Commodities & Energy Sector

Highlights Extreme global economic uncertainty has pushed demand for USD higher, and forced investors to liquidate gold holdings to raise cash for margin calls and to provide precautionary balances. Gold endured a succession of down moves that elected our stop, leaving us with a 24% gain on the long-standing portfolio-hedge recommendation. Gold failed to deliver on portfolio protection at the onset of the market drop, but we believe this is largely a result of liquidation of positions in the wake of the record price volatility in commodities generally that has attended the COVID-19 pandemic. In the run-up to the GFC in 2008 and the COVID-19 crises, gold reached cyclical highs and was amongst the best performing assets. Once these crises hit and liquidity collapsed, investors were forced to book gains on their winners – including gold – to cover losses elsewhere. Additionally, the yellow metal provided a liquid source of US dollars to foreign investors and sovereigns with large dollar debts and expanding holes in their budgets. We remain constructive toward gold and will be re-opening our long position at tonight’s close. Feature The US dollar is essential to the global economy due to its dominant use in international trade invoicing and to a massive – $12 Trillion – foreign dollar-denominated pile of debt.1 As extreme global economic stress pushed up the demand for dollars, a market risk-off period has been transformed into a broad-based asset liquidation. In this report, we revisit our tactical and strategic stance on gold considering the global COVID-19-induced selloff and ongoing monetary and fiscal policy responses to it. COVID-19-Induced Uncertainty Upends Asset Correlations As investors rushed for liquid dollar assets amid rising worries re the length of the pause in global economic activity, past cross-asset correlations were disrupted and traditional safe-assets contributed to portfolio volatility. The recent equity selloff dragged gold and other safe assets in its wake. As investors rushed for liquid dollar assets amid rising worries re the length of the pause in global economic activity, past cross-asset correlations were disrupted and traditional safe-assets contributed to portfolio volatility (Chart of the Week).2 Gold prices, in particular, experienced a succession of rapid shifts in value since the beginning of this year: Up 10% from Jan 1 to Feb 24, down 12% from Feb 24 to Mar 19, and up 10% since Mar 19 (Chart 2, panel 1). These massive moves pushed gold’s implied volatility to its highest level since 2008. Chart of the WeekVolatility In Safe Assets Volatility In Safe Assets Volatility In Safe Assets Chart 2Large Moves In Gold Prices YTD Large Moves In Gold Prices YTD Large Moves In Gold Prices YTD A $1,575/oz stop to our long-standing gold recommendation was triggered on March 13, leaving us with a 24% gain, ahead of gold’s decline to $1,475/oz. We argued in previous reports the probability of a technical pullback remained elevated based on our Tactical Composite Indicator (Chart 2, panel 2). The dollar’s appreciation – driven by heightened uncertainty and pronounced illiquidity in offshore dollar markets – acted as a catalyst to the gold correction. A continued dollar shortage remains a chief risk to both our bullish gold and 2H20 EM activity rebound views. Global non-US banks’ reliance on US dollar and wholesale funding has greatly expanded since the Global Financial Crisis (GFC) (Chart 3, panel 1). This increases bank’s reliance on foreign exchange swap markets to secure marginal funding, which pushes up financing costs when demand for dollar asset spikes (Chart 3, panel 2). Chart 3Greater Non-US Banks’ Funding Fragility Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Chart 4USD Gains From Rising Market-Wide Risk Aversion USD Gains From Rising Market-Wide Risk Aversion USD Gains From Rising Market-Wide Risk Aversion Generally, when USD supply ex-US expands in the so-called Eurodollar market, the global trade and banking systems function properly. In periods of low systematic volatility – an indication of low market-wide risk aversion – capital flows from safe US assets to stocks, high-yield bonds, and foreign markets in the search for stronger returns. In times of stress, however, risk-aversion spikes and demand for dollar surges as foreigners pile into liquid assets (Chart 4). Since global banks are highly interdependent, a troubled non-US bank unable to cover its dollar liabilities will be forced to dump assets to acquire USD at any price, creating additional stress amongst banks and increasing the convenience yield of holding on to dollar assets (Chart 5). Chart 5USD shortage Forces Foreign Banks To Sell Dollar Assets USD shortage Forces Foreign Banks To Sell Dollar Assets USD shortage Forces Foreign Banks To Sell Dollar Assets The USD As A Momentum Currency The global dominance of the US dollar in trade, funding and invoicing can create a vicious feedback loop. The global dominance of the US dollar in trade, funding and invoicing can create a vicious feedback loop (Diagram 1). Diagram 1Dollar Strength And Weak Global Growth Loop Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge This makes the dollar a momentum and counter-cyclical currency (Chart 6). It also explains gold’s recent price movements. The recent global liquidation of financial assets for USD is the result of the most severe liquidity crunch since the onset of the GFC in 2008 (Chart 7). Again, gold failed to provide much-needed portfolio protection at the onset of the market drop, since gold holdings often were liquidated to meet margin calls or by sovereigns to fill budget gaps (Chart 8). Chart 6A Weaker Dollar Bodes Well For Commodities The Dollar Is A Counter-Cyclical Currency A Weaker Dollar Bodes Well For Commodities The Dollar Is A Counter-Cyclical Currency A Weaker Dollar Bodes Well For Commodities The Dollar Is A Counter-Cyclical Currency Chart 7Liquidity Proxies To Watch Liquidity Proxies To Watch Liquidity Proxies To Watch A dearth of collateral in repo markets – proxied by rapid increases in primary dealers’ repo fails – typically leads to short-term plunges in gold prices, as the metal is used as an alternative source of loan collateral. Still, we do not interpret this liquidation as a sign that gold’s safe-haven status is fading. In the run-up to both crises, gold was reaching cyclical highs and was amongst the best performing assets. Once the crisis hit and liquidity collapsed, investors were forced to book gains on their winners – including gold – to cover losses elsewhere. Additionally, the yellow metal provided a liquid source of US dollars to foreign investors and sovereigns with large dollar debts and expanding (unfunded) budget obligations. These pressures were particularly acute among EM commodity-exporting countries, which saw revenues compress during the severe drop in cyclical commodities. Chart 8Gold Plunges At the Onset Of Severe Crisis Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Chart 9Gold Provides Liquidity During Crisis Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Lastly, scarce high-quality collateral in wholesale markets makes gold swaps a liquid funding source. A dearth of collateral in repo markets – proxied by rapid increases in primary dealers’ repo fails – typically leads to short-term plunges in gold prices, as the metal is used as an alternative source of loan and swap collateral (Chart 9). Swaps effectively release gold previously held in storage to markets, increasing its supply. Gauging The Recovery In Gold Prices Calling the bottom in gold prices depends on how the Fed responds to dollar-funding stress abroad and banks’ reluctance to lend. In the current circumstances, we believe the plunge in gold will be limited compared to the GFC. First, the latest shocks to markets globally come from outside the financial system. There are no pronounced quality concerns in high-quality collateral. Current disruptions are mainly a result of low capital deployment to market-making activities by the financial system. Importantly, banks are now more capitalized, due to tighter post-GFC regulations limiting bank risk-taking. Second, the Fed responded much more rapidly to the current market disruptions. It is taking steps to alleviate liquidity concerns by filling the role of market maker – acting as a dealer of last resort – and encouraging banks to use their available capital to conduct market-making activities. The Fed also acts as the global dollar lender of last resort by providing liquidity globally via swap lines (Chart 10). When the world is short of dollars, funding costs can increase drastically (Chart 11). Swap lines will ease oversea funding pressures, and we expect these will be expanded to more countries if needed. Chart 10Swap Lines Alleviate Funding Stress Swap Lines Alleviate Funding Stress Swap Lines Alleviate Funding Stress Chart 11A Rising USD Increases Funding Cost Abroad A Rising USD Increases Funding Cost Abroad A Rising USD Increases Funding Cost Abroad A few indicators are signaling some liquidity and dollar funding stress remains in the system. We believe the rapid intervention by global central banks over the course of the current market stress will keep any liquidity squeeze from becoming a solvency and collateral quality crisis (Chart 12). However, it is difficult to know the exact level central banks are targeting, and given the nature of the shock, a lot will depend on the fiscal policy response. We believe gold prices – along with the indicators shown in Chart 7 – provide valuable information on the effectiveness of central banks’ actions. Thus, gold’s recent recovery is a prescient signal. Still, a few indicators are signaling some liquidity and dollar funding stress remains in the system. With prices back at $1580/oz, it is possible gold prices would be liquidated in a renewed equity selloff. However, our tactical composite indicator is slightly better positioned now and with US treasury yields now close to zero, gold’s ability to hedge market risk will increase relative to bonds. This inclines us to think the move would be less severe compared to the early March 11% plunge. Chart 12Fiscal And Monetary Actions Will Ease Credit Shock Fiscal And Monetary Actions Will Ease Credit Shock Fiscal And Monetary Actions Will Ease Credit Shock Given these considerations, we recommend going long gold at tonight’s close. Longer-Term, Gold’s Upside Potential Is Attractive The expanding fiscal deficit also tackles the lack of collateral by increasing the issuance of Treasury Notes and Bills. Strategically, gold’s appeal has increased sharply following the unprecedented monetary and fiscal responses to the COVID-19 shock. Over the next 6-12 months, we expect the US dollar will weaken and respond to interest rate differentials as uncertainty dissipates – presuming, of course, the COVID-19 shock is controlled and contained in most countries (Chart 13). The global supply of US dollars will increase from the Fed’s balance sheet expansion, swap lines to foreign banks, and a deepening US current account deficit following the unprecedented $2 trillion fiscal-stimulus package approved by the US Congress. Importantly, the expanding fiscal deficit also tackles the lack of collateral by increasing the issuance of Treasury Notes and Bills. Chart 13The USD Is Diverging From Rates Differentials The USD Is Diverging From Rates Differentials The USD Is Diverging From Rates Differentials Longer-term, the odds of higher inflation have risen. Consequently, we expect the vicious circle illustrated above will work in reverse (Diagram 2). EM Asia economic growth – led by a recovery in China – will outpace that of the US. This will generate capital outflows from the US to riskier emerging markets, forcing the dollar down until the Fed moves to raise rates – something we do not expect over the next 12 months. Thus, the opportunity cost of holding gold likely will remain low for an extended period (Chart 14). Diagram 2A Virtuous Cycle Will Start In 2H20 Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Longer-term, the odds of higher inflation have risen. However, our base case is the inflationary scenario is more likely to develop over the next 2 years. Low and falling inflation expectations can be expected for an extended period – the result of the global shut-down and collapsed commodity prices, particularly oil. This would suggest fixed-income markets will be pricing in low rates for the foreseeable future until an actual inflation threat is apparent. Still, if our call on oil is correct – i.e., our expectation Brent crude oil will be trading at $45/bbl by year-end, and clear $60/bbl by 2Q21 as the global economy recovers from the COVID-19 pandemic and the OPEC 2.0 market-share war ceases – markets could be pricing to higher inflation expectations next year, which would benefit gold.3 In addition, the massive fiscal and monetary stimulus being deployed globally will remain in the system for an extended period, which could stoke inflationary pressures. Chart 14Gold's Opportunity Cost Will Remain Low Gold's Opportunity Cost Will Remain Low Gold's Opportunity Cost Will Remain Low Chart 15Gold Will Be Supported In A Savings Glut Gold Will Be Supported In A Savings Glut Gold Will Be Supported In A Savings Glut Conversely, there is a non-negligible deflation risk stemming from a semi-permanent increase in precautionary savings as a result of the traumatic pandemic episode.4 Even so, gold can benefit from an increasing pool of savings (Chart 15). Bottom Line: We are going long gold at tonight’s close. The tactical (easing in dollar-funding crisis), cyclical (weakening US dollar and low real interest rates), and strategic (policy-induced inflationary pressure) horizons are all supportive for adding gold positions to a diversified portfolio.   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight The makings of a deal among the three largest oil producers in the world – the US, Russia and the Kingdom of Saudi Arabia (KSA) continue to fall into place. Russia earlier this week leaked it would not be increasing output after the OPEC 2.0 1Q20 production cuts expired March 31, saying such an increase would be unprofitable. US President Donald Trump is offering to broker talks between KSA and Russia, with the Texas Railroad Commission – the historical regulator of output in the Lone Star State – indicating it would be willing to resume its prior role provided other states and countries got on board. For its part, KSA has made it clear it will not bear the burden of re-balancing global markets unless this burden is shared by all producers – including the US (Chart 16). Base Metals: Neutral Copper prices remain relatively well supported, even as other commodities are pressured lower. COVID-19-induced shipping delays at South African, particularly out of Durban, could tighten copper markets, just as major economies begin recovering from lockdowns and ramp infrastructure projects. Fastmarkets MB noted refining charges are weakening as supply contracts due to shipping delays. Precious Metals: Neutral We are leaving a standing buy order for spot Palladium if it trades to $2,000/oz. Once the COVID-19 pandemic has bee contained and economies begin returning to normal, the fundamental tightness we outlined in our February 27 report our February 27 report – falling supplies exacerbated by a derelict South African power-grid trying to cover steadily increasing demand and more stringent pollution restrictions – will re-assert itself (Chart 17). Ags/Softs:  Underweight CBOT Corn futures hedged lower on Tuesday after the USDA predicted corn acreage will reach 97mm in 2020, the largest in eight years and well above market expectations of 94mm. This comes at a time when numerous American ethanol plants – which account for 40% of corn usage – are closing in response to the diminished demand for biofuels used for gasoline, due to the COVID-19 outbreak. Corn futures ended the month down 7.1%, the largest decline since August. The USDA sees soybeans acres planted rising 10% in 2020, below average expectations and wheat acres planted slipping 1% to 44.7mm, the lowest since 1919. Wheat was down 0.75¢, while soybeans were up 3.75¢ at Tuesday’s close. Chart 16Oil Prices Collapsed After the Market-Share War Oil Prices Collapsed After the Market-Share War Oil Prices Collapsed After the Market-Share War Chart 17Palladium Deficit To Widen This Year Palladium Deficit To Widen This Year Palladium Deficit To Widen This Year     Footnotes 1     Please see our weekly report titled OPEC 2.0 Cuts, Fed Rate Cuts Will Support Oil Prices published March 5, 2020. 2     Following our US Bond strategist, the liquidity shock discussed in this report means investors are finding it more expensive or difficult to transact in certain markets because of scares amount of capital being deployed to those areas. This does not necessarily imply a lack of buyers of credit risk. Please see BCA Research’s US Bond Strategy report entitled Life At The Zero Bound published by BCA Research’s US Bond Strategy March 24, 2020. 3    Please see the Special Report we published with BCA Research’s Geopolitical Strategy March 30, 2020, entitled OPEC 3.0 In the Offing? It is available at ces.bcaresearch.com. 4    Please see BCA Research’s Global Investment Strategy report entitled Second Quarter 2020 Strategy Outlook: World War V published March 27, 2020.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Returning To Gold As A Portfolio Hedge Returning To Gold As A Portfolio Hedge

Highlights Recommended Allocation Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality The outlook for markets over the next few months is highly uncertain. On the optimistic side, new COVID-19 cases are probably close to peaking (for now), and so equities could continue to rally. But there are many risks too. Growth numbers will be horrendous for some months. Second-round effects (corporate defaults, problems in EM and with euro zone banks, for example) will emerge. We recommend a balanced portfolio, robust both for risk-on rallies and a further sell-off. We stay overweight equities versus bonds. Government bonds will not provide significantly positive returns even in a severe recession. Thus, over the next 12-months, equities are likely to outperform them. But we leaven the equity overweight with a “minimum volatility” strategy, overweight the low-beta US market, and more stable sectors such as Healthcare and Technology. Within bonds, we stay underweight government bonds, and raise Investment Grade credit to overweight, given the Fed’s backstop. Even in a risk-on rally, government yields will not rise quickly so we recommend a neutral stance on duration. The massive stimulus will eventually be inflationary, so we recommend TIPS, which are very cheaply valued. We are overweight cash and gold as hedges against further market turbulence. Among alternatives, macro hedge funds and farmland look attractively defensive now. We would start to look for opportunities in private debt (especially distressed debt) as the recession advances. Commodity futures are attractive as an inflation hedge. Overview Playing The Optionality From the start of the crisis, we argued that markets would bottom around the time when new cases of COVID-19 peaked. At the end of March, there were clear signs that this would happen in April, with Italy and Spain having probably already peaked and the US, if it follows the same trajectory, being only two or three weeks away (Chart 1). Chart 1Close To A Peak In New Cases? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality But what happens next? A relief rally is likely, as often happens in bear markets – and indeed one probably started with the three-day 18% rise in US equities in the last week of March. Note, for example, the strong rallies in spring 2008 and summer 2000 before the second leg down in those bear markets (Chart 2). Chart 2Mid Bear Market Rallies Are Common Mid Bear Market Rallies Are Common Mid Bear Market Rallies Are Common However, there is still a lot of potential bad news for markets to digest. Global growth has collapsed, as a result of people in many countries being forced to stay at home. US GDP growth in Q2 could fall by as much as 10% quarter-on-quarter (unannualized). Horrendously bad data will come as a shock to investors over the coming months. Despite the unprecedented stimulus measures from central banks and governments worldwide (Chart 3), nasty second-round effects are inevitable. Given the high level of corporate debt in the US, defaults will rise, to perhaps above the level of 2008-9 (Chart 4). EM borrowers have almost $4 trillion of foreign-currency debt outstanding, and will struggle to service this after the rise in the dollar and wider credit spreads. Euro area banks are poorly capitalized and have high non-performing debt levels left over from the last recession; they will be hit by a new wave of bankruptcies. Undoubtedly, there are some banks and hedge funds sitting on big trading losses after the drastic sell-off and stomach-churning volatility. Mid-East sovereign wealth funds will unload more assets to fill fiscal holes left by the collapsed oil price. Chart 3Massive Stimulus Everywhere Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality Chart 4Possible Second-Round Effects Possible Second-Round Effects Possible Second-Round Effects     There is also the question of when the pandemic will end. We are not epidemiologists, so find this hard to judge (but please refer to the answers from an authority in our recent Special Report1). The coronavirus will disappear only when either enough people in a community have had the disease to produce “herd immunity,” or there is a vaccine – which is probably 18 months away.  Some epidemiologists argue that in the UK and Italy 40%-60% of the population may have already had COVID-19 and are therefore immune.2 But an influential paper from researchers at Imperial College suggested that repeated periods of lockdown will be necessary each time a new wave of cases emerges3 (Chart 5). Chart 5More Waves Of The Pandemic To Come? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality At the end of March, global equities were only 23% off their mid-February record high – and were down only 34% even at their low point. That doesn’t seem like enough to fully discount all the potential pitfalls over coming months. This sort of highly uncertain environment is where portfolio construction comes in. We recommend that clients position their portfolios with optionality to remain robust in any likely outcome. There are likely to be rallies in risk assets over coming months, particularly when the coronavirus shows signs of petering out. There is significant asymmetric career risk for portfolio managers here. No portfolio manager will be fired for missing the pandemic and underperforming year-to-date (though some may because their firms go out of business or retrench). But a PM who misses a V-shaped rebound in risk assets over the rest of the year could lose their job.  This will provide a strong incentive to try to pick the bottom. Chart 6Bond Yields Can't Go Much Lower Bond Yields Can't Go Much Lower Bond Yields Can't Go Much Lower Government bond yields are close to their theoretical lows. The 10-year US Treasury yield is 0.6% and it unlikely to fall below 0% even in a severe recession (since the Fed has stated that it will not cut short-term rates below 0%). In other countries, the low for yields has turned out to be around -0.3% to -0.9% (Chart 6). The total return from risk-free bonds, therefore, will be close to zero even in a dire economic environment (Table 1). This means that the call between bonds and equities comes down to whether equity prices will be higher or lower in 12-months. Quite likely, they will be higher. Given this, and the optionality of participating in rebounds, we maintain our overweight on equities versus bonds. We would, however, be inclined to lower our equity weighting in the event of a big rally in stocks over the next few months.   Table 1Not Much Room For Upside From Bonds Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality Table 2Bear Markets Are Often Much Worse Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality But there are also many downside risks. In the past two recessions, global equities fell by 50%-60% (Table 2). Despite the much worse economic environment this time, the peak-to-trough decline is so far much more limited. Moreover, valuations are not particularly compelling yet (Chart 7). To leaven our overall overweight on equities, we recommend a “minimum volatility” strategy, with tilts towards the low-beta US market, and some more defensive sectors such as Healthcare and Technology. China and China-related stocks also look somewhat attractive, since that country got over the coronavirus first, and is responding with a big increase in infrastructure spending (Chart 8). To hedge against downside risk, we also leave in place our overweights in cash and gold. Chart 7Equities Are Not Yet Super Cheap Equities Are Not Yet Super Cheap Equities Are Not Yet Super Cheap Chart 8China Infra Spending To Rise China Infra Spending To Rise China Infra Spending To Rise Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking – About The Coronavirus Have We Seen The Bottom In Equity Markets?  Chart 9Watch Closely COVID-19 Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality After hitting a low on March 23, global equities have recovered more than one-third of their loss during this particularly rapid bear market, in response to the massive monetary and fiscal stimulus around the globe. It’s very hard to pinpoint the exact bottom of any equity bear market.  The current one is particularly difficult in two ways: First, it was largely due to the exogenous shock from the COVID-19 pandemic. If history is any guide, we will first need to see a peak in infected cases globally before we can call a true bottom in equities (Chart 9). Second, the massive and coordinated response from central banks and governments around the world is unprecedented, as the global “lockdown” freezes the global economy. It’s encouraging to see the Chinese PMI bouncing back to 52 in March after a sharp drop to deep contraction level in February. However, the bounce back was mostly from production. Both export orders and imports remain weak. US initial jobless claims have skyrocketed to 3.3 million. If the peak of infection in the US follows similar patterns in China and Italy, then it would be another encouraging sign even if the US economic data continued to get worse. BCA Research’s base-case is for this recession to have a U-shaped recovery. This means that equity markets are likely to be range bound until we have a better handle on the future course of the pandemic. As such, we suggest investors actively manage risk by adding to positions when the S&P 500 gets close to 2250 and reducing risk when it gets close to 2750 during the bottoming process. What Will Be The Long-Term Consequences? Maybe it seems too early to think about this, but the coronavirus pandemic will change the world at least as profoundly as did the 1970s inflation, 9/11, and the Global Financial Crisis (GFC). Here are some things that might change: Chart 10Government Debt Will Rise Significantly Government Debt Will Rise Significantly Government Debt Will Rise Significantly Government debt levels will rise dramatically, as a result of the huge fiscal packages being (rightly) implemented by many countries. In the US, after the $2 trillion spending increase and a fall in tax revenues, the annual fiscal deficit will rise from 6% of GDP to 15%-20%. Government debt/GDP could exceed the 122% reached at the end of WW2 (Chart 10). Ultimately, central banks will have to monetize this debt, perhaps by capping long-term rates or by buying a substantial part of issuance. This could prove to be inflationary. Households and companies may want to build in greater cushions and no longer live “on the edge”. US households have repaired their balance-sheets since 2009, raising the savings rate to 8% (Chart 11). But surveys suggest that almost one-third of US households have less than $1,000 in savings. They may, therefore, now save more. This could depress consumption further in coming years. Companies have maximized profitability over the past decades, under pressure from shareholders, by keeping inventories, spare cash, and excess workers to a minimum. Given the sudden stop caused by the pandemic (and who is to say that there will not be more pandemics in future), companies may want to protect themselves from future shocks. The inventory/sales ratio, which had been falling for decades, has picked up a little since the GFC (Chart 12). Inventory levels are likely to be raised further. Companies may also run less leveraged balance-sheets, rather than hold the maximum amount of debt their targeted credit rating can bear. This is all likely to reduce long-term profit growth. Chart 11Households May Become Even More Cautious Households May Become Even More Cautious Households May Become Even More Cautious Chart 12Companies Will Run With Higher Inventories Companies Will Run With Higher Inventories Companies Will Run With Higher Inventories The pandemic has highlighted the vulnerability of healthcare systems. China still spends only 5% of GDP on health, compared to 9% in Brazil and 8% in South Africa (Chart 13). The lack of intensive care beds and woefully inadequate epidemic plans in the US and other developed countries will also need to be tackled. Healthcare stocks should benefit. Chart 13Healthcare Spending Will Need To Rise Healthcare Spending Will Need To Rise Healthcare Spending Will Need To Rise How Risky Are Euro Area Banks? Chart 14Euro Area Banks Are Quite Fragile Euro Area Banks Are Quite Fragile Euro Area Banks Are Quite Fragile Banks in the euro area have underperformed their developed market peers by over 65% since the Global Financial Crisis (GFC) (Chart 14, panel 1). Their structural issues – many of which we highlighted in a previous Special Report – remain unsolved.  Euro area banks remain highly leveraged compared to their US counterparts (panel 2). Their exposure to emerging economies is high (panel 3), and they continue to be a major provider of European corporate funding. US corporates, by contrast, are mainly funded through capital markets. The sector is also highly fragmented with both outward and inward M&A activity declining post the GFC. Profitability continues to be a key long-term concern, despite having recently stabilized (panel 4). The ECB’s ultra-dovish monetary stance and negative policy rates do not help banks’ performance either.  Banks’ relative return has been correlated to the ECB policy rate since the GFC (panel 5). Following the coronavirus outbreak, the ECB is likely to remain dovish for a prolonged period. The ECB’s recently announced measures should, however, provide banks with ample liquidity to hold and spur economic activity through increased lending to households and corporates. Absent consolidation in the European banking sector, competition is likely to dampen banks’ profits. Additionally, the severity of the economic downturn caused by the coronavirus outbreak will determine if their significant exposure to emerging economies, the energy sector, and domestic corporates will hurt them further. For now, we would recommend investors underweight euro area banks. Where Can I Get Income In This Low-Yield World? Chart 15The Bear Market Has Unveiled Attractive Income Opportunities The Bear Market Has Unveiled Attractive Income Opportunities The Bear Market Has Unveiled Attractive Income Opportunities For long-term investors who can tolerate price volatility, there is currently an opportunity to invest in high-income securities at relatively cheap prices. Below we list three of our favorite assets to obtain income returns: Dividend Aristocrats: The S&P 500 Dividend Aristocrats Index is composed of S&P 500 companies which have increased dividend payouts for 25 consecutive years or more. In order to provide such a steady stream of income through a such long timeframe, and even provide dividend increases in recessions, the companies in this index need to have a track record of running cashflow-rich businesses. Thus, the risk of dividend cuts is relatively low in these companies. Currently, the Dividend Aristocrat Index has a trailing dividend yield of 3.2% (Chart 15 – top panel). Fallen Angels: As we discussed in our November Special Report, fallen angels have attractive characteristics that separate them from the rest of the junk market. They tend to have longer maturities as well as a higher credit quality than the overall index. Crucially, fallen angels often enter the high-yield index at a discount, since certain institutional investors are forced to sell them when they are no longer IG-rated (middle panel). Thus, selected fallen angels which are not at a substantial risk of default could be a tremendous income opportunity. Currently fallen angels have a yield to worst of 10.65%. Sovereign US dollar EM debt: Our Emerging Markets Strategy service has argued that most EM sovereigns are unlikely to default on their debts, and instead will use their currencies as a release valve to ease financial conditions in their economies. Thus, hard-currency sovereign issues could prove to be attractive income investments if held to maturity. The bottom panel of Chart 15 (panel 3) shows the current yield-to-worst of the EM sovereign hard currency debt that has an overweight rating by our Emerging Markets service. Global Economy Chart 16The Collapse Begins The Collapse Begins The Collapse Begins Overview: The global economy in early January looked on the cusp of a strong manufacturing pickup, driven by the natural cycle and by moderate fiscal stimulus out of China. The coronavirus changed all that. We now face a recession of a severity unseen since the 1930s. The fiscal and monetary response has been similarly rapid and radical. This will tackle immediate liquidity and even solvency risks. But, with consumers in many countries confined to their homes, a recovery is entirely dependent on when the number of new cases of COVID-19 peaks. In an optimistic scenario, this might be in late April or May. On a pessimistic one, the pandemic will continue in waves for several quarters.  US: It is highly likely that the NBER will eventually declare that the US entered recession in March 2020. With many states in lockdown, consumption (which comprises 70% of GDP) will slump: only half of consumption is non-discretionary (rent, food, utility bills etc.); the other half is likely to shrink significantly while lockdowns continue. Judged by the 3.3 million initial claims in the week of March 16-21, unemployment will jump from its February level of 3.5% very rapidly towards 10%. Fiscal and monetary stimulus measures will cushion the downside (enabling households to pay rent and companies to service debt). But whether the recession is V-shaped or prolonged will be dependent on the length of the pandemic. Euro Area: European manufacturing growth was showing clear signs of picking up before the coronavirus pandemic hit (Chart 16 panel 1). But lockdowns in Italy, Spain and other countries will clearly push growth way into negative territory. The severity is clear from the first datapoints to reflect March activity, such as the ZEW survey. The ECB, after an initially disappointing response, has promised EUR750 billion (and more if needed) in bond purchases. The fiscal response so far has been more lukewarm, although Germany has now scrapped its requirement to run a budget surplus. One key question: will the stronger nothern European economies agree to “euro bonds”, joint and severally guaranteed, to finance fiscal spending in the weaker periphery?   Chart 17...With Chinese Data Leading The Way ...With Chinese Data Leading The Way ...With Chinese Data Leading The Way Japan: Japan’s economy was performing poorly even before the coronavirus pandemic, mainly because of the side-effects of last October’s consumption tax hike, and the slowdown in China (Chart 17, panel 2). So far, Japan has seen fewer cases of COIVD-19 than other large countries, but this may just reflect a lack of testing. Japan also has less room for policy response. Government debt is already 250% of GDP. The Bank of Japan has moderately increased purchases of equity ETFs and remains committed to maintaining government bonds yields around 0%. But Japan seems culturally and institutionally unable to roll out the sort of ultra-radical measures taken in other developed economies. Emerging Markets: China’s economy was severely disrupted in January and February, as reflected in an unprecedented collapse of the Caixin Services PMI to 26.5 (Chart 17, panel 3). However, big data (such as traffic congestion) suggest that in March people were gradually returning to work and companies restarting manufacturing operations. Q1 GDP growth will clearly be negative, and growth for the year may be barely above 0%. The authorities are ramping up infrastructure spending, which BCA expects to grow by 6-8% this year.4 Interest rates have also fallen below their 2015 levels, but not yet to their 2009 lows. Both fiscal and monetary policy are likely to be eased further. Elsewhere in Emerging Markets, the key question is whether central banks will cut rates to support rapidly weakening economies, or keep rates steady to prop up collapsing currencies. This is not an easy choice. Interest Rates: Central banks in developed markets have cut rates to their lowest possible levels with the Fed, for example, slashing from 1.25%-1.5% to 0%-0.25% within just 10 days in March. The Fed has signalled that it will not go below zero. Short-term policy rates globally, therefore, have essentially hit their lower bounds. Long-term rates have been volatile, with the 10-year US Treasury yield swinging down to 0.6% before jumping to 1.2%. While uncertainty continues, long-term risk-free rates are unlikely to rise substantially and, in the event of a prolonged severe recession, we would see the US 10-year yield falling to zero – but no lower. Global Equities Chart 18Is The V-Shaped Recovery Sustainable? Quarterly Portfolio Outlook: Playing The Optionality Quarterly Portfolio Outlook: Playing The Optionality What’s Next?  Global equities lost 32.8% year-to-date as of March 23, 2020. All countries and sectors in our coverage were in the red. Even the best performing country (Japan) and the best performing global sector (Consumer Staples) lost 26.7% and 23.2% respectively.  From March 24 to March 26, however, equities made the best three-day gains since the Great Depression, recouping about one-third of the loss,  even though US initial jobless claims came in at 3.3 million and also the US reported a higher number of cumulative infected people than China, with a much higher number of deaths per million people (Chart 18). So have we reached the bottom of the bear market? Is this “V-shaped” recovery sustainable? How should an investor construct a multi-asset global portfolio that’s sound for the next 9-12 months given the uncertainty associated with COVID-19 and the massive monetary and fiscal stimulus around the world? Based on our long-held philosophy of taking risks where risks will most likely be rewarded, we are most comfortable taking risk at the asset class level, by overweighting equities versus bonds, together with overweights in cash and gold as hedges. Within the equity portfolio, we are reducing risk by making the following adjustments: Upgrade US to overweight from underweight financed by downgrading the euro zone to underweight from overweight. Upgrade Tech to overweight, while closing two overweight bets on Financials and Energy and one underweight on consumer staples to benchmark weighting.   Country Allocation: Becoming More Defensive Chart 19US And Euro Area: Trading Places US And Euro Area: Trading Places US And Euro Area: Trading Places In December 2019 we added risk by upgrading the euro area to overweight and Emerging Markets to neutral based on our macro view that the global economy was on its way to recovery.  Data releases in January did show signs of recovery in the global economy. However, the COVID-19 outbreak has changed the global landscape, and we are clearly in a recession now.  When conditions change, we change our recommendations. We must make a judgment call because the economic data will not give us any timely, useful readings for some time to come. Back in December, the key reason to upgrade the euro area was the recovery of China which flows into the exports of the euro area. We think China will continue to stimulate its economy. However, given the global growth collapse, the “flow through” effect to the euro area will be delayed for some time. We prefer to play the China effect directly rather than indirectly. That’s why we maintain the neutral weighting of EM versus DM, but downgrade the euro area to underweight, and upgrade US to overweight. We also note the two following factors: First, as shown in Chart 19, panel 1, the relative performance between the euro area and the US is highly correlated with the relative performance between global Financials and Technology. This is not surprising given the sector composition of the two region’s equity indices. As such, this country adjustment is in line with our sector adjustment of upgrading Technology and downgrading Financials. Second, with a lower beta, US equities provide a better defense when economic uncertainty and financial market volatility are high. The risk to this adjustment, however, is valuation. As shown in panel 4, euro area valuation is extremely cheap compared to the US. However, PMI releases as well as forward earnings estimates are likely to get worse again before they get better, given the region’s reliance on exports to China and the structural issues in its banking system. Global Sector Allocation: Getting Closer To Benchmark Chart 20Reducing Sector Bets Reducing Sector Bets Reducing Sector Bets We make four changes in the global sector portfolio to reduce sector bets, since we do not have a high conviction given market volatility and our house view that recovery out of this recession will be U-shaped. These are downgrading Financials to neutral, while upgrading Technology to overweight. We also close the overweight in Energy and underweight in Consumer Staples, leaving them both at benchmark weighting. Financials: We upgraded Financials in October last year as an upside hedge. This move did not pan out as bond yields plummeted. BCA Research’s US Bond Strategy service upgraded duration to neutral from underweight on March 10 as they do not see a high likelihood for yields to move significantly higher over the next 9-12 months. This does not bode well for Financials’ performance (Chart 20, panel 1). Even though the Fed and other central banks have come in as the lenders of last resort, loan growth could be weak going forward and non-performing loans could increase, especially in the euro area. Valuation, however, is very attractive. Technology: DRAM prices started to improve even before the COVID-19 outbreak. The global lockdown to fight against the pandemic is further spurring demand for both software and hardware, which should support better earnings growth (panel 2). The risk is that relative valuation is still not cheap, even though absolute valuation has come down after the recent selloff. Energy:  The outlook for oil prices is too uncertain. The fight between Saudi Arabia and Russia is weighing on the supply side, while the global lockdown is denting demand prospect. The earnings outlook for energy companies is dire, while valuations are very attractive (panel 3). Consumer Staples: This is a classic defensive sector that does well in recessions. In addition, its relative valuation has improved to neutral from very expensive (panel 4).   Government Bonds Chart 21Stay Aside On Duration Stay Aside On Duration Stay Aside On Duration Upgrade Duration To Neutral. Global bond yields had a wild ride in Q1 as equities plummeted into bear market territory. The 10-year US Treasury yield made an historical low of 0.32% overnight on March 9, then quickly reversed back up to 1.27% on March 18, closing the quarter at 0.67%, compared to 1.88% at the beginning of the quarter (Chart 21). We are already in a recession and BCA’s house view is for a U-shaped recovery. This implies that global bond yields will likely follow a bottoming process similar to global equities, as new infections peak and high-frequency economic data start to recover. As such, we upgrade our duration call to neutral, to be in line with the position of BCA Research’s US Bond Strategy (USBS) service. Favor Linkers Vs. Nominal Bonds.  The combined effect of the plummet in oil prices and the coronavirus outbreak has crushed inflation expectation to an extremely low level. As shown in Chart 22, the 10-year breakeven inflation rate is currently at 0.95%, 88 bps lower than its fair value. The fair value is estimated based on USBS’s Adaptive Expectations Model.  Investors with a 12-month investment horizon should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position. Chart 22TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection   Corporate Bonds Chart 23High Quality Junk High Quality Junk High Quality Junk It is undeniable that the dearth of cashflow caused by the lockdowns will spur a ferocious wave of defaults, particularly in the high-yield sector. It also is not clear that this risk is adequately compensated for. Currently, our US bond strategist believes that spreads are pricing an 11% default rate – in line with the default rate of the 2000/2001 recession. While it is not our base case, a default cycle like 2008, where 14% of companies in the index defaulted is a very clear possibility, as revenues have ground to a halt. However, several positive factors in the junk space must also be considered. Roughly 1% of the high-yield index matures in less than one year, which means that refinancing risk for junk credits should remain relatively subdued (Chart 23, top panel). Moreover, the quality of junk bonds is relatively high compared to previous periods of stress: when the market peaked in 2000 and 2007, Ba-rated credit (the highest quality of high yield) stood at 30% and 37% of the overall index respectively (middle panel). Today this credit quality stands at 49% of the high yield market, indicating a relatively healthier credit profile for junk. Additionally, the high-risk energy sector, which is likely to experience a substantial amount of defaults given the collapse in oil prices, now represents less than 8% of the market capitalization of the whole index (bottom panel). Taking these positive factors into consideration, we believe that a downgrade to underweight is not warranted, and instead we are downgrading high-yield credit from overweight to neutral. What about the investment-grade space? the massive stimulus package announced by the Fed, which effectively allows IG issuers to roll over their entire stock of debt, should provide a backstop to this market. One valid concern is that credit agencies can still downgrade a large number of issuers, making them ineligible to receive support. However, it seems that the credit agencies are aware of how much hinges on their ratings, and are communicating that they will factor the measures taken by various government programs into their credit analysis.5 Thus, considering that spreads are already extended, the Fed is providing unprecedent support and credit agencies are unlikely to knock out many companies out of investment-grade ratings, we are upgrading investment-grade credit from neutral to overweight.   Commodities Chart 24Oil Prices & Politics Do Not Mix Oil Prices & Politics Do Not Mix Oil Prices & Politics Do Not Mix Energy (Overweight): Oil markets were driven by supply/demand dynamics until a third factor, politics, shifted the market equilibrium. The recent clash between Saudi Arabia and Russia led to the breakdown of the OPEC 2.0 coalition and to Brent prices tanking by over 60% to $26 in March. The length of this breakdown is unknown. However, we believe the parties are likely to return to the negotiation table within the next months as the damage to countries which are dependent on oil begins to appear. The fiscal budget breakeven point remains much higher than the current oil price – it is around $83 for Saudi Arabia and $47 for Russia. Weakness in global crude demand will continue to put further downward pressure on prices, until economic activity recovers from the COVID-19 slowdown. Our Commodity & Energy Strategists expect the Brent crude oil price to average $36/bbl, with WTI trading some $3-$4 below that, in 2020 (Chart 24, panels 1 & 2). Industrial Metals (Neutral): Industrial metals prices were on track to pick up until the coronavirus hit global activity at the beginning of the year. Prices face further short-term headwinds as global manufacturing remains suppressed. Once the global social distancing ends and activity resumes, industrial metal prices should pick up as fiscal stimulus and infrastructure spending, especially in China, is implemented (panel 3). Precious Metals (Neutral):  As the coronavirus spread, global risk assets have tumbled. Over the past 12 months, we have recommended investors increase their allocation to gold as both an inflation hedge and a beneficiary of accommodative monetary policy globally. However, we also recently highlighted that gold was reaching overbought territory and that a pullback was possible in the short-term. Nevertheless, investors should continue to maintain gold exposure to hedge against the eventuality that the pandemic is not contained within the coming weeks (panels 4 & 5).   Currencies Chart 25Competing Forces Pushing The US Dollar In Different Directions Competing Forces Pushing The US Dollar In Different Directions Competing Forces Pushing The US Dollar In Different Directions The USD has gone through a rollercoaster during the coronavirus crisis. Initially, the DXY fell by 4.8%, as rate differentials moved violently against the dollar when the Fed cut rates to zero. But this fall didn’t last long: as liquidity dried up, the cost for dollar funding surged, causing the dollar to skyrocket by almost 8.3%. Since then, the liquidity measures taken by monetary authorities have made the dollar reverse course once more. At this point there are multiple forces pulling the greenback in opposing directions. On the one hand, the collapse in global growth caused by the shutdowns should push the dollar higher. Moreover, momentum – one of the most reliable directional indicators for the dollar – continues to point to further upside (Chart 25, panels 1 and 2). However, the Fed’s generous USD swap lines with other major central banks as well as the massive pool of liquidity deployed have already stabilized funding costs in European and British currency markets, and look poised to do the same in others (Chart 25, panel 3). Thus, since there is no clarity on which force will prevail in this tug of war, we are remaining neutral on the US dollar. That being said, long-term investors can begin to buy some of the most depressed currencies, such as AUD/USD. This cross is currently trading at a 12% discount to PPP according to the OECD – the steepest discount that this currency has had in 17 years. Additionally, our China Investment Strategy projects that China will accelerate infrastructure investment this year to counteract the negative economic effects of the lockdown. This pick up in investment should increase base-metal demand, proving a boost to the Australian dollar in the process.   Alternatives Chart 26Favor Macro Hedge Funds Over Private Equity During Recessions Favor Macro Hedge Funds Over Private Equity During Recessions Favor Macro Hedge Funds Over Private Equity During Recessions Intro: The coronavirus outbreak caused tremendous market volatility and huge declines in liquid assets. Many clients have asked over the past few weeks which illiquid assets make sense in the current environment. To answer that, we stick to our usual recommendation framework, dividing illiquid assets into three buckets: Return Enhancers: Over the past year, we have been recommending clients to pare back private-equity exposure and increase allocation to hedge funds – particularly macro hedge funds, which often outperform other risky alternative assets during economic slowdowns and recessions (Chart 26, panel 1). Private debt – particularly distressed debt – could become a beneficiary of the current environment. The market turmoil will leave some assets heavily discounted, which can provide an opportunity for nimble funds to make investments at attractive valuations. In a previous Special Report, we highlighted Business Development Companies (BDCs) as a liquid alternative to direct private lending.6 They have taken a hit over the past month, even compared to equities and junk bonds. However, their recovery as markets bottom is usually significant (panels 2 & 3). Inflation Hedges: The coordinated “whatever-it-takes” stance implemented by global governments and central banks to mitigate the coronavirus crisis is likely to have inflationary consequences in the long-term. In that environment, investors should favor commodity futures over real estate (panel 4). As global growth reaccelerates in response to stimulus and resumed manufacturing activity over the next 12 months, the USD should weaken, and commodity prices should rise. Volatility Dampeners: Timberland and farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets (panel 5). Farmland particularly should fare well in this environment, being more insulated from the economy, given food’s inelastic demand Risks To Our View Chart 27Dollar Would Fall In A Strong Recovery Dollar Would Fall In A Strong Recovery Dollar Would Fall In A Strong Recovery Since our recommendations are based on a middle course, hedging both upside and downside risks, we need to consider how extreme these two eventualities could be. On the upside, the most optimistic scenario would be one in which the coronavirus largely disappears after April or May. The massive amount of fiscal and monetary stimulus would produce a jet-fuelled rally in risk assets. The dollar has soared over the past few weeks, as a risk-off currency (Chart 27), and would likely fall sharply. This would be very positive for commodities and Emerging Markets assets. The strong cyclical recovery would also help euro zone and Japanese equities relative to the more defensive US. Value stocks and small caps would outperform. Chart 28Could It Get Worse Than 2008 - Or Even 1932? Could It Get Worse Than 2008 - Or Even 1932? Could It Get Worse Than 2008 - Or Even 1932? Downside risks are less easy to forecast. As Warren Buffet wrote in 2002: “you only find out who is swimming naked when the tide goes out.” The shock to the system caused by the coronavirus is certainly larger than the Global Financial Crisis of 2007-9 and could approach that caused by the Great Depression (Chart 28), though hopefully without the egregious policy errors of the latter. It is hard, therefore, to know where problems will emerge: US corporate debt, EM borrowers, and euro zone banks would be our most likely candidates. But there could be others. The oil price is another key uncertainty. Demand could collapse by at least 10% as a result of the severe recession. The breakdown of the production agreement between Saudi Arabia and Russia could produce a supply increase of 4-5%.  Given this, Brent crude would fall to $20 a barrel. That would represent a strong tailwind to global recovery (Chart 29). On the other hand, a rapprochement between Saudi and Russia (and even with regulators in Texas) could push oil prices back up again – a positive for markets such as Canada and Mexico. Chart 29Cheap Oil Boosts Growth Cheap Oil Boosts Growth Cheap Oil Boosts Growth   Footnotes 1   Please see BCA Special Report, "Questions On The Coronavirus: An Expert Answers," dated 31 March 2020, available at bcaresearch.com 2   https://www.medrxiv.org/content/10.1101/2020.03.24.20042291v1 3    https://www.imperial.ac.uk/media/imperial-college/medicine/sph/ide/gida-fellowships/Imperial-College-COVID19-NPI-modelling-16-03-2020.pdf 4    Please see China Investment Strategy Weekly Report, “Chinese Economic Stimulus: How Much For Infrastructure And The Property Market,” dated 25th March 2020, available at cis.bcaresarch.com 5    A release by Moody’s on March 25 stated that their actions “will be more tempered for higher-rated companies that are likely to benefit from policy intervention or extraordinary government support.” 6    Please see Global Asset Allocation Special Report, “Private Debt: An Investment Primer,” dated June 6, 2018, available at gaa.bcaresearch.com GAA Asset Allocation  

Highlights Chinese stocks have outperformed global benchmarks by a wide margin. We are taking profits on our overweight position, and downgrading our tactical call on Chinese stocks to neutral. In absolute terms, Chinese stocks have failed to buck the trend in a global selloff of risk assets. This suggests Chinese stocks are not immune to worldwide panics. Investors should wait for a peak in the global pandemic before going long on Chinese equities. Chinese stocks have become less cheap relative to global benchmarks. The size of Chinese stimulus is also less impressive compared with other major economies such as the US. Therefore, in order to maintain an overweight stance on Chinese risk assets in a global portfolio, Chinese stocks need to either offer a better price entry point, or a more upside potential in earnings outlook relative to their global peers. Feature Chart I-1Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... Chinese Stocks Have Significantly Outperformed Global Benchmarks... In the current pandemic environment, economic fundamentals mean little to panicked investors who have mostly ignored the unprecedented degree of monetary and fiscal stimulus pouring into the global economy. Investors are looking for clear signs that the COVID-19 crisis can be brought under control, but medical experts have been unable to predict the timing of a peak in the pandemic. Policymakers around the world are beginning to address investors’ concerns that substantial and timely fiscal policy supports are needed to offset the knock-on effects on businesses and individuals.1 However, until the number of new infections in major economies peaks, the erratic trading behavior among global investors will persist. Given the lack of near-term certainty, we are downgrading our tactical stance on Chinese stocks from overweight to neutral. Chart 1 highlights since we upgraded our tactical call to overweight in end-2019, Chinese stocks have significantly outperformed global stocks. This outperformance has been passive in nature; Chinese stocks are down about 10% year-to-date in US$ terms, versus a 23% decline in global stocks. We are also closing 7 of our 10 high-conviction investment calls from our trade book, for reasons cited here and then detailed in the next sections. Of the 10 active trades in our book, 7 have generated a positive return since their inceptions, including 3 that have recorded double-digit gains.2 Investors should wait for clarity on the peak of the global pandemic before going long on risk assets. Investors should wait for more signs of an upside potential in earnings and/or a better price entry point to go long on Chinese stocks. China Is Not Immune To A Global Pandemic Chart I-2...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms ...But Their Prices Have Also Plunged In Absolute Terms Chinese equities have not been immune from the gyrations in the global financial markets, which have not responded to monetary and fiscal stimulus measures in either a customary or predictive manner. Unlike the 2008 global recession triggered by a financial crisis, public health crises damage the economy by reducing human activity and, therefore, erode both supply and demand. A return to normalcy depends almost entirely on whether the pandemic can be contained. Even though Chinese business activities are gradually resuming, Chinese stocks failed to buck the worldwide trend of a liquidation in risk assets. While Chinese stocks have outperformed global benchmarks by a wide margin, the relative gains have mostly been passive since early March. In absolute terms, Chinese domestic stocks have lost all their gains from February and investable stock prices have fallen back to their November 2018 level (Chart 2). Chart I-3Number Of Imported Cases Now On The Rise Investing During A Global Pandemic Investing During A Global Pandemic China is not immune to a second COVID-19 wave. China has been reporting zero-to-low single-digit numbers of locally transmitted cases since mid-March, but it is now experiencing an increase in imported cases from overseas travelers (Chart 3). The mounting numbers have led the Chinese government to shut its borders to non-Chinese citizens.3 This indicates that it is still too early to claim a victory in China’s virus containment efforts.  Given that China’s domestic businesses are open, the trajectory of new cases also remains unknown. These lingering doubts will slow the pace in the resumption of Chinese production (Chart 4).   Chart I-4Chinese Companies Operating At 80% Capacity Investing During A Global Pandemic Investing During A Global Pandemic Moreover, China is not immune to qualms about the depth and duration of a global recession. China has the political will and policy room to stimulate its economy, and the country’s dominant domestic demand makes the economy relatively insulated from a global recession. However, when more than 40% of China’s trading partners (including Europe and the US) remain under lockdown, a collapse of external demand will weigh on China’s economic and corporate profit recovery in the next quarter or two. Therefore, short-term risks on Chinese stocks are tilted to the downside. Bottom Line: Chinese stocks have failed to buck the trend in the global pandemic and the tsunami selloff in risk assets. Investors should wait for a peak in the outbreak before going long on Chinese equities. Chinese Stocks Have Become Less Cheap Relative To Global Benchmarks Chart I-5Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Outperformance In Chinese Stocks Seems Quite Extended Chinese stocks, particularly in the domestic market, are no longer priced at deep discounts compared with global equities (Chart 5). The recent outperformance of Chinese stocks has brought the relative performance trend in both investable and domestic stocks back close to late-2017/early-2018 levels. That was before the US-China trade war began, and at a point where China’s economy was close to peak strength for the cycle. Although a passive outperformance does not automatically warrant an underweight stance on Chinese stocks, investors will demand a higher upside potential in Chinese corporate earnings to justify an overweight position in Chinese equities. Therefore, we will watch for the following signs before buying Chinese stocks: a strengthening in China’s economy and corporate profits outpacing recoveries in other major economies, and/or a near-term drop in Chinese stock prices outsizing the decline in global stock prices. Given the exceedingly strong policy responses from G20 economies (particularly the US), China’s stimulus will need to be amplified so that investors are confident that the rate of Chinese corporate profit recovery will surpass their global counterparts.4 In a recent Politburo meeting, Chinese policymakers signaled their willingness to expand stimulus, including much larger fiscal deficits and local-government special bond issuance quotas in 2020, along with further interest rate cuts.5 An escalation in policy support will probably bring China’s stimulus in line with that extended in the 2008-2009 global financial crisis. However, the size of the stimulus package will be determined at the National People’s Congress (NPC) meeting, which is delayed to end-April or early May. In the near term, the selloff in Chinese stocks will likely persist as financial markets continue to price in bad news in the global economy. Chinese investable stock prices continue to be priced at a discount relative to global benchmarks, although the discount is much smaller than it was three months ago. In absolute terms, Chinese investable stock prices have not reached their technical support levels.  The offshore market historically rebounds when prices approach a major defense line, measured by a 12-year moving average. This technical support for the MSCI China Index is currently 65, still about 13% below the March 30 close (Chart 6). Chart I-6Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support Investable Stock Prices Not Yet At Their Long-Term Support The prices in Chinese domestic stocks have reached their 12-year moving average, although A-share prices are not decisively in a structural “cheap” territory yet (Chart 7).  Investors should wait on the sidelines for now, since the full effects of any enhanced stimulus in China will be felt in the real economy with a time lag. China’s production supply side is only operating at about 80% of normal capacity, and demand has yet to catch up (Chart 4 and Chart 8).  This suggests the rebound in economic activities in Q2 will likely be gradual, and corporate profits are likely to remain depressed. Chart I-7Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Domestic Stock Prices Approaching A Structural "Cheap" Territory Chart I-8Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Demand In Manufacturing Remains Sluggish Bottom Line: Chinese stocks have become less cheap against the backdrop of a massive liquidation of global equities. Chinese existing stimulus also appears moderate compared with other major economies. Therefore, in order for investors to overweight Chinese risk assets in a global portfolio, Chinese stocks either will have to offer a better entry price point or more upside corporate earnings potential. Both are currently missing. Investment Conclusions Investors should stay neutral on Chinese stocks in the next 3 months, and we are closing 7 out of the 10 active positions in our trade book. These trades are especially vulnerable to a protracted global recession and more selloffs in the domestic stock market. We will look for opportunities to incrementally add new trades to our book in the coming months. Here are our reasons for retaining or closing some of our positions: Long China Onshore Corporate Bonds (Maintain): The trade has yielded a handsome return of 16% since its inception in June 2017, (Chart 9). Although the spread in Chinese onshore corporate bond yields has widened sharply in the past few weeks, it has been the result of an indiscriminate global selloff of financial assets rather than the market pricing in any China-centric credit risks (Chart 10). In the next 6 to 12 months, corporate credit spreads should normalize as we expect monetary policies in major economies to remain ultra-loose, the global economy to recover and investors’ risk sentiment to improve. Chinese onshore corporate bonds will likely continue to offer a better risk-reward profile relative to other economies, with a higher risk premium and relatively stable default rate. Chart I-9Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chinese Onshore Corporate Bonds Remain Attractive Chart I-10Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon Corporate Credit Spreads Should Narrow Over A 12-Month Horizon     Long MSCI China Energy Stocks (Close): This trade has had the worst performance among our positions due to consistently falling oil prices since October 2018 (Chart 11). Although BCA’s commodity strategists expect Brent prices to average $36/barrel in 2020, $3 higher than the average oil prices in March, it is still at a 50% discount from the $70 price tag just 3 months ago. Such a minor improvement in the price outlook does not offer enough upside potentials to offset downside risks in earnings in the next 9 months. Therefore, we would rather cut the losses. Long China Domestic Consumer Discretionary Equities Versus Benchmark and Long China Domestic Consumer Discretionary Equities/Short China Domestic Consumer Staples Equities (Close): As explained in the previous sections, we think there will be better entry price points for Chinese stocks as well as cyclical stocks. Besides, discretionary consumption in China has yet to show signs of a meaningful rebound. In the near term, we will also look for opportunities to go long position in domestic consumer staple stocks because we think that food and beverage price inflation will persist well into the second half of this year (Chart 12).  Chart I-11Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Chart I-12Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices   Long MSCI China Index, Long MSCI China Onshore Index, Long MSCI China Growth Index/ Short MSCI All Country World (Close): We will need to see more stable sentiment in the global financial markets, a better entry price point for Chinese stocks and a sure sign of outsized Chinese stimulus before reinitiating a long position on Chinese stocks. Jing Sima China Strategist jings@bcaresearch.com   Appendix Table 1Massive Stimulus In Response To Pandemic Investing During A Global Pandemic Investing During A Global Pandemic Footnotes 1  Please see Table 1 in the Appendix. 2  Please see the trade table at the end of the report. 3  https://www.bloomberg.com/news/articles/2020-03-26/china-to-suspend-foreigners-entry-starting-saturday?mc_cid=1bdcd29ddd&mc_eid=9da16a4859 4  The stimulus package announced in the US amounts to 9% of the country’s 2019 GDP, whereas China’s stimulus would be about 3% of its 2019 GDP. 5  http://www.xinhuanet.com/politics/leaders/2020-03/27/c_1125778940.htm Cyclical Investment Stance Equity Sector Recommendations

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

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

Highlights The pandemic has a negative impact on households and has not peaked in the US. But a depression is likely to be averted. Our market-based geopolitical risk indicators point toward a period of rising political turbulence across the world. We are selectively adding risk to our strategic portfolio, but remain tactically defensive. Stay long gold on a strategic time horizon. Feature I'm going where there's no depression, To the lovely land that's free from care. I'll leave this world of toil and trouble My home's in Heaven, I'm going there. - “No Depression In Heaven,” The Carter Family (1936) Chart 1The Pandemic Stimulus Versus The Great Recession Stimulus GeoRisk Update: No Depression GeoRisk Update: No Depression Markets bounced this week on the back of a gargantuan rollout of government spending that is the long-awaited counterpart to the already ultra-dovish monetary policy of global central banks (Chart 1). Just when the investment community began to worry about a full-fledged economic depression and the prospect for bank runs, food shortages, and martial law in the United States, the market rallied. Yet extreme uncertainty persists over how long one third of the world’s population will remain hidden away in their homes for fear of a dangerous virus (Chart 2). Chart 2Crisis Has Not Verifiably Peaked, Uncertainty Over Timing Of Lockdowns GeoRisk Update: No Depression GeoRisk Update: No Depression Chart 3The Pandemic Shock To The Labor Market The Pandemic Shock To The Labor Market The Pandemic Shock To The Labor Market While an important and growing trickle of expert opinion suggests that COVID-19 is not as deadly as once thought, especially for those under the age of 50, consumer activity will not return to normal anytime soon.1 Moreover political and geopolitical risks are skyrocketing and have yet to register in investors’ psyche. Consider: American initial unemployment claims came in at a record-breaking 3.3 million (Chart 3), while China International Capital Corporation estimates that China’s GDP will grow by 2.6% for the year. These are powerful blows against global political as well as economic stability. This should convince investors to exercise caution even as they re-enter the equity market. We are selectively putting some cash to work on a strategic time frame (12 months and beyond) to take advantage of some extraordinary opportunities in equities and commodities. But we maintain the cautious and defensive tactical posture that we initiated on January 24. No Depression In Heaven The US Congress agreed with the White House on an eye-popping $2.2 trillion or 10% of GDP fiscal stimulus. At least 46% of the package consists of direct funds for households and small businesses (Chart 4). This includes $290 billion in direct cash handouts to every middle-class household – essentially “helicopter money,” as it is financed by bonds purchased by the central bank (Table 1). The purpose is to plug the gap left by the near complete halt to daily life and business as isolation measures are taken. A depression is averted, but we still have a recession. Go long consumer staples. Chart 4The US Stimulus Package Breakdown GeoRisk Update: No Depression GeoRisk Update: No Depression Table 1Distribution Of Cash Handouts Under US Coronavirus Response Act GeoRisk Update: No Depression GeoRisk Update: No Depression China, the origin of the virus that triggered the global pandemic and recession, is resorting to its time-tried playbook of infrastructure spending, with 3% of GDP in new spending projected. This number is probably heavily understated. It does not include the increase in new credit that will accompany official fiscal measures, which could easily amount to 3% of GDP or more, putting the total new spending at 6%. Germany and the EU have also launched a total fiscal response. The traditionally tight-fisted Berlin has launched an 11% of GDP stimulus, opening the way for other member states to surge their own spending. The EU Commission has announced it will suspend deficit restrictions for all member states. The ECB’s Pandemic Emergency Purchase Program (PEPP) enables direct lending without having to tap the European Stability Mechanism (ESM) or negotiate the loosening of its requirements. It also enables the ECB to bypass the debate over issuing Eurobonds (though incidentally Germany is softening its stance on the latter idea). The cumulative impact of all this fiscal stimulus is 5% of global GDP – and rising (Table 2). Governments will be forced to provide more cash on a rolling basis to households and businesses as long as the pandemic is raging and isolation measures are in place. Table 2The Global Fiscal Stimulus In Response To COVID-19 GeoRisk Update: No Depression GeoRisk Update: No Depression President Trump has signaled that he wants economic life to begin resuming after Easter Sunday, April 12. But he also said that he will listen to the advice of the White House’s public health advisors. State governors are the ones who implement tough “shelter in place” orders and other restrictions, so the hardest hit states will not resume activity until their governors believe that the impact on their medical systems can be managed. Authorities will likely extend the social distancing measures in April until they have a better handle on the best ways to enable economic activity while preserving the health system. Needless to say, economic activity will have to resume gradually as the government cannot replace activity forever and the working age population can operate even with the threat of contracting the disease (social distancing policies would become more fine-tuned for types of activity, age groups, and health risk profiles). The tipping point from recession to depression would be the point at which the government’s promises of total fiscal and monetary support for households and businesses become incapable of reassuring either the financial markets or citizens. The largest deficit the US government has ever run was 30% of GDP during World War II (Chart 5). Today’s deficit is likely to go well beyond 15% (5% existing plus 10% stimulus package plus falling revenue). If authorities were forced to triple the lockdown period and hence the fiscal response the country would be in uncharted territory. But this is unlikely as the incubation period of the virus is two weeks and China has already shown that a total lockdown can sharply reduce transmission. Chart 5The US's Largest Peacetime Budget Deficit The US's Largest Peacetime Budget Deficit The US's Largest Peacetime Budget Deficit Any tipping point into depression would become evident in behavior: e.g. a return to panic selling, followed by the closure of financial market trading by authorities, bank runs, shortages of staples across regions, and possibly the use of martial law and curfews. While near-term selloffs can occur, the rest seems very unlikely – if only because, again, the much simpler solution is to reduce the restrictions on economic activity gradually for the low-risk, healthy, working age population. Bottom Line: Granting that the healthy working age population can and will eventually return to work due to its lower risk profile, unlimited policy support suggests that a depression or “L-shaped” recovery is unlikely. The Dark Hour Of Midnight Nearing While the US looks to avoid a depression, there will still be a recession with an unprecedented Q2 contraction. The recovery could be a lot slower than bullish investors expect. Global manufacturing was contracting well before households got hit with a sickness that will suppress consumption for the rest of the year. There is another disease to worry about: the dollar disease. The world is heavily indebted and holds $12 trillion in US dollar-denominated debt. Yet the dollar is hitting the highest levels in years and global dollar liquidity is drying up. The greenback has rallied even against major safe haven currencies like the Japanese yen and Swiss franc (Chart 6). Of course, the Fed is intervening to ensure highly indebted US corporates have access to loans and extending emergency dollar swap lines to a total of 14 central banks. But in the near term global growth is collapsing and the dollar is overshooting. This can create a self-reinforcing dynamic. The same goes for any relapse in Chinese growth. Unlike in 2008 – but like 2015 – China is the epicenter of the global slowdown. China has much larger economic and financial imbalances today than it did in 2003 when the SARS outbreak occurred, and it will increase these imbalances going forward as it abandons its attempt to deleverage the corporate sector (Chart 7). Chart 6The Greenback Surge Deprives The World Of Liquidity The Greenback Surge Deprives The World Of Liquidity The Greenback Surge Deprives The World Of Liquidity Chart 7China's Financial Imbalances Are A Worry China's Financial Imbalances Are A Worry China's Financial Imbalances Are A Worry The rest of emerging markets face their own problems, including poor governance and productivity, as well as the dollar disease and the China fallout. They are unlikely to lift themselves out of this crisis, but they could become the source for credit events and market riots that prolong the global risk-off phase. Bottom Line: It is too soon to sound the all-clear. If the dollar continues on its rampage, then the gigantic stimulus will not be enough, markets will relapse, and fears of deflation will grow. World Of Toil And Trouble Political risk is the next shoe to drop. The pandemic and recession are setting in motion a political earthquake that will unfold over the next decade. Almost all of our 12 market-based geopolitical risk indicators have exploded upward since the beginning of the year. Chart 8China's Political Risk Is Rising China's Political Risk Is Rising China's Political Risk Is Rising These indicators show that developed market equities and emerging market currencies are collapsing far more than is justified by underlying fundamentals. This risk premium reflects the uncertainty of the pandemic, but the recession will destabilize regimes and fuel fears about national security. So the risk premium will not immediately decline in several important cases. China’s political risk is shooting up, as one would expect given that the pandemic began in Hubei (Chart 8). The stress within the Communist Party can be measured by the shrill tone of the Chinese propaganda machine, which is firing on all cylinders to convince the world that Chinese President Xi Jinping did a great job handling the virus while the western nations are failing states that cannot handle it. The western nations are indeed mishandling it, but that does not solve China’s domestic economic and social troubles, which will grow from here. Of course, our political risk indicator will fall if Chinese equities rally more enthusiastically than Chinese state banks expand credit as the economy normalizes. But this would suggest that markets have gotten ahead of themselves. By contrast, if China surges credit, yet equity investors are unenthusiastic, then the market will be correctly responding to the fact that a credit surge will increase economic imbalances and intensify the tug-of-war between authorities and the financial system, particularly over the effort to prevent the property sector bubble from ballooning. China needs to stimulate to recover from the downturn. Obviously it does not want instability for the 100th birthday of the Communist Party in 2021. An even more important reason for stimulus is the 2022 leadership reshuffle – the twentieth National Party Congress. This is the date when Xi Jinping would originally have stepped down and the leading member of the rival faction (Hu Chunhua?) would have taken over the party, the presidency, and the military commission. Today Xi is not at risk of losing power, but with a trade war and recession to his name, he will have to work hard to tighten control over the party and secure his ability to stay in power. An ongoing domestic political crackdown will frighten local governments and private businesses, who are already scarred by the past decade and whose animal spirits are important to the overall economic rebound. It is still possible that Beijing will have to depreciate the renminbi against the dollar. This is the linchpin of the trade deal with President Trump – especially since other aspects of the deal will be set back by the recession. As long as Trump’s approval rating continues to benefit from his crisis response and stimulus deals, he is more likely to cut tariffs on China than to reignite the trade war. This approach will be reinforced by the bump in his approval rating upon signing the $2 trillion Families First Coronavirus Response Act into law (Chart 9). He will try to salvage the economy and his displays of strength will be reserved for market-irrelevant players like Venezuela. But if the virus outbreak and the surge in unemployment turn him into a “lame duck” later this year, then he may adopt aggressive trade policy and seek the domestic political upside of confronting China. He may need to look tough on trade on the campaign trail. Diplomacy with North Korea could also break down. This is not our base case, but we note that investors are pricing crisis levels into the South Korean won despite its successful handling of the coronavirus (Chart 10). Pyongyang has an incentive to play nice to assist the government in the South while avoiding antagonizing President Trump. But Kim Jong Un may also feel that he has an opportunity to demonstrate strength. This would be relevant not because of North Korea’s bad behavior but because a lame duck President Trump could respond belligerently. Chart 9Trump’s Approval Gets Bump From Crisis Response And Stimulus GeoRisk Update: No Depression GeoRisk Update: No Depression Chart 10South Korean Political Risk Rising South Korean Political Risk Rising South Korean Political Risk Rising We highlighted Russia as a “black swan” candidate for 2020. This view stemmed from President Vladimir Putin’s domestic machinations to stay in power and tamp down on domestic instability in the wake of domestic economic austerity policies. For the same reason we did not expect Moscow to engage in a market share war with Saudi Arabia that devastated oil prices, the Russian ruble, and economy. At any rate, Russia will remain a source of political surprises going forward (Chart 11). Go long oil. Putin cannot add an oil collapse to a plague and recession and expect a popular referendum to keep him in power till 2036. The coronavirus is hitting Russia, forcing Putin to delay the April 22 nationwide referendum that would allow him to rule until 2036. It is also likely forcing a rethink on a budget-busting oil market share war, since more than the $4 billion anti-crisis fund (0.2% of GDP) will be needed to stimulate the economy and boost the health system. Russia faces a budget shortfall of 3 trillion rubles ($39 billion) this year from the oil price collapse. It is no good compounding the economic shock if one intends to hold a popular referendum – even if one is Putin. For all these reasons we agree with BCA Research Commodity & Energy Strategy that a return to negotiations is likely sooner rather than later. Chart 11Russia: A Lake Of Black Swans Russia: A Lake Of Black Swans Russia: A Lake Of Black Swans However, we would not recommend buying the ruble, as tensions with the US are set to escalate. Instead we recommend going long Brent crude oil. Political risk in the European states is hitting highs unseen since the peak of the European sovereign debt crisis (Chart 12). Some of this risk will subside as the European authorities did not delay this time around in instituting dramatic emergency measures. Chart 12Europe: No Delay In Offering 'Whatever It Takes' Europe: No Delay In Offering 'Whatever It Takes' Europe: No Delay In Offering 'Whatever It Takes' Chart 13Political Risk Understated In Taiwan And Turkey Political Risk Understated In Taiwan And Turkey Political Risk Understated In Taiwan And Turkey However, we do not expect political risk to fall back to the low levels seen at the end of last year because the recession will affect important elections between now and 2022 in Italy, the Netherlands, Germany, and France. Only the UK has the advantage of a single-party parliamentary majority with a five-year term in office – this implies policy coherence, notwithstanding the fact that Prime Minister Boris Johnson has contracted the coronavirus. The revolution in German and EU fiscal policy is an essential step in cementing the peripheral countries’ adherence to the monetary union over the long run. But it may not prevent a clash in the coming years between Italy and Germany and Brussels. Italy is one of the countries most likely to see a change in government as a result of the pandemic. It is hard to see voters rewarding this government, ultimately, for its handling of the crisis, even though at the moment popular opinion is tentatively having that effect. The Italian opposition consists of the most popular party, the right-wing League, and the party with the fastest rising popular support, which is the right-wing Brothers of Italy. So the likely anti-incumbent effect stemming from large unemployment would favor the rise of an anti-establishment government over the next year or two. The result would be a clash with Brussels even in the context of Brussels taking on a more permissive attitude toward budget deficits. This will be all the worse if Brussels tries to climb down from stimulus too abruptly. Our political risk indicators have fallen for two countries over the past month: Taiwan and Turkey (Chart 13). This is not because political risk is falling in reality, but because these two markets have not seen their currencies depreciate as much as one would expect relative to underlying drivers of their economy: In Taiwan’s case the reason is the US dollar’s unusual strength relative to the Japanese yen amidst the crisis. Ultimately the yen is a safe-haven currency and it will eventually strengthen if global growth continues to weaken. Moreover we continue to believe that real world politics will lead to a higher risk premium in the Taiwanese dollar and equities. Taiwan faces conflicts with mainland China that will increase with China’s recession and domestic instability. In Turkey’s case, the Turkish lira has depreciated but not as much as one would expect relative to European equities, which have utterly collapsed. Therefore Turkey’s risk indicator shows its domestic political risk falling rather than rising. Turkey’s populist mismanagement will ensure that the lira continues depreciating after European equities recover, and then our risk indicator will shoot up. Chart 14Brazilian Political Risk Is No Longer Contained Brazilian Political Risk Is No Longer Contained Brazilian Political Risk Is No Longer Contained Prior to the pandemic, Brazilian political risk had remained contained, despite Brazilian President Jair Bolsonaro’s extreme and unorthodox leadership. Since the outbreak, however, this indicator has skyrocketed as the currency has collapsed (Chart 14). To make matters worse, Bolsonaro is taking a page from President Trump and diminishing the danger of the coronavirus in his public comments to try to prevent a sharp economic slowdown. This lackadaisical attitude will backfire since, unlike the US, Brazil does not have anywhere near the capacity to manage a major outbreak, as government ministers have warned. This autumn’s local elections present an opportunity for the opposition to stage a comeback. Brazilian stocks won’t be driven by politics in the near term – the effectiveness of China’s stimulus is critical for Brazil and other emerging markets – but political risk will remain elevated for the foreseeable future. Bottom Line: Geopolitical risk is exploding everywhere. This marks the beginning of a period of political turbulence for most of the major nation-states. Domestic economic stresses can be dealt with in various ways but in the event that China’s instability conflicts with President Trump’s election, the result could be a historic geopolitical incident and more downside in equity markets. In Russia’s case this has already occurred, via the oil shock’s effect on US shale producers, so there is potential for relations to heat up – and that is even more true if Joe Biden wins the presidency and initiates Democratic Party revenge for Russian election meddling. The confluence of volatile political elements informs our cautious tactical positioning. Investment Conclusions If the historic, worldwide monetary and fiscal stimulus taking place today is successful in rebooting global growth, then there will be “no depression.” The world will learn to cope with COVID-19 while the “dollar disease” will subside on the back of massive injections of liquidity from central banks and governments. Gold: The above is ultimately inflationary and therefore our strategic long gold trade will be reinforced. The geopolitical instability we expect to emerge from the pandemic and recession will add to the demand for gold in such a reflationary environment. No depression means stay long gold! US Equities: Equities will ultimately outperform government bonds in this environment as well. Our chief US equity strategist Anastasios Avgeriou has tallied up the reasons to go long US stocks in an excellent recent report, “20 Reasons To Buy Equities.” We agree with this view assuming investors are thinking in terms of 12 months and beyond. Chart 15Oil/Gold Ratio Extreme But Wait To Go Long Oil/Gold Ratio Extreme But Wait To Go Long Oil/Gold Ratio Extreme But Wait To Go Long Tactically, however, we maintain the cautious positioning that we adopted on January 24. We have misgivings about the past week’s equity rally. Investors need a clear sense of when the US and European households will start resuming activity. The COVID-19 outbreak is still capable of bringing negative surprises, extending lockdowns, and frightening consumers. Hence we recommend defensive plays that have suffered from indiscriminate selling, rather than cyclical sectors. Go tactically long S&P consumer staples. US Bonds: Over the long run, the Fed’s decision to backstop investment grade corporate bonds also presents a major opportunity to go long on a strategic basis relative to long-dated Treasuries, following our US bond strategists. Global Equities: We prefer global ex-US equities on the basis of relative valuations and US election uncertainty. Shifting policy winds in the United States favor higher taxes and regulation in the coming years. This is true unless President Trump is reelected, which we assess as a 35% chance. Emerging Markets: We are booking gains on our short TRY-USD trade for a gain of 6%. This is a tactical trade that remains fundamentally supported. Book 6% gain on short TRY-USD.   Oil: For a more contrarian trade, we recommend going long oil. Our tactical long oil / short gold trade was stopped out at 5% last week. While we expect mean reversion in this relationship, the basis for gold to rally is strong. Therefore we are going long Brent crude spot prices on Russia’s and Saudi Arabia’s political constraints and global stimulus (Chart 15). We will reconsider the oil/gold ratio at a later date.     Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 See Joseph T. Wu et al, "Estimating clinical severity of COVID-19 from the transmission dynamics in Wuhan, China," Nature Medicine, March 19, 2020, and Wei-jie Guan et al, "Clinical Characteristics of Coronavirus Disease 2019 in China," The New England Journal Of Medicine, February 28, 2020. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Rapidly changing news flows are forcing oil markets to recalibrate supply-demand fundamentals continuously. This will keep volatility at or close to recent record highs (Chart of the Week). The demand shock from COVID-19 accounts for ~ 65% of the oil price collapse, based on our modeling. USD demand is fueling record dollar strength, which could suppress commodity consumption after the COVID-19 shock dissipates. If the Fed’s epic monetary policy response sates USD demand, commodity demand will rebound strongly. Highly uncertain expectations on the supply side – fueled by the market-share war between the Kingdom of Saudi Arabia (KSA) and Russia set to begin in earnest April 1 – will keep global policy uncertainty elevated post-COVID-19. Texas regulators are debating the efficacy of re-establishing a long-dormant policy mandating the state’s Railroad Commission (RRC) pro-rate production. The chairman of the RRC and the CEO of Russia’s state oil champion Rosneft both oppose production-management schemes, arguing they allow other producers to steal market share. The Trump administration, however, sees potential in working with KSA to stabilize markets. Feature Sparse information available to markets makes it extremely difficult to estimate the impact of the COVID-19 shock to demand. Oil options’ implied volatility reached record levels following unprecedented price changes – down and up – in the underlying futures markets over the past month, as the Chart of the Week shows.1 This reflects the markets’ profound uncertainty regarding supply, demand and near-term policy outcomes that will affect these fundamentals in the short-, medium- and long-term. Sparse information available to markets makes it extremely difficult to estimate the impact of the COVID-19 shock to demand. The ever-changing evolution of supply dynamics presents its own – unprecedented – difficulties. The usual lags in information on supply and demand are compounded by the near-certain substantial revisions that will accompany these data as a better picture of the fundamentals emerges. Chart of the WeekOil Price Volatility At Record Level Oil Price Volatility At Record Level Oil Price Volatility At Record Level That said, we are attempting to develop models and an intuition for likely turning points on both sides of the fundamentals. We stress up front that these estimates are tentative, particularly on the demand side, as they use commodity prices and financial variables that are difficult to track closely even in the best of times, and are themselves continuously adjusting to highly uncertain fundamentals. COVID-19 Crushes Commodity Demand Oil prices fell 60% YTD after being struck by simultaneous demand and supply exogenous shocks (Chart 2). We capture the effect of the demand shock with a combination of multivariate regressions using various cyclical commodities, the US trade-weighted dollar, and 10-year treasury yields. Global demand for cyclical commodities – including oil – is fundamentally related to global economic activity. By extracting the common information from these commodity prices, we can estimate the proportion of the oil price decline associated with the ongoing demand shock.2 Chart 2Oil-Price Collapse Of 2020 Oil-Price Collapse Of 2020 Oil-Price Collapse Of 2020 We estimate roughly 60% of the crude oil price drop so far this year can be explained by the sharp contraction in global demand caused by the COVID-19 pandemic. To estimate the impact of the demand shock from the COVID-19 pandemic on crude oil prices, we expanded a model developed by James Hamilton in the last market-share war of 2014-16.3 Hamilton’s model uses market-cleared prices outside of oil – copper, the USD and 10-year nominal US treasurys – to estimate the extent of the global aggregate demand shock. We estimate roughly 60% of the crude oil price drop so far this year can be explained by the sharp contraction in global demand caused by the COVID-19 pandemic (Chart 3). Some specific refined-product demand (i.e., air and car travel, marine-fuel consumption) was hit harder, meaning the demand shock would be higher in those sectors. For transportation-related refined products, COVID-19-related impacts could account for as much as 70% of the decline in prices. Chart 3COVID-19 Crushes Oil Demand COVID-19 Crushes Oil Demand COVID-19 Crushes Oil Demand Chinese Demand May Be Recovering News reports suggesting a tentative recovery from the COVID-19 demand shock are emerging in China, where the virus originated late last year. Weekly data indicate inventories in bellwether commodity markets – copper and steel – should begin to fall as demand slowly recovers. While encouraging, this may not be sufficient to offset the massive losses in copper demand that likely will be posted this year as a result of the lockdown imposed in China – and globally – to contain the spread of COVID-19. China accounts for ~ 50% of global demand and ~ 40% of refined copper supply.4 Global copper inventories will be useful indicators of the state of China’s recovery, as they will be sourced early as mining and refining operations are ramped up in response to increasing demand (Chart 4). Chart 4Copper Inventories Will Track Aggregate Demand Recovery Copper Inventories Will Track Aggregate Demand Recovery Copper Inventories Will Track Aggregate Demand Recovery Chart 5China Expected To Roll Infrastructure Investment Into 2020 China Expected To Roll Infrastructure Investment Into 2020 China Expected To Roll Infrastructure Investment Into 2020 China is set to roll a large portion of its multi-year 34-trillion-yuan (~ $5 trillion) investment plan into this year, to secure economic recovery from the COVID-19 pandemic. For example, our colleagues at BCA Research’s China Investment Service expect a near 10% increase in infrastructure investments this year, which would take such investment to 198 billion yuan (Chart 5). Local governments already have ramped up their expenditures, frontloading 1.2 trillion yuan of bond issuance in the first two months of 2020, a 53% jump versus the same period last year. This includes 1 trillion yuan of special government bonds (SPBs), which is expected to rise to 3-3.5 trillion yuan by the end of 2020, up 30% from 2019 levels. Additional funding channels likely will be opened to support public spending this year. Aggressive policy easing by the Peoples Bank of China (PBOC) in recent weeks, coupled with likely additional debt issuance and infrastructure spending this year will support revived aggregate demand in China. China’s policy responses will be additive to those of the US, where more than $2.2 trillion of fiscal stimulus could be deployed following Congressional agreement on a massive fiscal package that likely will be endorsed by the White House. For its part, the Fed has gone all-in on fighting the economic, liquidity and credit shocks unleashed by the COVID-19 pandemic.5 The EU also is expected to roll out large fiscal-stimulus packages, led by Germany, which is lining up a 150-billion-euro (~ $162 billion) bond issue this year, and a 156 billion-euro supplementary budget.6 Texas Railroad Commission To The Rescue? Another possible element of a global oil-production-regulation scheme emerged in recent days from America’s Lone Star state: The Texas Railroad Commission (RRC). Based on our modeling, 30% to 40% of the decline in oil prices this year is explained by the expectation of higher supply in the coming months (Chart 6).7 It is worthwhile remembering this is anticipatory, given statements and actions from KSA and Russia regarding steps both are taking to sharply increase future production. KSA, for example, provisionally chartered transport to move close to ~ 38mm barrels of crude to refining centers, 12mm barrels of which will be pointed toward the US.8 This was part of the Kingdom’s plan to boost supplies to the market to 12.3mm b/d beginning in April, most of which will come from higher production, augmented by storage drawdowns. If we get a rapprochement between OPEC 2.0’s leaders – KSA and Russia – and the coalition’s production-management scheme is rebuilt, oil prices could outperform other cyclical commodities post-COVID-19, as a large component of supply uncertainty is removed. However, before that can happen, markets will have to absorb the surge in exports from KSA that are being priced in for April and May. Chart 6Expected Supply Increase From KSA, Russia Accounts For 30-40% Of Oil Price Collapse Expected Supply Increase from KSA, Russia Accounts for 30-40% Of Oil Price Collapse Expected Supply Increase from KSA, Russia Accounts for 30-40% Of Oil Price Collapse Another possible element of a global oil-production-regulation scheme emerged in recent days from America’s Lone Star state: The Texas Railroad Commission (RRC). Texas regulators are openly debating the efficacy of re-establishing a long-dormant policy mandating the RRC pro-rate production. The idea was floated by outgoing RRC Commissioner Ryan Sitton, who earlier this month in an op-ed proposed KSA, Russia and the US could jointly agree to 10% reductions in output to stabilize global oil markets. This would expand the management of oil production and spare capacity globally, a profound shift from earlier eras when the RRC then OPEC took on that role.9 While RRC staff are studying the idea, Sitton’s proposal has not received the endorsement of fellow commissioners, particularly Wayne Christian, the chairman of the RRC.10 Christian’s argument against the scheme is similar to that of Rosneft CEO Igor Sechin’s: Both argue such schemes allow other producers to steal market share. Russian government officials continue to signal they are open to returning to the negotiating table with KSA. The Trump administration, however, sees potential in working with KSA and to stabilize markets. Earlier this month, the administration sent a “senior Energy Department official” to Riyadh to support the State Department and the US’s energy attache.11 For its part, Russian government officials continue to signal they are open to returning to the negotiating table with KSA. The “Russian position was never about triggering an oil prices fall. This is purely our Arab partners initiative,” according to a Reuters report quoting Andrei Belousov, Russia’s first deputy prime minister, in an interview with state news agency TASS. “Even oil companies who are obviously interested to maintain their markets, did not have a stance that the deal (OPEC+) should be dissolved.” According to Reuters, Russia proposed an extension of existing production cuts of 1.7mm b/d, perhaps to the end of this year, but “(our) Arab partners took a different stance.” 12 Investment Implications The big uncertainty at present is the extent of demand destruction that will be caused by COVID-19. At this point, the diplomatic maneuvering among states on the oil-supply side is a distraction. Any substantive action will require drawn-out negotiation, particularly to reconstitute and expand OPEC 2.0 to include the Texas RRC in the management of global oil production and spare capacity. In the here and now, markets are forcing sharp reductions in oil output, particularly in the US shales – e.g., Chevron announced it will be cutting capex and exploratory spending 20% this year on Tuesday.13 This is occurring throughout the industry in the US and around the world. Reuters compiled announcements by oil producers that have indicated they will cut an average 30% reduction in capex in response to the oil-price collapse.14 We are expecting US shale output to grow ~ 650k b/d this year, and to fall by ~ 1.35mm b/d next year on the back of the price collapse this year (Chart 7).15 We do not expect a resurgent shale-producing sector in the short- to medium-term, given the capital markets’ demonstrated aversion to funding this sector until it can demonstrate long-term profitability. The big uncertainty at present is the extent of demand destruction that will be caused by COVID-19, and the effectiveness of fiscal and monetary policy in supporting national economies during the pandemic. Equally important will be policy responsiveness post-COVID-19, and how quickly economies worldwide return to normal. Chart 7US Shale Output Will Fall Sharply US Shale Output Will Fall Sharply US Shale Output Will Fall Sharply Bottom Line: We expect a re-building of OPEC 2.0, with KSA and Russia restoring their production-management scheme before global storage facilities are filled and markets push prices below cash costs to force production to shut in. The revenue gains from this course of action far exceed any benefit derived from increasing production and prolonging a market-share war.16 Any agreement to include the Texas RRC will occur after demand is bottoming and moving up – i.e., once the outlook for demand is more stable – as happened when OPEC 2.0 was formed.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight The COVID-19 pandemic produced one undisputed winner: the environment. Limits on movement and factory shutdowns have massively reduced air pollution in countries hit by the pandemic early on (e.g. China and Italy). We expect similar declines elsewhere in Europe. This already is reflected in the ~ 30% drop in Carbon Emission Allowances (EUA) futures this year (Chart 8). Following the GFC, worldwide CO2 emissions dropped by 2.2%, but rapidly rebounded in 2010 – surpassing pre-crisis levels. We expect a similar recovery in global emissions as record stimulus measures kick in and normal traffic resumes post-COVID-19. Therefore, we are going long December 2020 ICE EUA futures. Base Metals: Neutral The LME base metal index is down 20% YTD. Downside risks remain large as lockdowns globally continue to intensify in the wake of the COVID-19 pandemic. These drastic measures also threaten mine operations for some metals. Copper supply is reportedly reduced in Peru and Chile. Nonetheless, weak economic growth along with a strong US dollar remain the dominant factors. Base metals prices gained from a lower USD on Tuesday, signaling market participants welcomed the Fed’s actions to relieve global liquidity fears. Still, it is too early to confirm these measures will be sufficient to circumvent further deterioration in the global economy. Precious Metals: Neutral Gold, silver, platinum, and palladium rose 12%, 15%, 14%, and 16% from the start of the week, recovering part of the sharp losses from the COVID-19 shock. Metals – especially Gold – were supported by the Fed’s resolve to provide much-needed liquidity to markets. Platinum and palladium were pushed higher following South Africa’s government decision to halt metal and mining operations as part of a 21-day nationwide shutdown to prevent the spread of the virus. Silver prices remain disconnected from their main drivers – i.e. safe-haven and industrial demand – and should rise along with gold once liquidity concerns dissipate (Chart 9). Ags/Softs:  Underweight After being under pressure for the last three sessions, CBOT May Corn futures rose this week, trading above $3.50/bu, as expectations of stronger demand for ethanol were revived by increasing oil prices. Wheat and beans also put in strong showings this week, as demand starts to lift. US grain exports are holding up relatively well versus the competition – chiefly the South America powerhouses Argentina and Brazil – as COVID-19 hampers their exports. Wheat futures remain firm on the back of stronger demand as consumers stockpile during the pandemic. Chart 8 EUA Futures Will Rebound As Traffic Resumes Post Covid-19 EUA Futures Will Rebound As Traffic Resumes Post Covid-19 Chart 9 Silver Prices Should Rise As Liquidity Concerns Dissipate Silver Prices Should Rise As Liquidity Concerns Dissipate   Footnotes 1     The Chart of the Week shows prompt volatility at the end of last week, when it stood at a record 183.22%, and a sharply backwardated volatility forward curve. Implied volatility is a parameter in option-pricing models, which equates the premium paid for options with the principal factors determining its value (i.e., the underlying futures price, the option’s strike price, time to expiry, interest rates and the expected volatility, or standard deviation of expected returns on the underlying). All of the factors other than volatility can be observed in the underlying market and interest rate markets, leaving volatility to be determined using an iterative search. Please see Ryan, Bob and Tancred Lidderdale (2009), Short-Term Energy Outlook Supplement: Energy Price Volatility and Forecast Uncertainty, published by the US Energy Information Administration, for a discussion of volatility as a market-cleared parameter. 2     We estimate our model both in (1) levels given that base metals, the US dollar and oil prices are cointegrated – i.e. these variable follow a common long-term stochastic trend – and (2) log-difference. We include the US dollar and 10-year treasury yields as explanatory variables. These series are closely linked to global growth trends, weakness in global economic activity is associated with a rising dollar and falling treasury yields. We only include treasury yields in the first difference model given that it is not cointegrated with oil and metal prices in levels. 3     Please see Oil prices as an indicator of global economic conditions, posted by Prof. Hamilton on his Econbrowser blog December 14, 2014. Our model uses monthly market inputs – non-oil commodities, the trade-weighted USD, US 10-year treasurys from January 2000 to February 2020, and the last daily close for March 2020. We extend Brian Prest’s 2018 model, which is based on Hamilton but uses monthly data instead of weekly data as in Hamilton. Please see Prest, C. Brian, 2018. "Explanation for the 2014 Oil Price Decline: Supply or Demand?" Energy Economics 74, 63-75. 4    Please see China steel, copper inventories dip as demand recovers from virus and Rupture of copper demand to fuel surplus as industry hit by virus, published March 20 and March 23, 2020, by reuters.com. 5     For an in-depth discussion, please see Life At The Zero Bound published March 24, 2020, by BCA Research’s US Bond Strategy. It is available at usbs.bcaresearch.com. 6    Please see Germany expected to announce fiscal stimulus as European death toll rises published by thehill.com March 23, 2020. 7     We estimate the share of the price collapse explained by the supply shock using the residuals from our demand-only Brent price model presented in Chart 3. The difference between actual Brent prices and our demand-only estimates captures oil-specific factors unexplained by global economic growth – mainly supply dynamics. 8    Please see Saudi provisionally charters 19 supertankers, six to U.S. as global oil price war heats up published by reuters.com March 11, 2020. 9    Please see Texas regulator considers oil output cuts for the first time in decades published by worldoil.com on March 20, 2020. We discussed the historic role of the RCC during the 2014-16 OPEC-led market-share war in End Of An Era For Oil And The Middle East, a Special Report published April 9, 2014, with BCA Research’s Geopolitical Strategy. We noted, “In March of 1972, the (RRC) effectively relinquished control of Texas oil production, when it allowed wells in the state to produce at 100% of their capacity. This signaled the exhaustion of U.S. spare capacity – production no longer had to be pro-rated to maintain prices above marginal costs – and the ascendance OPEC to global prominence in the oil market.” 10   Please see Texas Railroad Commission chairman opposes OPEC-style oil production cuts published by S&P Global Platts March 20, 2020. 11    Please see U.S. to send envoy to Saudi Arabia; Texas suggests oil output cuts published by reuters.com March 20, 2020. 12    Please see Russia: Gulf nations, not us, to blame for oil prices fall -TASS published by reuters.com March 22, 2020. 13   Please see Chevron cuts spending by $4 billion, suspends share buybacks published by worldoil.com March 24, 2020. 14   Please see Factbox: Global oil, gas producers cut spending after crude price crash, published by reuters.com March 23, 2020. Refiners also are cutting runs – particularly in the US and Europe – in the wake of collapsing demand for gasoline and distillates (jet, diesel and marine fuels), as S&P Global Platts reported March 23, 2020: Refinery margin tracker: Global refining margins take a severe hit on falling gasoline demand. 15   This extends to oil-services companies as well, which are anticipating a deeper crash in their businesses than occurred in the 2014-16 market-share war. Please see Shale service leaders warn of a bigger crash this time around published by worldoil.com March 24, 2020. 16   We argued this outcome was more likely than not – given the economic and welfare stakes – in last week’s report, KSA, Russia Will Be Forced To Quit Market-Share War.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals Oil-Market Risk At Unprecedented Levels, As Is Uncertainty Regarding Fundamentals