Developed Countries

Highlights The good stock market = ‘growth defensives’ like technology that benefit from lower bond yields. The bad stock market = ‘value cyclicals’ like banks that suffer from lower bond yields. Structurally favour growth defensives given that ultra-low bond yields are here to stay. Adjust the sovereign bond portfolio to: Long 30-year US T-bonds and Spanish Bonos. Short 30-year German Bunds and French OATs. Fractal trade: Long 10-year Spanish Bonos, short 10-year New Zealand bonds. Feature It has become increasingly meaningless to talk about ‘the stock market’ as one entity. The stock market has split into two distinct markets: a ‘good stock market’ and a ‘bad stock market’. To be clear, the split started before the coronavirus crisis, but the crisis has hastened the break-up (Chart of the Week). Chart of the WeekThe Good Stock Market, And The Bad Stock Market What distinguishes the good stock market from the bad stock market? The answer is the relationship with the bond yield. For the good market, the dominant message from lower bond yields is a valuation boom and higher prices (Chart I-2); but for the bad market, the dominant message from lower bond yields is a profits recession and lower prices. Chart I-2Tech Stocks Rally On Lower Bond Yields The Good Stock Market, And The Bad Stock Market For the good stock market, the valuation uplift that comes from lower bond yields far outweighs the coronavirus induced slump to sales and profits. Conversely, for the bad stock market, the coronavirus induced slump to sales and profits far outweighs any valuation uplift from lower bond yields. For the ‘good stock market’, the valuation uplift from lower bond yields outweighs the coronavirus induced slump to sales and profits.  The valuation uplift from lower bond yields is greatest for growth stocks. This is because the further into the future that cashflows are, the greater the increase in their ‘net present values’ Moreover, this valuation uplift becomes exponential at ultra-low bond yields. As bond prices start to have less upside than downside, they become riskier. Hence, both components of the required return on growth stocks – the bond yield and the equity risk premium – shrink together, justifying the exponentially higher net present value (Chart I-3).   Chart I-3Tech Valuations Rise Exponentially On Lower Bond Yields Meanwhile, the coronavirus induced slump to sales and profits is greatest for cyclical stocks. For many cyclicals – such as airlines, hotels, and restaurants – the hit to sales, profits, and employment will be long-lasting, as consumer and business behaviour adapts to the post Covid-19 world. Hence: The good stock market = ‘growth defensives’ whose epitome is technology. The bad stock market = ‘value cyclicals’ whose epitome is banks (Chart I-4). Chart I-4Banks Sell Off On Lower Bond Yields Banks suffer a double whammy. Not only does the lower bond yield signify a structurally poor outlook for credit creation which constitutes bank ‘sales’, but the flattening yield curve also signifies a shrinking net interest (profit) margin. Euro area banks suffer an additional complication. They are exposed to the sovereign yield spread on ‘periphery’ bonds such as Italian BTPs over German bunds. A widening of such spreads signals heightening tensions within the euro area, which hurts the solvencies of periphery banks with large holdings of periphery bonds (Chart I-5). Chart I-5Euro Area Banks Also Sell Off On Wider Sovereign Yield Spreads It follows that euro area banks need two conditions to rally. High quality bond yields must rise, and peripheral euro area yield spreads must fall. Given that such a star alignment is likely to be the exception rather than the norm, euro area banks should be bought for the occasional countertrend rally when technical signals justify it. Right now, the required signal is for high-quality bonds to become technically overbought, presaging a tactical bout of bond underperformance and bank outperformance. However, our most-trusted technical indicator is not yet giving the required signal. Stay tuned (Chart I-6). Chart I-6Bonds Are Not Yet Technically Overbought In the meantime, we prefer to play the euro area’s increasing solidarity – specifically, to underwrite a €500bn coronavirus recovery plan – through relative value positions in sovereign bonds. In our recent webcast Why Leaving The Euro Would be MAD, But Mad Things Happen we pointed out that in the euro era, labour market competitiveness in Spain has improved by more than in France. Making it hard to justify the near 100bps yield premium on 30-year Spanish Bonos versus French OATs (Chart I-7). Chart I-7The Yield Premium On Spanish Bonos Is Hard To Justify Since inception a year ago, our long 30-year US T-bonds and Italian BTPs versus 30-year German Bunds and Spanish Bonos is up by 15 percent. It is time to adjust this bond portfolio. Go long 30-year US T-bonds and Spanish Bonos versus 30-year German Bunds and French OATs. And take profit on long 10-year Italian BTPs versus 10-year Spanish Bonos. Are Ultra-Low Bond Yields Sustainable? At first glance, the divergence of the stock market into a booming good part and a languishing bad part might tempt investors to play long-term ‘mean reversion’: specifically, to sell growth defensives like technology and buy value cyclicals like banks. But be careful. The concept of mean reversion is only meaningful if the underlying trend is sideways – or in technical terms ‘stationary’. Statistics 101 warns us that if the underlying trend is not stationary, the concept of mean reversion – and indeed the much-abused concept of ‘standard deviation’ – is meaningless. If inflation persists below 2%, bond yields will remain ultra-low. Given that all investment is now just one big correlated trade to the bond yield, this raises a crucial question: is the bond yield stationary? Put another way, are bonds in an almighty bubble? Are bond yields unsustainably low, and at risk of a violent spike upwards? The answer depends on a further question: is sub-2 percent inflation unsustainably low? (Chart I-8) If inflation persists below central banks’ totemic 2 percent inflation target, then central banks will have no choice but to push and hold the monetary easing ‘pedal to the metal’. Therefore, bond yields will keep trending lower until, one by one, they reach the lower bound at around -1 percent. Chart I-8Is Sub-2 Percent Inflation Unsustainably Low? To us, the answer to this question is crystal clear. Not only is sub-2 percent inflation sustainable, it is the norm. Genuine price stability is not an arbitrary 2 percent inflation target that central banks can pluck out of the air. Rather, it is a steady state of broadly flat-lining prices that economies can remain in for centuries, so long as governments do not debase the broad money supply. Between 1675 and 1914 – when Great Britain was mostly on the gold standard – the price level barely budged, meaning inflation averaged near-zero for hundreds of years (Chart I-9). Chart I-9Inflation Averaged Near-Zero For Hundreds Of Years Today we have fiat money rather than the gold standard. However, the rapidly growing cryptocurrency asset-class is an embryonic 21st century gold standard ‘waiting in the wings.’ The mere fact that an alternative, and potentially superior, monetary system is waiting in the wings is a strong incentive for competent governments to preserve the value of fiat money. Which is to say, an incentive not to destroy the genuine price stability that advanced economies have now re-entered after a brief lapse in the 20th century. Ultra-Low Bond Yields Are Here To Stay, Structurally Favouring Growth Defensives It is in the gift of governments to destroy price stability should they desire. Witness Argentina, Venezuela or Zimbabwe. Yet these examples and the example of the 1970s teach us that when price stability is destroyed, inflation appears non-linearly, which is to say unpredictably and uncontrollably. This is because it suddenly becomes rational for governments to create money as fast as possible, and for consumers and firms to spend it as fast as possible. As the product of money supply and its velocity equals nominal demand, inflation skyrockets (Chart I-10). Chart I-10When Price Stability Is Destroyed, Inflation Appears Non-Linearly An early warning sign that governments are on the road to Venezuela is that central banks lose their independence. Or, at the very least, their inflation-targeting remits become diluted. Neither of these seem conceivable right now. Sub-2 percent inflation was the norm for hundreds of years. Never say never – but in the advanced economies the destruction of price stability is a tail-risk rather than a central threat. The upshot is that ultra-low bond yields are here to stay. Long-term investors should structurally own the good stock market – growth defensives – and structurally avoid the bad stock market – value cyclicals. That said, from time to time, there will be tactical countertrend opportunities to go long value cyclicals like banks. Stay tuned for those tactical opportunities. This leaves one final question: when all investment has just become one big correlated trade to the bond yield, how can investors take on uncorrelated positions to diversify? The answer is to take long-short positions within growth defensives, and within value cyclicals. For example, within growth defensives right now, stay tactically long personal products versus healthcare. Fractal Trading System* As discussed, Spanish Bonos offer good relative value. They are also technically oversold relative to other developed market sovereign bonds. Accordingly, this week’s recommended trade is long Spanish 10-year Bonos, short New Zealand 10-year bonds. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long PLN/EUR quickly achieved its 2 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 62 percent. Chart I-11 When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Bank Credit Analyst

    Highlights Risk assets continue to ignore the dire state of the economy. “Don’t fight the Fed” will dictate investment policy for the coming months. Populism and supply-chain diversification will shape the world after COVID-19. Global stimulus will result in higher long-term inflation when the labor market returns to full employment. Asset prices are not ready for higher inflation rates. Precious metals, especially silver, will offer inflation protection. Stocks should structurally outperform bonds, even if they generate lower returns than in the past. Tech will continue to rise for now, but this sector will suffer when inflation turns higher. Feature Despite the continued collapse in economic activity, the S&P 500 remains resilient, bolstered by the largesse of the Federal Reserve and US government, and generous stimulus packages in other major economies. Stocks will likely climb even higher with this backdrop, but a violent second wave of COVID-19 infections may derail the scenario in the near term. The biggest risk, which is long-term in nature, is rising inflation. Public debt ratios will skyrocket in the G-10 and many emerging markets. Private debt loads, which are elevated in most countries, will also increase. Add rising populism and ageing populations into this mix and the incentive to push prices higher and reduce real debt loads becomes too enticing. Long-term investors must be wary. For the time being, overweight equities relative to bonds, but the specter of rising inflation suggests that growth stocks (e.g. tech) will not offer attractive long-term returns. Investors with an eye on multi-year returns should use the ongoing surge in growth stocks to strategically switch their portfolios toward small-cap equities, traditional cyclicals and precious metals. Economic Freefall Continues Most economic indicators paint a dismal picture for the US. Industrial activity is suffering tremendously. In April, industrial production collapsed by 15%, a pace matching the depth of the Great Financial Crisis (GFC). The ISM New Orders-to-Inventories ratio remains extremely weak with no glimmer of a rebound in IP in May. The numbers for trucking activity and railway freight are equally poor. Chart I-1A Worried Consumer Saves The US labor market has not been this ill since the 1930s. 20.5 million jobs vanished in April and the unemployment rate soared to 14.7%, despite a 2.5 percentage point decline in the participation rate. The number of employees involuntarily working in part-time positions has surged by 5.9 million, which has hiked up the broader U-6 unemployment rate to 22.8%. Wage growth has rebounded smartly to 7.7%, but this is an illusion. Average hourly earnings rose only because low-wage workers in the leisure and hospitality fields bore the brunt of the pain, accounting for 37% of layoffs. The worst news is that the Bureau of Labor Statistics (BLS) classifies any worker explicitly fired due to COVID-19 as temporarily laid off, but without a vaccine it is highly unlikely that employment in the leisure, hospitality or airline sectors will normalize anytime soon. Unsurprisingly, lockdowns have limited the ability of households to spend. Americans have boosted their savings rate to 13.1%, the highest level in 39 years, as they worry about catching a potentially deadly illness, losing their jobs, watching their incomes fall, or all of the above (Chart I-1). This double hit to both employment and consumer confidence sparked a 22% collapse in retail sales on an annual basis in April, the worst reading on record. Putting it all together, real GDP contracted at a 4.8% quarterly annualized rate in Q1 2020 and the Congressional Budget Office expects second-quarter annual growth to plummet to -37.7%. The New York Fed’s Weekly Economic Index suggests a more muted contraction of 11.1% (Chart I-2), which would still represent a post-war record. Investors must look beyond the gloom. The economic weakness is not limited to the US. In Europe and in emerging markets, retail sales and auto sales are disappearing at an unparalleled pace. Industrial production readings in those economies have been catastrophic and manufacturing PMIs are still in deeply contractionary territory. As a result, our Global Economic A/D line and our Global Synchronicity indicator continues to flash intense weakness (Chart I-3). Chart I-2The Worst Is Still To Come Chart I-3Dismal Growth, Everywhere   Chart I-4China Leads The Way Investors must look beyond the gloom. China’s experience with COVID-19 is instructive despite questions regarding the number of cases reported. China was the first country to witness the painful impact of COVID-19 and the quarantines needed to fight the disease. It was also the first country to control the virus’s spread and, most importantly, to escape the lockdown, along with being the first to enact economic stimulatory measures. The results are clear: industrial production, domestic new orders, and to a lesser extent, retail sales, are all experiencing V-shaped recoveries (Chart I-4). Even Chinese yields are rising, despite interest rate cuts by the People’s Bank of China. Accommodative Policy Matters Most The global policy “put option” is still in full force, which is boosting asset prices. A 41% rally in the median US stock reflects both a massive amount of funds inundating the financial system and a recovery that will take hold in the coming 12 months in response to this stimulus and the end of lockdowns. Global monetary policies have been even more aggressive than after the GFC. Interest rates have fallen as quickly and as broadly as they did around the Lehman bankruptcy. Moreover, unorthodox policy measures have become the norm (Chart I-5). Chart I-5Easy Policy, Everywhere In China, credit generation is quickly accelerating and has reached 28% of GDP, the highest in 2 years. Moreover, policymakers are emphasizing the need to create 9 million jobs in cities and keep the unemployment rate at 6%. Consequently, the recent rebound in construction activity will continue because it is a perfect medium to absorb excess workers. The ever-expanding quotas for local government special bonds to CNY3.75 trillion will also ensure that infrastructure spending energizes any recovery. Therefore, we expect Chinese imports of raw materials and machinery to accelerate into the second half of the year. The country’s orders of machine tools from Japan have already bottomed, which bodes well for overall Japanese orders (Chart I-6). Europe has also moved in the right direction. Government support continues to expand and combined public deficits will reach EUR 0.9 trillion, or 8.5% of GDP. Governmental guarantees have reached at least EUR1.4 trillion. Meanwhile, the European Central Bank’s balance sheet is swelling more quickly than during either the GFC or the euro area crisis (Chart I-7). Unsurprisingly, European shadow rates have collapsed to -7.6% and European financial conditions are the easiest they have been in 8 years. Chart I-6Will China's Rebound Matter? Chart I-7The ECB Is Aggressive   More importantly, COVID-19 has broken the taboo of common bond issuance in Europe. Last week, Chancellor Merkel, President Macron and EC President von der Leyen hatched a plan to issue common bonds that will finance a EUR 750 billion recovery fund as part of the European Commission Multiannual Financial Framework. The EC will then allocate EUR 500 billion of grants (not loans) to EU nations as long as they adhere to European principles. The unified front by the three most senior European politicians reflects elevated support for the EU among all European nations and an understanding that economic ruin in the smaller nations could capsize the core nations (Chart I-8). Hence, fiscal risk-sharing will increasingly become the norm in Europe. Unsurprisingly, Italian, Spanish, Portuguese and Greek bond spreads all narrowed significantly following the announcement. Chart I-8The Forces That Bind Chart I-9Negative Rates Are Here, Sort Of US policymakers have abandoned any semblance of orthodoxy. The Fed’s programs announced so far have lifted its balance sheet by $2.9 trillion and could generate an expansion to $11 trillion by year-end. Moreover, Fed Chair Jerome Powell has highlighted that there is “no limit” to what the Fed can do with its unconventional policy apparatus. The nature of the US funding market makes negative rates very dangerous and, therefore, highly doubtful in that country. Nonetheless, the Fed is willing to buy more paper from the public and private sectors to push the shadow rate and real interest rates further into negative territory (Chart I-9). Moreover, the Federal government has already bumped up the deficit by $3 trillion and the House has passed another $3 trillion in spending. Senate Republicans will pass some of this program to protect themselves in November. According to BCA Research’s Geopolitical Strategy service, a total escalation in the federal deficit of $5 trillion (or 23% of 2020 GDP) is extremely likely this year. Chart I-10The Fed Is Monetizing The Deficit Combined fiscal and monetary policy in the US will have a more invigorating impact on the recovery than the measures passed in 2008-09. They represent a larger share of output than during the GFC (10.5% versus 6% of GDP for the government spending and 15.2% versus 8.3% for the Fed’s balance sheet expansion). Moreover, the Fed is buying a much greater percentage of the Treasury’s issuance than during the GFC (Chart I-10). Therefore, the Fed is much closer to monetizing government debt than it was 11 years ago. The combined monetary and fiscal easing should result in a larger fiscal multiplier because the private sector is not financing as much of the government’s largesse. Thus, the increase in the private sector’s savings rate should be short-lived and the current account deficit will widen to reflect the greater fiscal outlays. Low real rates and a larger balance-of-payments disequilibrium should weaken the dollar which will ease US financial conditions further. A Trough In Inflation Maintaining incredibly easy monetary and fiscal conditions as the economy reopens will lead to higher inflation when the labor market reaches full employment. Core CPI has collapsed to 1.4% on an annual basis and to -2.4% on a three-month annualized basis, the lowest reading on record. The breakdown of the CPI report is equally dreadful (Chart I-11). However, CPI understates inflation because the basket measured by the BLS includes many areas of commerce currently not frequented by consumers. Items actually purchased by households, such as food, have experienced accelerating inflation in recent months. Fiscal risk-sharing will increasingly become the norm in Europe. Beyond this technicality, the most important factor behind the anticipated structural uptick in inflation is a large debt load burdening the global economy. Total nonfinancial debt in the US stands at 254% of GDP, 262% in the euro area, 380% in Japan, 301% in Canada, 233% in Australia, 293% in Sweden and 194% in emerging markets (Chart I-12). Historically, the easiest method for policymakers to decrease the burden of liabilities is inflation; the current political climate increases the odds of that outcome. Chart I-11Weak Core Chart I-12Record Debt, Everywhere   Households in the G-10 and emerging markets are angry. Growing inequalities, coupled with income immobility, have created dissatisfaction with the economic system (Chart I-13). Before the GFC, US households could gorge on debt to support their spending patterns, and inequalities went unnoticed. After the crisis revealed weakness in the household sector, banks tightened their credit standards and consumption slowed, constrained by a paltry expansion of the median household income. As a consequence, the American public increasingly supports left-wing economic policies (Chart I-14). Chart I-13Inequalities + Immobility = Anger Chart I-14The US Population's Shift To The Left COVID-19 is exacerbating the population’s discontent and highlighting economic disparities. The recession is hitting poor households in the US harder than the general population or highly skilled white-collar employees who can easily telecommute. Millennials, the largest demographic group in the US, are also irate. Their lifetime earnings were already lagging that of their parents because most millennials entered the job market in the aftermath of the GFC.1 Their income and balance sheet prospects were beginning to improve just as the pandemic shock struck. Finally, in response to the lockdowns and school closures caused by COVID-19, young families with children have to juggle permanent childcare and daily work demands from employers, resulting in a lack of separation between home and office.2  Economic populism will generate a negative supply shock, which will push up prices (Diagram I-1). BCA has espoused the theme of de-globalization since 20143 and COVID-19 will accelerate this trend. Firms do not want fragile supply chains that fall victim to random shocks; instead, they are looking to diversify their sources (Chart I-15). Additionally, workers and households want protection from foreign competition and perceived unfair trade practices. This sentiment is evident in a lack of trust toward China (Chart I-16). China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business (Chart I-17). Last year’s Sino-US trade war was a precursor of events to come. Diagram I-1The Inflationary Impact Of A Stifled Supply Side Chart I-15COVID-19 Accelerates The Desire To Repatriate Production Chart I-16China As A Political Piñata Chart I-17The Cost Of Doing International Business Will Rise Chart I-18A Problem For Productivity The rate of capital stock accumulation does not bode well for the supply side of the economy. Productivity trails the path of capex, with a long time lag. The 10-year moving average of non-residential investment in the US bottomed three years ago. Its subsequent uptick should enhance average productivity. However, the growth of the real net capital stock per employee remains weak and will not strengthen because companies are curtailing spending in the recession. Moreover, the efficiency of the capital stock is well below its long-term average and probably will not mend if supply chains are made less efficient. These factors are negative for productivity and thus, the capacity to expand the supply side of the economy (Chart I-18). Finally, a significant share of capital stock is stranded and uneconomical. The airline industry is a good example. Going forward, regulations will keep the middle row seats empty. Fewer filled seats imply that the capital stock has lost significant value, which creates a negative supply shock for the industry. To break even, airlines will have to raise the price of fares. IATA estimates that fares will increase by 43%, 49% and 54% on North American, European and Asian routes, respectively (Table I-1). The same analysis can be applied to restaurants, hotels, cinemas, etc. – industries that will have to curtail their supplies and change their practices in response to COVID-19. Table I-1The Inflationary Impact Of Supply Cuts Chat I-19Pandemics Boost Wages While rising populism will hurt the supply side of the economy, it will also hike demand. Redistribution is an outcome of populism. Corporate tax hikes hurt rich households that receive more than 50% of their income from profits. High marginal tax rates on high earners will also curtail their disposable income. Shifting a bigger share of national income to the middle class will depress the savings rate and boost demand. It is estimated that the middle class’s marginal propensity to spend is 90% compared with 60% for richer households. In fact, in the past 40 years, the shift in income distribution has curtailed demand by 3% of GDP. Pandemics also increase real wages. Òscar Jordà, Sanjay Singh, and Alan Taylor demonstrated that European real wages accelerated following pandemics (Chart I-19). Fewer willing workers contributed to the climb in real wages by decreasing the supply of labor. Higher real wages are positive for consumption. China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business. Populism will also put upward pressure on public spending. Governments globally and in the US are bailing out the private sector to an even larger extent than they did after the GFC. Discontent with expanding inequalities and the perceived lack of accountability of the corporate sector4 will push the government to be more involved in economic management than it was after 2008. Moreover, the post-2008 environment showed that austerity was negative for private sector income growth and the economic welfare of the middle class (Chart I-20). Thus, government spending and deficits as a share of GDP will be structurally higher for the coming decade. Higher deficits mechanically boost aggregate demand which is inflationary if the advance of aggregate supply is sluggish. Chat I-20Austerity Hurts Central banks will likely enable these inflationary dynamics. The Fed knows that it has missed its objective by a cumulative 4% since former Chairman Ben Bernanke set an official inflation target of 2% in 2012. Thus, it has lost credibility in its ability to generate 2% inflation, which is why the 10-year breakeven rate stands at 1.1% and not within the 2.3%-2.5% range that is consistent with its mandate. Moreover, the Fed is worried that the immediate deflationary impact of COVID-19 will further depress inflation expectations and reinforce low realized inflation. This logic partly explains why the Fed currently recommends more stimulus and the Federal Open Market Committee will be reluctant to remove accommodation anytime soon. Inflation will likely move toward 4-5% after the US economy regains full employment. Central banks may fall victim to growing populism. Both the Democrats and Republicans want control over the US Fed. If Congress changes the Fed’s mandate, there would be great consequences for inflation. Prior to the Federal Reserve Reform Act of 1977, the Fed’s mandate was to foster full employment conditions without any explicit mention of inflation. Therefore, the Fed kept the unemployment rate well below NAIRU for most of the post-war period. This tight labor market was a key ingredient behind the inflationary outbreak of the 1970s. After the reform act explicitly imposed a price stability directive on top of the Fed’s employment mandate, the unemployment rate spent a much larger share of time above NAIRU, which contributed to the structural decline in inflation after 1982 (Chart I-21). Chat I-21The Fed's Mandate Matters Finally, demographics will also feed inflationary pressures. The global support ratio peaked in 2014 as the number of workers per dependent decreased due to ageing of the population in the West and China (Chart I-22). A declining support ratio depresses the growth of the supply side of the economy because the dependents continue to consume. In today’s world, dependents are retirees, who have higher healthcare spending needs. This healthcare spending will accrue additional government spending. Moreover, it will continue to push up healthcare inflation, which will contribute to higher overall inflation (Chart I-23). Chat I-22Demographics: From Deflation To Inflation Chat I-23Aging Will Feed Healthcare Inflation   Bottom Line: COVID-19 has highlighted inequalities in the population and will accelerate a move toward populism that started four years ago. Consequently, the supply side of the economy will grow more slowly than it did in prior decades, while greater government interventions and redistributionist policies will boost aggregate demand. Additionally, monetary policy will probably stay easy for too long and demographic factors will compound the supply/demand mismatch. Inflation will likely move toward 4-5% after the US economy regains full employment, but will not surge to 1970s levels. Investment Implications Chat I-24Breakevens Will Listen To Commodities Extremely accommodative economic policy and a shift to higher inflation will dominate asset markets for the next five years or more. Breakevens in the G-10 are pricing in permanently subdued inflation for the coming decade, which creates a large re-pricing opportunity if inflation troughs when the labor market reaches full employment. Investors cannot wait for inflation to turn the corner to bet on higher breakevens. After the GFC, core CPI bottomed in October 2010, but US breakevens hit their floor at 0.15% in December 2008. Instead, a rebound in commodity prices and a turnaround in the global economic outlook may signal when investors should buy breakevens (Chart I-24). Chat I-25Deleterious US Balance Of Payments Dynamics A repricing of inflation expectations will depress real rates. Central banks want to see inflation expectations normalize towards 2.3%-2.5% before signaling an end to accommodation. Moreover, political pressures and high debt loads will likely loosen their reaction functions to higher breakeven. As a result, real interest rates will decline because nominal ones will not rise by as much as inflation expectations. This is exactly what central banks want to achieve because it will foster a stronger recovery. Our US fixed-income strategists favor TIPS over nominal Treasurys. The dollar will probably depreciate in the post-COVID-19 environment. As we wrote last month, the US is the most aggressive reflator among major economies. The twin deficit will expand while US real rates will remain depressed. This is very negative for the USD, especially in an environment where the US money supply is outpacing global money supply (Chart I-25).5 Additionally, Chinese reflation will stimulate global industrial production, which normally hurts the dollar. EM currencies are cheap enough that long-term investors should begin to bet on them (Chart I-26), especially if global inflation structurally shifts higher. Precious metals win from the combination of higher inflation, lower real rates and a weaker dollar. However, silver is more attractive than gold. Unlike the yellow metal, it trades at a discount to the long-term inflation trend (Chart I-27). Moreover, silver has more industrial uses, especially in the solar panel and computing areas. Thus, the post-COVID-19 recovery and the need to double up supply chains will boost industrial demand for silver and lift its price relative to gold. Our FX strategists recommend selling the gold-to-silver ratio.6 Chat I-26Cheap EM FX Chat I-27Silver Is The Superior Inflation Hedge   Chat I-28Still Time To Favor Stocks Over Bonds Investors should favor stocks over bonds. This statement is more an indictment of the poor value of bonds and their lack of defense against rising inflation than a structural endorsement of stocks. The equity risk premium is elevated. To make this call, we need to account for the lack of stationarity of this variable and adjust for the expected growth rate of earnings. Nonetheless, once those factors are accounted for, our ERP indicator continues to flash a buy signal in favor of equities at the expense of bonds (Chart I-28). Moreover, bonds tend to underperform stocks when inflation trends up for a long time (Table I-2).   Table I-2Rising Inflation Flatters Stocks Over Bonds Chart I-29Bonds Are Prohibitively Expensive In absolute terms, G-7 government bonds are also vulnerable, both tactically and structurally. They are overbought and currently trade at their greatest premium to fair value since Q4 2009 and Q1 1986, two periods followed by sharp rebounds in yields (Chart I-29). Moreover, the previous experience with QE programs shows that even if real rates diminish, the reflationary impact of aggressive monetary policy on breakeven rates is enough to increase nominal interest rates (Chart I-30). Additionally, as our European Investment Strategy team indicates, bond yields are close to their practical lower bound, which creates a negative skew to their return profile.7 This asymmetric return distribution destroys their ability to hedge equity risk going forward, making this asset class less appealing to investors. This problem is particularly salient in Europe and Japan. A lower dollar, which is highly reflationary for global growth, will likely catalyze the rise in yields.   Chart I-30QE Will Lift Breakevens And Yields As long as real rates remain under downward pressure, the window to own stocks remains open, even if stocks continue to churn. Equities are expensive, but when yields are taken into consideration, their adjusted P/E is in line with the historical average (Chart I-31). Moreover, periods of weak growth associated with lower real interest rates can foster a large expansion in multiples (Chart I-32). Chart I-31Low Bond Yields Allow High Stock Multiples Chart I-32Multiples Will Rise Further As The Fed Floods The World With Low Rates Whether to have faith in stocks in absolute terms on a long-term basis is complicated by our view on inflation and populism. Strong inflation will increase nominal rates. Moreover, low productivity coupled with higher real wages, less-efficient supply chains and higher taxes will accentuate the margin compression that higher inflation typically creates. Thus, equities are expected to generate poor real returns over the long term, even if they beat bonds. Chart I-33Tech EPS Leadership Tech stocks are another structural problem for equities. Including Amazon, Google and Facebook, tech stocks account for 41% of the S&P 500’s market cap. As our US Equity Strategy service explains, wherever tech goes, so does the US market.8 Tech stocks are the current market darling. Today, the tech sector is the closest thing to a safe-haven in the mind of market participants, because a post-COVID-19 environment will favor tech spending (telecommuting, e-commerce, cloud computing, etc.). The problem for long-term investors is that this view is the most consensus view. Already, investors expect the tech sector to generate the highest EPS outperformance relative to the rest of the S&P 500 in more than 15 years (Chart I-33). Moreover, in a low-yield environment, investors are particularly willing to bid up the multiples of growth stocks such as tech equities because low interest rates result in muted discount factors for long-term cash flows. When should investors begin betting against the tech sector? Backed by a powerful narrative, tech stocks are evolving into a mania. Yet, contrarian investors understand, being too early to sell a mania can be deadly. Bond yields should not be relied on to signal an end to the bubble. During most of the 1990s, tech would outperform the market when Treasury yields declined. However, when the tech outperformance became manic, yields became irrelevant. From the fall of 1998 to the beginning of 2000, 10-year yields rose from 4.2% to 6.8%, yet the tech sector outperformed the S&P 500 by 127%. More recently, yields rose from 1.33% in the summer of 2016 to 3.25% in November 2018, but tech outperformed the broader market by 39%.   Investors should favor stocks over bonds. Instead, higher inflation will be the key factor to end the tech sector’s infallibility. Since the 1990s, higher core inflation has led periods of tech underperformance by roughly six months. This relationship also held at the apex of the tech bubble in the second half of the 1990s (Chart I-34). Relative tech forward EPS suffers when core inflation rises, as the rest of the S&P 500 is more geared to higher nominal GDP growth. In essence, if nominal growth is less scarce, then the need to bid up growth stocks diminishes. Moreover, the dollar will likely be the first early signal because it leads nominal GDP. As a result, a weak dollar leads to a contraction in tech relative multiples by approximately 9 months (Chart I-35). Chart I-34Tech Hates Inflation... Chart I-35...And A Soft Dollar   We recommend long-term investors shift their portfolios toward industrial equities when inflation turns the corner. As a corollary, the low exposure of European and Japanese stocks to the tech sector suggests these cheap bourses will finally reverse their more-than-a-decade-long underperformance at the same time. This strategy means that even if the S&P 500 generates negative real returns during the coming decade, investors could still eke out positive returns from their stock holdings. Higher inflation will be the key factor to end the tech sector’s infallibility. Chart I-36The Time For Commodities Is Coming Back Finally, commodities plays are also set to shine in the coming decade. Commodities are very cheap and oversold relative to stocks (Chart I-36). Commodities outperform equities in an environment where inflation rises, real rates decline and the dollar depreciates. Consequently, materials and energy stocks may be winners. As a corollary, Latin American and Australian equities should also reverse their decade-long underperformance when inflation and the dollar turn the corner. This month's Section II Special Report is an in depth study of the Spanish Flu pandemic, written by our colleague Amr Hanafy and also published in BCA Research’s Global Asset Allocation service. Amr thoroughly analyses the evolution of the 100-year old pandemic and which measures mattered most to contain the virus and allow a return to economic normality. Mathieu Savary Vice President The Bank Credit Analyst May 28, 2020 Next Report: June 25, 2020 II. Lessons From The Spanish Flu What Can 1918/1919 Teach Us About COVID-19?   “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905 Chart II-1Coronavirus: As Contagious But Not As Deadly As Spanish Flu Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart II-1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.9  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart II-2The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart II-2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.10 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map II-1).11 Map II-1The Spread Of Influenza Through Europe Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.12 Most countries did not begin investigating and reporting cases until the second wave was underway (Chart II-3). Chart II-3Most Countries Began Reporting Only When The Second Wave Hit This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart II-4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.13 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart II-4A Unique Characteristic: Impacting Younger Adults By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.14 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) Chart II-5Travel Slowed...Just Not Enough What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans. The number of passengers carried during the months of the pandemic did noticeably decline though (Chart II-5). Table II-1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table II-2). Table II-1Measures Applied Then Are Very Similar To Those Applied Today Table II-2NPIs Were Implemented Only For Short Periods Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart II-6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart II-6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart II-6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart II-6, panel 3) Chart II-7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart II-6Fast Response And Longer Implementation Led To Fewer Deaths... Chart II-7...So Did Policy Strictness     For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919. While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.15,16 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart II-8). Chart II-8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... Chart II-9...And So Can Highly Effective Measures Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart II-9).17 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.  The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).18 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.19 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.20 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.21 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Chart II-10Short-Term Price Impact Was Disinflationary Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart II-10). US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart II-11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.22 Factory employment in New York fell by over 10% during this period. The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart II-12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart II-12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart II-11Loss Of Middle-Aged Adults = Loss Of Breadwinners Chart II-12Activity Slowed, But Rebounded Quickly   Chart II-13The War Had A Bigger Impact On The Stock Market Than The Pandemic Chart II-14Monetary Policy Was Easy...Even Before The Pandemic Started The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart II-13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.23 The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart II-14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst Global Asset Allocation III. Indicators And Reference Charts Last month, we maintained a positive disposition toward stocks, especially at the expense of government bonds. The global economy may be in the midst of its most severe contraction since the Great Depression, but betting against stocks is too dangerous when fiscal and monetary policy are both as easy as they are today. In essence, don’t fight the Fed. This view remains in place, even if the short-term risk/reward ratio for holding stocks is deteriorating. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further as real interest rates weakened. Additionally, our Speculation Indicator has eased, which indicates that contrary to many commentators’ perceptions, speculation is not rampant. Confirming this intuition, the equity risk premium remains elevated (even when one takes into account its lack of stationarity) and expected growth rates of earnings are still very low. Finally, our Revealed Preference Indicator is finally flashing a strong buy signal. Tactically, equities are still overbought. We have had four 5% or more corrections since March 23. More of them are in the cards. However, the most likely outcome for the S&P 500 this summer is a churning pattern, not a major downward move below 2700. The median stock is still 26% below its August 2018 low and only a fraction of equities on the NYSE trade above their 30-week moving average. These indicators do not scream that a major correction is on the horizon, especially when policy is as accommodative as it is today. We continue to recommend investors take advantage of the supportive backdrop for stocks by buying equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought on a cyclical basis and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. The yield curve is therefore slated to steepen further. Since we last published, the dollar has not meaningfully depreciated, but the DXY is trying to breakdown while our composite technical indicator is making lower highs. It is too early to gauge whether the recent rebound in the IDR, the MXN, or the ZAR is anything more than an oversold bounce, but if it were to continue, it would indicate that the expensive greenback is starting to buckle under the weight of the quickly expanding twin deficit. The widening in the current account deficit that will result from extraordinarily loose fiscal policy means that the large increase in money supply by the Fed will leak out of the US economy. This process is highly bearish for the dollar. Ultimately, the timing of the dollar’s weakness will all boil down to global growth. As signs are building up that global growth is bottoming, odds are rising that the dollar will finally breakdown. Get ready for a meaningful downward move over the coming months. Finally, commodities seem to be gaining traction. The Continuous Commodity Index’s A/D line is quickly moving up and our Composite Technical Indicator is quickly rising from extremely oversold levels. Oil will hold the key for the broad complex. Oil supply has started to adjust lower and oil demand is set to improve starting June/July as the global economy re-opens, fueled with massive amounts of stimulus. As a result, inventories should start to meaningfully decline this summer, which will support the recent recovery in oil prices. If oil can rebound further, industrial commodities will follow. Finally, gold is a mixed bag in the near term. The dollar is set to weaken significantly and inflation breakevens to move higher, which will mitigate the negative impact of declining risk aversion. Silver is a superior play to gold as it will benefit from a recovery in global growth. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Reid Cramer et al., The Emerging Millennial Wealth Gap, Divergent Trajectories, Weak Balance Sheets, and Implications for Social Policy, New America, Oct 2019. 2 https://www.wsj.com/articles/new-normal-amid-coronavirus-working-from-home-while-schooling-the-kids-11584437400 3 Please see Geopolitical Strategy Special Report "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com 4  Please see The Bank Credit Analyst Special Report "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bca.bcaresearch.com 5  Please see The Bank Credit Analyst Monthly Report "May 2020," dated April 30, 2020, available at bca.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report "A Few Trades Amidst A Pandemic," dated May 22, 2020, available at fes.bcaresearch.com 7 Please see European Investment Strategy Weekly Report "European Investors Left Defenceless," dated May 21, 2020, available at eis.bcaresearch.com 8 Please see US Equity Strategy Special Report "Debunking Earnings," dated May 19, 2020, available at uses.bcaresearch.com 9 Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 10 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 11 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 12 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 13 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 14 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 15 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 16 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 17 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 18 Please see https://www.nber.org/cycles.html 19 Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/res…12               Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 20 Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 21 Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 22 Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 23 Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.

Highlights Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Chart 3US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Chart 5Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Chart 7UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Chart 9Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, underpinning the equity market. While those key drivers are well established, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, see chart). In other words, there is still room for equities to rise before sentiment reaches maximum greed. A number of other equity sentiment indicators we track – which we updated in yesterday’s Weekly Report – confirm the tame VIX futures positioning reading and signal that the path of least resistance is higher for the SPX. Bottom Line: We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon.