Topples Goliath: The Flint Sit-Down Strike   The broad mass of factory workers had not been organized to any meaningful degree before the New Deal, and the United Auto Workers (UAW) was not formed until 1935. Despite federal protections, the fledgling UAW had to conduct its operations covertly, lest its members face employer reprisals. At the end of 1936, when it took on GM, only one in seven GM employees was a dues-paying member. The strike began the night of December 30th when workers in two of GM’s Flint auto body plants sat down at their posts, ignoring orders to return to work. The sit-down action was more effective than a conventional strike because it prevented GM from simply replacing the workers with strikebreakers. It also made GM think twice about attempting to remove them by force, lest valuable equipment be damaged. GM was unsure how to dislodge the workers after a court injunction it obtained on January 2nd went nowhere once the UAW publicized that the presiding judge held today’s equivalent of $4 million in GM shares. It turned off the heat in one of the plants on January 11th, before police armed with tear gas and riot guns stormed it. The police were rebuffed by strikers who threw bottles, rocks, and car parts from the plant’s upper windows while spraying torrents of water from its fire hoses. No one died in the melee, but the strike was already front-page news across the country, and the attack helped the strikers win public sympathy. Michigan’s governor responded by calling out the National Guard to prevent a rematch, shielding the strikers from any further violence. The strike was finally settled on February 11th when GM accepted the UAW as the workers’ exclusive bargaining agent and agreed not to hinder its attempts to organize its work force. The UAW signed a similar accord with Chrysler immediately after the Flint sit-down strike, and the CIO (the UAW’s parent union) swiftly reached an agreement with US Steel that significantly improved steelworkers’ pay and hours. Labor unions’ path wasn’t always smooth – Ford fiercely resisted unionization until 1941, and ten protesters were killed, and dozens injured, by Chicago police at a peaceful Memorial Day demonstration in support of strikers against the regional steelmakers that did not follow US Steel’s conciliatory lead – but it generally trended upward after the New Deal (Figure II-2). From the 1950 signing of the Treaty of Detroit, a remarkably generous five-year agreement between the UAW and the Big Three automakers, the UAW ran roughshod over the US auto industry for three-plus decades. The New Deal’s encouragement of unionization had given labor a fighting chance, and was the foundation on which all of its subsequent gains were built. Figure II-2Significant Events In The UAW Era March 2020 March 2020 The Reagan-Thatcher Era (1981 - ??) The disastrous strike by the air traffic controllers’ union (PATCO) is the watershed event that heralded the end of unions’ golden age. Strikes by federal employees were illegal, so PATCO broke the law when it went on strike in April 1981, spurning the generous contract terms its leaders had negotiated with the Reagan administration. PATCO had periodically held the flow of air traffic hostage throughout the seventies to extract concessions from its employer, earning the lasting enmity of airlines, government officials and the public. Other unions were aghast at PATCO’s openly contemptuous attitude, and declined to support it with sympathy strikes, while conservatives blasted the new administration behind closed doors for the profligacy of its initial PATCO offer. President Reagan therefore had an unfettered opportunity to make an example out of the controllers, and he seized it, firing those who failed to return to work within 48 hours and banning them from ever returning to government employment. A fed-up public supported the president’s hard line, and employers and unions got the message that a new sheriff was in town. His deputies were not inclined to enforce labor-friendly statues, or investigate labor grievances, with much vigor, and they would not necessarily look the other way when public sector unions illegally struck. Management has been in the driver's seat, but the factors that have kept it there have a high risk of reversing. Unions also found themselves on the wrong side of the growing disaffection with bureaucracy that was bound up with the push for deregulation. The globalization wave further eroded labor’s power. Unskilled workers in the developed world would be hammered by the flat world that allowed people, capital and information to hopscotch around the globe. Eight years of a Democratic presidency brought no relief, as the “Third Way” Clinton administration embraced the free-market tide (Chart II-5), and the unionized share of employees has receded all the way back to mid-thirties levels (Chart II-6). Chart II-5Inequality Took Off ... Inequality Took Off ... Inequality Took Off ... Chart II-6... As Unions Lost Their Way ... As Unions Lost Their Way ... As Unions Lost Their Way A Fourth Phase? A handful of data points do not make a trend, especially in a series that stands out for its persistence, but the bargaining power pendulum could be shifting. Public school teachers won improbable statewide victories with illegal strikes in three highly conservative states in the first half of 2018 (Table II-1); a canny hotel workers union steered its members to big gains in their contract negotiations with Marriott in the second half of 2018; and the UAW bested General Motors and the rest of the Big Three automakers last fall. Unions may have more bargaining power than markets and employers realize, and they could be on the cusp of becoming more aggressive in flexing it. Table II-1Teachers' Unions Conquer The Red States March 2020 March 2020 Takeaways (I) There are two key takeaways from our historical review: 1. US industrial history makes it clear that employees are unlikely to gain ground if government sides with employers. Employees no longer have to fear that the state will look the other way while strikers are beaten, or fail to prosecute those responsible for loss of life, but they face especially long odds when the government is inclined to favor employers. Its thumb weighs heavily on the scale when it drags its feet on enforcement; cuts funding to agencies policing workplace standards; and appoints agency or department heads that are conditioned to see things solely from employers’ perspective, shaped by long careers in management. 2. Successful strikes beget strikes, and the converse is also true. Withholding their labor is employees’ most powerful weapon, and when employers can’t replace them cheaply and easily, strikes often succeed. Striking is frightening for an individual, however, because it cuts off his or her income (or sharply reduces it, if the striker’s union has a strike fund) until the strike is over. If the strike fails, the employee may find him/herself blacklisted, impairing his/her long-term income prospects on top of his/her short-term losses. Prudent workers should therefore strike sparingly, with the due consideration that a prudent poker player exercises before going all-in. Companies will do whatever they perceive to be socially acceptable in conflicts with employees, but no more. When other unions facing comparable conditions pull off successful strikes, it makes it much easier for another union to take the leap, in addition to making success more likely, provided conditions truly are comparable. “Before they occur, successful strikes appear impossible. Afterward, they seem almost inevitable .”4 The retrospective inevitability stiffens the spine of potential strikers who observe successful outcomes, and raises the bar for action among potential strikers who observe failures. “Just as defeats in struggle lead to demoralization and resignation, victories tend to beget more victories .”5 Public opinion matters just as surely as momentum, and it proved decisive in the Flint sit-down strike and in the air traffic controllers’ showdown with President Reagan. According to Gallup’s annual poll, Americans now regard unions as favorably as they did before Thatcher and Reagan came to power (Chart II-7). Chart II-7Could Unions Make A Comeback? Could Unions Make A Comeback? Could Unions Make A Comeback? Where Strikes Come From And Who Wins Them Since strikes are such an important determinant of the support for labor, what drives successful labor actions? The Origin Of Strikes Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative power, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached fairly quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, and when both parties recognize that relative bargaining positions are fluid, they are likely to exercise it. It's no surprise that unions have started to look pretty good to workers after a decade of sluggish growth and widening inequality. History shows that the pendulum between labor and management swings, albeit slowly, as societal views evolve6 and the business cycle fluctuates. As a general rule, management will have the upper hand during recessions, when the supply of workers exceeds demand, and labor will have the advantage when expansions are well advanced, and capacity tightens. A high unemployment rate broadly favors employers, and a low unemployment rate favors employees. Neither the number of work stoppages (Chart II-8, top panel), nor the number of workers involved (Chart II-8, middle panel) correlates very well with the unemployment gap (Chart II-8, bottom panel), in the Reagan-Thatcher era, however, as work stoppages have dwindled almost to zero. Chart II-8Swamped By The Legal And Regulatory Tide Swamped By The Legal And Regulatory Tide Swamped By The Legal And Regulatory Tide Game theory is better equipped than simple regression models to offer insight into the origin of strikes. We posit a simple framework in which each side can hold any of five perceptions of its own bargaining power, resulting in a total of 25 possible joint perceptions. Management (M) can believe it is way stronger than Labor (L), M >> L; stronger than Labor, M > L; roughly equal, M ≈ L; weaker than Labor, L > M; or way weaker than Labor, L >> M. Labor also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure II-3 displays only the outcomes consistent with management’s belief that it has the upper hand. For completeness, the exhibit lists all of labor’s potential perceptions, but we deem the two in which labor is feeling its oats (circled) to be most likely, given the success of recent high-profile strikes.7 Management’s confidence follows logically from four decades of victories, but may prove to be unfounded if its power has already peaked. Figure II-3The Eye Of The Beholder March 2020 March 2020 Strike outcomes turn on which side has overestimated its leverage. The broad factors we use to assess leverage are overall labor market slack; economic concentration; regulatory and legal trends; and the sustainability of either side’s accumulated advantage, which we describe as the labor-management rubber band. Other factors that matter on a case-by-case basis, but are beyond the scope of our analysis, include industry-level slack, a labor input’s susceptibility to automation, and the degree of labor specialization/skill involved in that input. For these micro-level factors, a given group of workers’ leverage is inversely related to the availability of substitutes for their input. Labor Market Slack              Despite muted wage growth, the labor market is demonstrably tight. The unemployment rate is at a 50-year low, the broader definition of unemployment is at the lowest level in its 26-year history, and the prime-age employment-to-population ratio is back to its 2001 levels, having surpassed the previous cycle’s peak (Chart II-9). The job openings rate is high, indicating that demand for workers is robust, and so is the quits rate, indicating that employers are competing vigorously to meet it. The NFIB survey’s job openings and hiring plans series (Chart II-10) echo the JOLTS findings. Chart II-9Prime-Age Employment Is At An 18-Year High ... Prime-Age Employment Is At An 18-Year High ... Prime-Age Employment Is At An 18-Year High ... Chart II-10... But There Are Still Lots Of Help Wanted Signs ... But There Are Still Lots Of Help Wanted Signs ... But There Are Still Lots Of Help Wanted Signs The lack of labor market slack decisively favors workers’ negotiating position. It is a sellers’ market when demand outstrips supply, and labor victories tend to be self-reinforcing. Successful strikes beget strikes, and management volunteers concessions as labor peace becomes a competitive advantage during strike waves. Given that the crisis-driven damage to the labor force participation rate has healed as the gap between the actual part rate (Chart II-11, solid line) and its demographically-determined structural proxy has closed (Chart II-11, dashed line), the burden of proof rests squarely with those who argue that there is an ample supply of workers waiting to come off the sidelines. Chart II-11The Labor Force Participation Gap Has Closed The Labor Force Participation Gap Has Closed The Labor Force Participation Gap Has Closed Economic Concentration The trend toward economic concentration (Chart II-12) has endowed the largest companies with greater market power, as evidenced by surging corporate profit margins. The greater the concentration of employment opportunities in local labor markets, the more closely they resemble monopsonies.8 Unfortunately for labor, monopsonies restrain prices just as monopolies inflate them. As we have shown,9 there is a robust inverse relationship between employment concentration and real wages (Chart II-13). Chart II-12Less Competition = More Power March 2020 March 2020 Chart II-13One Huge Buyer + Plus Multiple Small Sellers = Low Prices March 2020 March 2020 Economic concentration has been a major driver of management’s Reagan-Thatcher era dominance. Sleepy to indifferent antitrust enforcement has helped businesses capture market power, and it will continue to prevail through 2024 unless the Democrats take the White House in November. The silver lining for workers is that concentration could have the effect of promoting labor organization in services, where unions have heretofore made limited progress. The only way for employees to combat employers’ monopsony power is to organize their way to becoming a monopoly supplier of labor. Regulatory And Legal Trends Over the last four decades, unions have endured a near-constant drubbing from state capitols, federal agencies and the courts, as union and labor protections have been under siege from all sides. Since the air traffic controllers’ disastrous strike, labor’s regulatory and legal fortunes have most closely resembled the competitive fortunes of the Harlem Globetrotters’ beleaguered opposition. But the regulatory and legal tide has been such a huge benefit for management since the beginning of the Reagan administration that it cannot continue to maintain its pace. If the electorate has had enough of Reagan-Thatcher policies, elected officials will stop implementing them. Investors seem to assume that it will, however, to the extent that they think about it at all. It stands to reason that employers may be similarly complacent. We will look more closely at the presidential election and its potential consequences in Part 3, but labor concerns and inequality are capturing more attention, even among Republicans. With Republicans’ inclination to side with business only able to go in one direction, the chances are good that it has peaked. The Labor-Management Rubber Band For all of the romantic allure of labor’s battles with management in the Colosseum era, employees and employers have a deeply symbiotic relationship. One can’t exist without the other, and pursuing total victory in negotiations is folly. Even too many incremental wins can prove ruinous, as the UAW discovered to its chagrin in 2008. A half-century of generous compensation and stultifying work rules saddled Detroit automakers with a burden that would have put them out of business had the federal government not intervened. Table II-2Average Salaries Of Public School Teachers By State March 2020 March 2020 We think of labor and management as being linked by a tether with a finite range. Since neither side can thrive for long if the other side is suffering, the tether pulls the two sides closer together when the gap between them threatens to become too wide. When labor does too well for too long at management’s expense, profit margins shrink and the company’s viability as a going concern is threatened. When management does too well, deteriorating living standards drive the best employees away, undermining productivity and profitability. Before the low-paying entity’s work force becomes a listless dumping ground for other firms’ castoffs, it may rise up and strike out of desperation. Teachers’ unions might have appeared to be setting themselves up for a fall in 2018 by illegally striking in staunchly conservative West Virginia, Oklahoma and Arizona, but desperate times call for desperate measures. Per the National Education Association’s data for the 2017-18 academic year, average public school teacher pay in West Virginia ranked 50th among the 50 states and the District of Columbia, Oklahoma ranked 49th and Arizona ranked 45th (Table II-2). Adjusting the nominal salaries for cost disparities across states, West Virginia placed 41st, Oklahoma 44th and Arizona 48th. Given that real teacher salaries had declined by 8% and 9% since 2009-10 in West Virginia and Arizona, respectively, the labor-management rubber band had stretched nearly to the breaking point. Consolidating The Macro Message Parties to negotiations derive leverage from the availability of substitutes. When alternative employment opportunities are prevalent, workers have a lot of leverage, because they can credibly threaten to avail themselves of them. Teaching is a skill that transfers easily, and every state has a public school system, so teachers in low-salary states have a wealth of ready alternatives. The converse is true for low-salary states; despite much warmer temperatures, it is unlikely that teachers from top-quintile states will be willing to take a 25-33% cost-of-living-adjusted pay cut to decamp to Arizona (Table II-3). Table II-3Cost Of Living-Adjusted Public School Teacher Salaries By State March 2020 March 2020 It is easy to see from Figure II-4 why management has had the upper hand. Economic concentration and the legal and regulatory climate have increasingly favored it for decades. The immediate future seems poised to favor labor, however, as the legal and regulatory climate cannot get materially better for employers, and the labor-management rubber band has become so stretched that some sort of mean reversion is inevitable. We have high conviction that labor’s one current advantage, a tight labor market, will remain in its column over the next year or two. On a forward-looking basis, the macro factors as a whole are poised to support labor. Figure II-4Macro Drivers Of Negotiating Leverage March 2020 March 2020 Takeaways (II) We think it is more likely than not that the labor movement in the United States will remain weak relative to its 1950s to 1970s heyday. We do think, however, that the probability that unions could rise up to exert the leverage that accrues to workers in a tight labor market is considerably larger than the great majority of investors perceive. Alpha – market-beating return – arises from surprises. An investor captures excess returns when s/he successfully anticipates something that the consensus does not. If the disparity involves a trivial outcome, then any excess return is likely to be trivial, but if the outcome is significant, the investor who zigged when the rest of the market zagged stands to separate him/herself from the pack. We think the outcome of a shift in leverage from employers to employees would be very large indeed. We would expect that aggregate wage gains of 4% or higher would quickly drive the Fed to impose restrictive monetary policy settings, eventually inducing the next recession and the end of the bull markets in equities, credit and property. A union revival may be a low-probability event, but it would have considerable impact on markets and the economy. Given our conviction that the probability, albeit low, is much greater than investors expect, we think the subject is well worth sustained attention. The Public-Approval Contest The last question to approach is how does labor or management win in the court of public opinion? Capturing Hearts And Minds Public opinion has shaped the outcomes of labor-management contests throughout US labor relations history. Labor was continually outgunned before the New Deal, coming up against private security forces, local police and/or the National Guard when they struck. Employers were able to turn to hired muscle, or request the deployment of public resources on their behalf, because the public had few qualms about using force to break strikes. College athletes were even pressed into service as strikebreakers after the turn of the century for what was viewed at the time as good, clean fun.10 Public opinion is not immutable, however, and by the time of the Flint sit-down strike, it had begun to shift in the direction of labor. The widespread misery of the Depression went a long way to overcoming Americans’ deep-seated suspicion of the labor movement and the fringe elements associated with it. Some employers were slow to pick up on the change in the public mood, however, and Ford’s security force thuggishly beat Walter Reuther and other UAW organizers while they oversaw the distribution of union leaflets outside a massive Ford plant just three months after Flint. Ford won the Battle of the Overpass, but its heavy-handed, retrograde tactics helped cost it the war. Reuther, who later led the UAW in its ‘50s and ‘60s golden age, was a master strategist with a knack for public relations. Writing the playbook later used to great effect by civil rights leaders, Reuther invited clergymen, Senate staffers and the press to accompany the largely female team of leafleteers. When the Ford heavies commenced beating the men, and roughly scattering the women, photographers were on hand to document it all.11 The photos helped unions capture public sympathy, just as televised images of dogs and fire hoses would later help secure passage of landmark civil rights legislation. Unions’ Fall From Grace Figure II-5Unions' 1980s Public Opinion Vortex March 2020 March 2020 Labor unions enjoyed their greatest public support in the mid-fifties, and largely maintained it well into the sixties, until rampant corruption and ties to organized crime undermined their public appeal. The shoddy quality of American autos further turned opinion against the UAW, the nation’s most prominent union, and a college football star named Brian Bosworth caused a mid-eighties furor by claiming that he had deliberately sought to prank new car buyers during his summer job on a Chevrolet assembly line. Bosworth later retracted the claim that GM workers had shown him how to insert stray bolts in inaccessible parts of car bodies to create a maddening mystery rattling, but the fact that so many Sports Illustrated readers found it credible eloquently testified to the UAW’s image problem. President Reagan accelerated the trend when he successfully stood up to the striking air traffic controllers, but his administration could not have taken such a hard line if unions hadn’t already been weakened by declining public support. Together, the public’s waning support for unions and the Reagan administration’s antipathy for them were powerfully self-reinforcing, and they fueled a vicious circle that powered four decades of union reversals (Figure II-5). As a prescient November 1981 Fortune report put it, “‘Managers are discovering that strikes can be broken, … and that strike-breaking (assuming it to be legal and nonviolent) doesn’t have to be a dirty word. In the long run, this new perception by business could turn out to be big news.’”12 Emboldened by the federal government’s replacement of the controllers, and the growing public perception that unions had devolved into an insular interest group driving the cost of living higher for everyone else, businesses began turning to permanent replacement workers to counter strikes.13 As an attorney that represented management in labor disputes told The New York Times in 1986, “If the President of the United States can replace [strikers], this must be socially acceptable, politically acceptable, and we can do it, also.”14 Labor’s New Face … Polling data indicate that unions have been recovering in the court of public opinion since the crisis, when the public presumably soured on them over the perception that the UAW was selfishly impeding the auto industry bailout. Their image got a boost in 2018 (Chart II-14), as striking red-state teachers embodied the shift from unions’ factory past to their service-provider present. “The teachers, many of them women, are redefining attitudes about organized labor, replacing negative stereotypes of overpaid and underperforming blue-collar workers with a more sympathetic face: overworked and underappreciated nurturers who say they’re fighting for their students as much as they’re fighting for themselves.”15 Chart II-14Feeling The Bern? Feeling The Bern? Feeling The Bern? Several commentators have heard organized labor’s death knell in US manufacturing’s irreversible decline. Unions gained critical mass on docks, factory floors, steel mills and coal mines, but few of today’s workers make their living there. Those who remain have little recourse other than to accept whatever terms management offers, as their jobs can easily be outsourced to lower-cost jurisdictions. The decline in private-sector union membership has traced the steady diminution of factory workers’ leverage (Chart II-15). Chart II-15Tracking Manufacturing's Slide Tracking Manufacturing's Slide Tracking Manufacturing's Slide Service workers represent unions’ future, and they have two important advantages over their manufacturing counterparts: many of their functions cannot be offshored, and a great deal of them are customer-facing. When MGM’s chairman was ousted from his job after clashing with Las Vegas’ potent UNITE-HERE local over the new MGM Grand Hotel’s nonunion policy, his successor explained why he immediately came to terms with the union. “‘The last thing you want is for people who are coming to enjoy themselves to see pickets and unhappy workers blocking driveways. … When you’re in the service business, the first contact our guests have is with the guest-room attendants or the food and beverage servers, and if that person’s [sic] unhappy, that comes across to the guests very quickly.’”16 … Management’s New Leaf … The Business Roundtable’s latest statement on corporate governance principles laid out a new stakeholder vision, displacing the Milton Friedman view that corporations are solely responsible for maximizing shareholder wealth. The statement itself is pretty bland, but the preamble in the press release accompanying it sounds as if it had been developed with labor advocates’ help (Box II-2). It is a stretch to think that the ideals in the Roundtable’s communications will take precedence over investment returns, but they may signal that management fears the labor-management rubber band has been stretched too far.17 The Environmental, Social and Governance (ESG) movement has the potential to improve rank-and-file workers’ wages and working conditions. ESG proponents have steadily groused about outsized executive pay packages, but if asset owners and institutional investors were to begin pushing for higher entry-level pay to narrow the income-inequality gap, unions could gain some powerful allies. BOX II-2 Farewell, Milton Friedman   America’s economic model, which is based on freedom, liberty and other enduring principles of our democracy, has raised standards of living for generations, while promoting competition, consumer choice and innovation. America’s businesses have been a critical engine to its success. Yet we know that many Americans are struggling. Too often hard work is not rewarded, and not enough is being done for workers to adjust to the rapid pace of change in the economy. If companies fail to recognize that the success of our system is dependent on inclusive long-term growth, many will raise legitimate questions about the role of large employers in our society. With these concerns in mind, Business Roundtable is modernizing its principles on the role of a corporation. Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance that include language on the purpose of a corporation. Each version of that document issued since 1997 has stated that corporations exist principally to serve their shareholders. It has become clear that this language on corporate purpose does not accurately describe the ways in which we and our fellow CEOs endeavor every day to create value for all our stakeholders, whose long-term interests are inseparable. We therefore provide the following Statement on the Purpose of a Corporation, which supersedes previous Business Roundtable statements and more accurately reflects our commitment to a free market economy that serves all Americans. This statement represents only one element of Business Roundtable’s work to ensure more inclusive prosperity, and we are continuing to challenge ourselves to do more. Just as we are committed to doing our part as corporate CEOs, we call on others to do their part as well. In particular, we urge leading investors to support companies that build long-term value by investing in their employees and communities. … And The Public’s Left Turn Chart II-16Help! Help! Help! As our Geopolitical Strategy colleagues have argued since the 2016 primaries, the median voter in the US has been moving to the left as the financial crisis, the hollowing out of the middle class and the widening wealth gap have dimmed the luster of Reagan-Thatcher free-market policies.18 Globalization has squeezed unskilled labor everywhere in the developed world, and white-collar workers are starting to look over their shoulders at artificial intelligence programs that may render them obsolete as surely as voice mail and word processing decimated secretaries and typists. Banding together hasn’t sounded so good since the Depression, and nearly half of all workers polled in 2017 said they would join a union if they could (Chart II-16). Millennials are poised to become the single biggest voting bloc in the country. They were born between 1981 and 1996, and their lives have spanned two equity market crashes, the September 11th attacks, and the financial crisis, instilling them with a keen awareness of the way that remote events can upend the best-laid plans. Many of them emerged from college with sizable debt and dim earnings prospects. They would welcome more government involvement in the economy, and their enthusiastic embrace of Bernie Sanders and Elizabeth Warren (Chart II-17) indicates they’re on unions’ side. Chart II-17No 'Third Way' For Millennials March 2020 March 2020 Elections Have (Considerable Regulatory) Consequences Electoral outcomes influence the division of the economic pie between employers and employees. Labor-friendly presidents, governors and legislatures are more likely to expand employee protections, while more vigilantly enforcing the employment laws and regulations that are already on the books. The White House appoints top leadership at the Labor Department, the National Labor Review Board (NLRB), and the Occupational Safety and Health Administration (OSHA), along with the attorney general, who dictates the effort devoted to anti-trust enforcement. The differences can be stark. Justice Scalia’s son would no more have led the Obama Department of Labor than Scott Pruitt (EPA), Wilbur Ross (Commerce) or Betsy Devos (Education) would have found employment anywhere in the Obama administration. McDonald’s has good reason to be happy with the outcome of the 2016 election; its business before the NLRB wound up being resolved much more favorably in 2019 than it would have been when it began in 2014 (Box II-3). At the state level, Wisconsin public employees suffered a previously unimaginable setback when Scott Walker won the 2010 gubernatorial election, along with sizable legislative majorities (Box II-4). BOX II-3 The Right Referee Makes All The Difference The Fight for $15 movement that began in 2012 aimed to nearly double the median fast-food worker’s wages. A raise of that magnitude would pose an existential threat to fast-food’s business model, and McDonald’s and its franchisees sought to stymie the movement’s momentum. The NLRB opened an investigation in 2014 following allegations that employees were fired for participating in organizing activities. McDonald’s vigorously contested the case in an effort to avoid the joint-employer designation that would open the door for franchise employees to bargain collectively with the parent company. (Absent a joint-employer ruling, a union would have to organize the McDonald’s work force one franchise at a time.) When the case was decided in McDonald’s favor in December, the headline and sub-header on the Bloomberg story reporting the outcome crystallized our elections-matter thesis: McDonald’s Gets Win Under Trump That Proved Elusive With Obama Board led by Trump appointees overrules judge in case that threatened business model BOX II-4 Wisconsin Guts Public-Sector Unions Soon after Wisconsin Governor Scott Walker took office in January 2011, backed by sizable Republican majorities in both houses of the legislature, he sent a bill to legislators that would cripple the state’s public-sector unions. Protestors swarmed Madison and filled the capitol building every day for a month to contest the bill, and Democratic legislators fled the state to forestall a vote, but it eventually passed nonetheless. The bill struck at a rare union success story; nearly one-third of public-sector employees are union members and that ratio has remained fairly steady over the last 40 years (Chart II-18). Wisconsin’s public-sector unions now do little more than advocate for their members in disciplinary and grievance proceedings, and overall union membership in the state has fallen by a whopping 43% since the end of 2009. Judicial appointments make a difference, too. The Supreme Court’s Janus decision in April 2018, banning any requirement that public employees pay dues to the unions that bargain for them on not-so-readily-apparent First Amendment grounds,19 was widely viewed as a body blow to public-sector unions. The 5-4 decision would certainly have gone the other way had President Obama’s nominee to succeed the late Justice Scalia been confirmed by the Senate. Chart II-18Public-Sector Union Membership Has Held Up Well Public-Sector Union Membership Has Held Up Well Public-Sector Union Membership Has Held Up Well Final Takeaways We do not anticipate that organized labor will regain the position it enjoyed in the fifties and sixties, when global competition was weak and shareholders and consumers were anything but vigilant about corporate operations. Even a more modest flexing of labor muscle that pushes wages higher across the entire economy has a probability of less than one half. Investors seem to think the probability is negligible, though, and therein lies an opportunity. Elected officials deliver what their constituents want, as do the courts, albeit with a longer lag. Society’s view of striking/strikebreaking tactics heavily influences how they’re deployed and whether or not they’ll be successful. We believe that public opinion is beginning to coalesce on employees’ side as labor puts on a more appealing face; as businesses increasingly fret about inequality’s consequences; and as millennials swoon over progressives, undeterred by labels that would have left their Cold War ancestors reaching for weapons. The median voter theory has importance beyond predicting future outcomes; it directly influences them. As the center of the electorate leans to the left, elected officials will have to deliver more liberal outcomes if they want to keep their jobs. If the electorate has given up on Reagan-Thatcher principles, organized labor is bound to get a break from the four-decade onslaught that has left it shrunken and feeble. There is one overriding market takeaway from our view that a labor recovery is more likely than investors realize: long-run inflation expectations are way too low. Although we do not expect wage growth to rise enough this year to give rise to sustainable upward inflation pressures that force the Fed to come off of the sidelines, we do think investors are overly complacent about inflation. We continue to advocate for below-benchmark duration positioning over a cyclical timeframe and for owning TIPS in place of longer-maturity Treasury bonds over all timeframes. Watch the election, as it may reveal that labor’s demise has been greatly exaggerated. Doug Peta, CFA Chief US Investment Strategist Bibliography Aamidor, Abe and Evanoff, Ted. At The Crossroads: Middle America and the Battle to Save the Car Industry. Toronto: ECW Press (2010). Allegretto, S.A.; Doussard, M.; Graham-Squire, D.; Jacobs, K.; Thompson, D.; and Thompson, J. Fast Food, Poverty Wages: The Public Cost of Low-Wage Jobs in the Fast-Food Industry. Berkeley, CA. UC-Berkeley Center for Labor Research and Education, October 2013. Bernstein, Irving. The Lean Years: A History of the American Worker, 1920-1933. Boston: Houghton Mifflin (1960). Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics. Brooklyn, NY: Verso (2019). Emma, Caitlin. “Teachers Are Going on Strike in Trump’s America.” Politico, April 12, 2018, accessed January 20, 2020. Finnegan, William. “Dignity: Fast-Food Workers and a New Form of Labor Activism.” The New Yorker, September 15, 2014 Greenhouse, Steven. Beaten Down, Worked Up: The Past, Present and Future of American Labor. New York: Alfred A. Knopf (2019). Greenhouse, Steven. “The Return of the Strike.” The American Prospect, Winter 2019 Ingrassia, Paul. Crash Course: The American Auto Industry’s Road from Glory to Disaster. New York: Random House (2010). King, Gilbert. “How the Ford Motor Company Won a Battle and Lost Ground.” smithsonianmag.com, April 30, 2013, accessed January 24, 2020. Loomis, Erik. A History of America in Ten Strikes. New York: The New Press (2018). Manchester, William. The Glory and the Dream: A Narrative History of America, 1932-1972. New York: Bantam (1974). Norwood, Stephen H. “The Student As Strikebreaker: College Youth and the Crisis of Masculinity in the Early Twentieth Century. Journal of Social History Winter 1994: pp. 331-49. Sears, Stephen W. “Shut the Goddam Plant!” American Heritage Volume 33, Issue 3 (April/May 1982) Serrin, William. “Industries, in Shift, Aren’t Letting Strikes Stop Them.” The New York Times, September 30, 1986 Wolff, Leon. “Battle at Homestead.” American Heritage Volume 16, Issue 3 (April 1965) *Current newspaper and Bloomberg articles omitted. III. Indicators And Reference Charts Last month, we warned that the S&P 500 rally looked increasingly vulnerable from a tactical perspective and that the spread of Covid-19 was likely to be the catalyst of a pullback that could cause the S&P 500 to retest its October 2019 breakout. Since then, the S&P 500 has corrected significantly. As long as new cases of Covid-19 continue to grow quickly outside of China, the S&P 500 can suffer additional downside. Limited inflationary pressures, accommodative global central banks, and the potential for a large policy easing in China suggest that stocks have significant upside once Covid-19 becomes better contained. Nonetheless, despite the positive signals from our Willingness-To-Pay measure or our Monetary and Composite Technical Indicators, we recommend a cautious tactical stance on equities. Our BCA Composite Valuation index is not depressed enough to warrant closing our eyes when the risk of a recession caused by a global pandemic remains as high as it is today. Either valuations will have to cheapen further or Covid-19 will have to be clearly contained before we buy stocks without strong fears. 10-year Treasurys yields remain extremely expensive. However, our Composite Technical Indicator suggests that in such an uncertain climate, yields can fall a little more. Nonetheless, Treasurys seem like an asset that has nearly fully priced in the full impact of Covid-19, and thus, any downside in yield will be very limited.  The rising risk premia linked to the coronavirus is also helping the dollar right now, but as we have highlighted before, many signs show that global growth was in the process of bottoming before the outbreak took hold. As a result, we anticipate that the dollar could suffer plentiful downside if Covid-19 passes soon. Moreover, the rising probability that Senator Bernie Sanders wins the Democratic nomination could hurt the greenback over the remainder of the year. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of Covid-19. However, they have not pullback below the levels where they traded when they broke out in late 2019. Moreover, the advanced/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar. EQUITIES: Chart III-1US Equity Indicators March 2020 March 2020 Chart III-2Willingness To Pay For Risk March 2020 March 2020 Chart III-3US Equity Sentiment Indicators March 2020 March 2020   Chart III-4Revealed Preference Indicator March 2020 March 2020 Chart III-5US Stock Market Valuation March 2020 March 2020 Chart III-6US Earnings March 2020 March 2020 Chart III-7Global Stock Market And Earnings: Relative Performance March 2020 March 2020 Chart III-8Global Stock Market And Earnings: Relative Performance March 2020 March 2020   FIXED INCOME: Chart III-9US Treasurys And Valuations March 2020 March 2020 Chart III-10Yield Curve Slopes March 2020 March 2020 Chart III-11Selected US Bond Yields March 2020 March 2020 Chart III-1210-Year Treasury Yield Components March 2020 March 2020 Chart III-13US Corporate Bonds And Health Monitor March 2020 March 2020 Chart III-14Global Bonds: Developed Markets March 2020 March 2020 Chart III-15Global Bonds: Emerging Markets March 2020 March 2020   CURRENCIES: Chart III-16US Dollar And PPP March 2020 March 2020 Chart III-17US Dollar And Indicator March 2020 March 2020 Chart III-18US Dollar Fundamentals March 2020 March 2020 Chart III-19Japanese Yen Technicals March 2020 March 2020 Chart III-20Euro Technicals March 2020 March 2020 Chart III-21Euro/Yen Technicals March 2020 March 2020 Chart III-22Euro/Pound Technicals March 2020 March 2020   COMMODITIES: Chart III-23Broad Commodity Indicators March 2020 March 2020 Chart III-24Commodity Prices March 2020 March 2020 Chart III-25Commodity Prices March 2020 March 2020 Chart III-26Commodity Sentiment March 2020 March 2020 Chart III-27Speculative Positioning March 2020 March 2020   ECONOMY: Chart III-28US And Global Macro Backdrop March 2020 March 2020 Chart III-29US Macro Snapshot March 2020 March 2020 Chart III-30US Growth Outlook March 2020 March 2020 Chart III-31US Cyclical Spending March 2020 March 2020 Chart III-32US Labor Market March 2020 March 2020 Chart III-33US Consumption March 2020 March 2020 Chart III-34US Housing March 2020 March 2020 Chart III-35US Debt And Deleveraging March 2020 March 2020   Chart III-36US Financial Conditions March 2020 March 2020 Chart III-37Global Economic Snapshot: Europe March 2020 March 2020 Chart III-38Global Economic Snapshot: China March 2020 March 2020   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Non-seasonally adjusted growth is always negative in Q1, due to the impact of the Chinese Lunar New Year Celebration. This is why we emphasize the seasonal adjustment. 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 The Bank Credit Analyst "February 2020," dated January 30, 2020 available at bca.bcaresearch.com 4 Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics, Verso: New York (2019), p. 204. 5 Ibid, p. 209. 6 We will discuss public opinion, and its impact on elected officials and courts, in Part 3. 7 Please see the January 13, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History,” available at www.bcaresearch.com. 8 A monopsony is a market with a single buyer, akin to a monopoly, which is a market with only one seller. 9 Please see the July 2019 Bank Credit Analyst Special Report, “ The Productivity Puzzle: Competition Is The Missing Ingredient,” available at bcaresearch.com. 10 Students were excused from classes and exams and sometimes even received academic credit for their work. 11 King, Gilbert, “How The Ford Motor Company Won a Battle and Lost Ground,” Smithsonian.com, April 30, 2013. 12 Greenhouse, Steven, Beaten Down, Worked Up, Alfred A. Knopf: New York (2019), pp. 137-8. 13 High unemployment, in addition to declining respect for unions, helped erase the stigma of crossing picket lines. 14 Serrin, William, “Industries, in Shift, Aren’t Letting Strikes Stop Them,” New York Times, September 30, 1986, p. A18. 15 Emma, Caitlin, “Teachers Are Going on Strike in Trump’s America,” Politico, April 12, 2018. 16 Greenhouse, p. 44. 17 Please see the January 20, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them,” available at usis.bcaresearch.com. 18 Please see the June 8, 2016 Geopolitical Strategy Monthly Report, “Introducing The Median Voter Theory,” available at gps.bcaresearch.com. 19 The Court found for the plaintiff in Janus, who bridled at the closed-shop law that forced him to join the union that bargained on his and his colleagues’ behalf, because the union’s espousal of views with which he disagreed constituted a violation of his free-speech rights as guaranteed by the First Amendment.