Developed Countries

Special Report

Highlights The Fed has been awfully busy since the middle of March, … : Over the last 30 days, the Fed has unleashed a barrage of measures to support market liquidity and alleviate economic hardship. … unveiling a package of facilities to keep credit flowing to consumers, businesses and municipalities, … : The Fed is building a sizable firewall against market seizure, touching on commercial paper, money market funds, asset-backed securities, small business loans, municipal notes, investment-grade corporate bonds and ETFs and high-yield corporate ETFs. … and loosening regulatory strictures to encourage banks to put their capital buffers to work: The Fed and other major bank regulators have eased some of the post-2008 rules to encourage banks to ramp up market-making activity and increase lending to cushion the shock to the economy. Investors should buy what the Fed is buying: Fixed income investors should look to capture excess spreads in markets that have not yet priced in the full effect of the Fed’s indemnity. Banks and agency mortgage REITs offer a way to implement this theme in equities. Feature What A Difference A Pandemic Makes “Whatever it takes” is clearly the order of the day for Jay Powell and company, as well as Congress and the White House, to mitigate the potentially pernicious second-round economic damage from COVID-19. In this Special Report, we detail the Fed’s key initiatives. Central banks are neither omniscient nor omnipotent, and they cannot stave off all of the pressure from mass quarantines, but we do expect the Fed’s measures will cushion the economic blow, and reflate prices in targeted asset markets. The Fed began pulling out all the stops to fight the virus on Sunday, March 15th with what have now become stock emergency responses: zero rates and purchases of Treasuries and agency mortgage-backed securities (MBS). Although the MBS purchases began the week of March 23rd, and have continued at a steady clip despite appearing to have swiftly surpassed their $200 billion target, they have not yet achieved much traction in the mortgage market. The spread between the current coupon agency MBS and the 10-year Treasury yield has come down a bit, but the average 30-year fixed-rate home mortgage rate does not reflect the 150 basis points ("bps") of rate cuts since the beginning of March (Chart 1). The Fed’s measures are intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. Other measures to relieve liquidity pressures, like the Fed’s ongoing overnight repo operations, have achieved their aim. The signal indicator of liquidity strains, the effective fed funds rate, was bumping up against the top of the Fed’s target range for several days after the return to zero interest rate policy. Over the last week, however, it has settled around 5 bps, near the bottom of its range (Chart 2), suggesting that the formerly tight overnight funding market is now amply supplied. Chart 1MBS Purchases Haven't Helped Main Street Yet Chart 2Overnight Funding Stresses ##br##Have Eased The rest of the Fed’s measures (Table 1) have been more finely targeted, intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. We focus on the most important measures in the following section and summarize their common elements in Table 2. The following discussions of the individual programs highlight their intent, their chances of success, and yardsticks for tracking their progress. We conclude with the fixed income and equity niches that are most likely to benefit from the Fed’s efforts. Table 1A Frenzied Month Of Activity Table 2The 2020 Federal Reserve Emergency Programs A Field Guide To The Acronym Jungle Money Market Mutual Fund Liquidity Facility (MMLF) Under the MMLF, which started on March 23rd, US banks can borrow from the Fed to purchase eligible assets mainly from prime money market funds. These assets are in turn pledged to the Fed as collateral, effectively allowing the Fed to lend to prime money market funds via banks. Assets eligible for purchase from these funds include: US Treasuries & fully guaranteed agencies Securities issued by US GSEs Asset-backed commercial paper (ABCP) rated A1 or its equivalent, issued by a US issuer US municipal short-term debt (excluding variable rate demand notes) Backed by $10 billion of credit protection from the Treasury, the Fed will lend at the primary credit rate (the discount rate, currently 0.25%) for pledged asset purchases of US Treasuries, fully guaranteed agencies or securities issued by US GSEs. For any other assets pledged, the Fed will charge an additional 100 bps – with the exception of US municipal short-term debt to which the Fed only applies a 25-bps surcharge. Chart 3The MMLF Already Providing Some Relief Loans made under the MMLF are fully non-recourse (the Fed can recover nothing more from the borrower than the pledged collateral). Banks borrowing from the Fed under the MMLF bear no credit risk and have therefore been exempted from risk-based capital and leverage requirements for any asset pledged to the MMLF, an important element that should promote MMLF participation. This facility is a direct descendant of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), which operated from September 2008 to February 2010 to prevent a run on prime money market funds after a prominent fund “broke the buck.” Its objective is to help prime money market funds meet redemption requests from investors and increase liquidity in the markets for the assets held by these funds – most notably commercial paper where prime money market funds represent 21% of the market. Those funds have experienced large outflows in the midst of the coronavirus pandemic and building economic crisis – erasing $140 billion, or 18%, of the fund segment’s total net assets in a matter of days (Chart 3, top panel). Since it started, the MMLF has extended $53 billion of credit to prime money funds, about a third of AMLF’s output in its first 10 days of operation. The financial sector is suffering a big shock, but it is not the source of the problem like it was in 2008, so the situation is not as dire as it was in late 2008, and we are already seeing a tentative stabilization of asset outflows from money market funds. Commercial paper spreads have also narrowed, implying that the combination of the MMLF and the CPFF (see below) is having the intended effect (Chart 3, bottom panel). Commercial Paper Funding Facility (CPFF) Starting today, April 14th, the Fed will revive 2008’s Commercial Paper Funding Facility (CPFF) with the aim of restoring liquidity to a market where investment grade corporate borrowers raise cash to finance payroll, inventories, accounts payable and other short-term liabilities. The 2020 iteration applies to municipalities as well, extending its reach across the real economy. Via a Special Purpose Vehicle (SPV) (see Box) funded with a $10 billion equity investment from the Treasury Department, the CPFF will purchase US dollar-denominated investment-grade (A1/P1/F1) three-month asset-backed, corporate and municipal commercial paper priced at the overnight index swap rate (OIS) plus 110 bps. Lower-rated issuers are not eligible, but investment-grade borrowers who were downgraded to A2/P2/F2 after March 17th, 2020 can be grandfathered into the program at a higher spread of OIS+200 bps. The pricing is tighter than it was in 2008, when unsecured investment grade and asset-backed issues were priced at OIS+100 bps and OIS+300 bps, respectively, and the Fed did not have the loss protection provided by an equity investment in the SPV.   Box 1 - SPV Mechanics The Fed has set up Special Purpose Vehicles (SPV) in connection with most of the facilities we examine here. Each SPV has been seeded by the Treasury department to carry out the facility’s work. The Fed lends several multiples of the Treasury’s initial equity investment to each SPV to provide it with a total capacity of anywhere from eight to fourteen times its equity capital, based on the riskiness of the assets the SPV is purchasing or lending against. The result is that most of the cash used to operate the facilities will come from the Fed in the form of loans with full recourse to the SPVs’ assets, but the Treasury department will own the equity tranche. The Treasury therefore bears the first credit losses, should any occur. Issuers are only eligible if they have issued three-month commercial paper in the twelve months preceding the March 17th announcement of the program. The Federal Reserve did not set an explicit limit on the size of the program, but funding for any single issuer is limited to the amount of outstanding commercial paper it had during that twelve-month period. The 2020 CPFF could therefore max out above $750 billion, the peak size of the domestic commercial paper market over the past year (Chart 4). If the first CPFF’s experience is any guide, however, it’s unlikely that its full capacity will be needed. Its assets peaked at $350 billion in January 2009, around a quarter of 2008’s $1.5 trillion average outstanding balance. A similar proportion today would cap the fund at $175-200 billion. As in 2008 (Chart 5, bottom panel), the mere announcement of the program has driven commercial paper spreads significantly below their previously stressed levels (Chart 5, top panel). Chart 4Pressure On The Domestic Commercial Paper Market... Chart 5...Is Being Relieved Ahead Of The CPFF Implementation Term Asset-Backed Securities Loan Facility (TALF) The asset-backed securities (ABS) market funds a significant share of the credit extended to consumers and small businesses. The Fed’s TALF program that started on March 23rd aims to provide US companies holding AAA collateral with funding of up to $100 billion, in the form of 3-year non-recourse loans secured by AAA-rated ABS. It will be conducted via an SPV backed by a $10 billion equity investment from the US Treasury Department. Chart 6Narrower Spreads Promote Easier Financial Conditions At The Margin Eligible collateral includes ABS with exposure to auto loans, student loans, credit card receivables, equipment loans, floorplan loans, insurance premium finance loans, SBA-guaranteed loans and leveraged loans issued after March 23rd, 2020. Last week, the Fed added agency CMBS issued before March 23rd, 2020 and left the door open to further expansion of the pool of eligible securities. The rate charged on the loans is based on the type of collateral and its weighted average life. Depending on the ABS, the spreads will range from 75 bps to 150 bps over one of four different benchmarks (LIBOR, SOFR, OIS or the upper 25-bps bound of the target fed funds range). The spreads are reasonable, and will not keep ABS holders away from the facility, but they’re not meant to be giveaways. The 2009 TALF program originally had a $200 billion capacity, which was later expanded to $1 trillion. Those numbers make the current iteration’s $100 billion limit look awfully modest, but only $71 billion worth of loans were eventually granted the first time around. ABS spreads have already narrowed significantly (Chart 6), suggesting the program is already making a difference. Although an incremental $100 billion of loans is not likely to move the needle much for the US economy, narrower spreads will promote easier financial conditions at the margin. Secondary Market Corporate Credit Facility (SMCCF) Though no firm start date has been given, the Fed will soon enter the secondary market and start purchasing corporate bonds. As with all of the other facilities discussed in this section except the MMLF, the SMCCF is set up as an SPV. It will have up to $250 billion of buying power, anchored by $25 billion of equity funding from the Treasury department. Once it’s up and running, the SMCCF will buy non-bank corporate bonds in the secondary market that meet the following criteria: Issuer rated at least BBB-/Baa3 (the lowest investment grade tier) as of March 22nd, 2020 A remaining maturity of 5 years or less Issuer is a US business with material operations, and a majority of its employees, in the US Issuer is not expected to receive direct financial assistance from the federal government The SMCCF can own a maximum of 10% of any single firm’s outstanding debt, and it may dip into the BB-rated market for securities that were downgraded from BBB after March 22nd. In addition to cash bonds, the SMCCF will also buy ETFs that track the broad corporate bond market. The Fed says that the “preponderance” of SMCCF ETF purchases will be of ETFs tracking investment grade corporate bond benchmarks (like LQD), but it will also buy some high-yield ETFs (like HYG). We expect that the SMCCF will be able to achieve its direct goal of driving down borrowing costs for otherwise healthy firms that may struggle to access credit markets in the current environment. One way to track the program’s success is to monitor investment grade corporate credit spreads (Chart 7). Spreads have been tightening aggressively since the Fed announced the program on March 23rd but are still elevated compared to average historical levels. The slope of the line of investment grade corporate bond spreads plotted by maturity will be another important metric (Chart 8). An inverted spread slope tends to coincide with a sharply rising default rate, since it signals that investors are worried about near-term default risk. By purchasing investment grade bonds with maturities of 5 years or less, the Fed hopes to maintain a positively sloped spread curve. Chart 7SMCCF Announcement Marked The Peak In Spreads Chart 8Fed Wants A Positive ##br##Spread Slope Primary Market Corporate Credit Facility (PMCCF) The PMCCF employs the same structure as the SMCCF, but it is twice as large. The Treasury’s initial equity investment will be $50 billion and Fed loans will scale its capacity up to $500 billion. As a complement to the SMCCF, the PMCCF will purchase newly issued non-bank corporate bonds. The eligibility criteria are the same as the SMCCF’s, but the PMCCF will only buy bonds with a maturity of 4 years or less. The new issuance purchased by the PMCCF can be new debt or it can be used to refinance existing debt. The only caveat is that the maximum amount of borrowing from the facility cannot exceed 130% of the issuer’s maximum debt outstanding on any day between March 22nd, 2019 and March 22nd, 2020. Essentially, eligible firms can use the facility to refinance their entire stock of debt and then top it up by another 30% if they so choose. The goals of the PMCCF are to keep the primary issuance markets open and to prevent bankruptcy for firms that were rated investment grade before the virus outbreak. Investment grade corporate bond issuance shut down completely for a stretch in early March, but then surged once the Fed announced the PMCCF and SMCCF on March 23rd. The PMCCF will have achieved lasting traction if gross corporate bond issuance holds up in the coming months (Chart 9). It should also meet its bankruptcy-prevention goal, since firms will be able to refinance their maturing obligations and tack on some new debt to get through the next few months. Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market. While we expect the PMCCF will succeed in achieving its primary aims, it is unlikely to prevent a large number of ratings downgrades. If a given firm only makes use of the facility to refinance its existing debt at a lower rate, then its ability to service its debt will improve at the margin and its rating should be safe. However, any firm that increases its debt load via this facility will end up with a riskier balance sheet. Ratings agencies will not look through an increased debt burden, and we expect a significant number of ratings downgrades in the coming months (Chart 10, top panel). Chart 9Primary Markets Have Re-Opened Chart 10Fed Actions Won't Prevent Downgrades Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market (Chart 10, middle and bottom panels). The Fed will try to contain the surge by allowing the SMCCF to purchase fallen angel debt, and by providing some support to the upper tiers of high-yield credits through its Main Street Lending Programs. Main Street New Loan Facility (MSNLF) and Main Street Expanded Loan Facility (MSELF) The goal of the MSNLF and MSELF is to provide relief to large firms that are not investment grade credits. Both facilities will draw from the same SPV, which will be funded by a $75 billion equity stake from the Treasury and will then be levered up to a total size of “up to $600 billion” by the Fed. The Main Street facilities are structured differently than the PMCCF and SMCCF in that the Fed will not transact directly with nonfinancial corporate issuers. Rather, the Fed will purchase 95% of the par value of eligible loans from banks (which will retain 5% of the credit risk of each loan), hoping to free up enough extra room on bank balance sheets to promote more lending. To be eligible for purchase by the Main Street New Loan Facility, loans must be issued after April 8th, 2020 and meet the following criteria: Borrowers have less than 10,000 employees or $2.5 billion of 2019 revenue Borrowers are US firms with significant operations, and a majority of employees, in the US Loans are unsecured and have a maturity of 4 years Loans are made at an adjustable rate of SOFR + 250-400 bps Principal and interest payments are deferred for one year Loan size of $1 million to the lesser of $25 million or the amount that keeps the borrower’s Debt-to-EBITDA ratio below 4.01 Loan proceeds cannot be used to refinance existing debt Borrowers must commit to “make reasonable efforts to maintain payroll and retain employees during the term of the loan” The Main Street Expanded Loan Facility applies similar criteria to existing loans that banks will upsize before transferring 95% of the incremental risk to the Fed. The MSELF allows for loans up to the lesser of $150 million, 30% of the borrower’s existing debt (including undrawn commitments) or the amount keeps the borrower’s Debt-to-EBITDA ratio below 6.0. Borrowers can participate in only one of the MSNLF, MSELF and PMCCF, though they can tap the PPP alongside one of the Main Street lending facilities. Chart 11Main Street Programs Will Spur Bank Lending The Main Street facilities endeavor to have banks adopt an “originate to distribute” model. With the Fed assuming 95% of each loan’s credit risk, banks will have nearly unlimited balance sheet capacity to continue originating these sorts of loans. Retaining 5% of each loan ensures that the banks will have enough skin in the game to perform proper due diligence. We expect to see a significant increase in commercial bank C&I loan growth in the coming months once these facilities are up to speed (Chart 11). Crucially for high-yield investors, the debt-to-EBITDA constraints ensure that the Main Street facilities will aid BB- and some B-rated issuers but will not bail out high-default-risk issuers rated CCC and below. BB-rated firms typically have debt-to-EBITDA ratios between 3 and 4, while B-rated issuers typically fall in a range of 4 to 6. For the most part, BB-rated firms will be able to make use of either the MSNLF or MSELF, while B-rated firms will be limited to the MSELF. By leaving out issuers rated CCC & below, the Fed is acquiescing to a significant spike in corporate defaults over the next 12 months. The bulk of corporate defaults come from firms that were rated CCC or below 12 months prior (Chart 12). Chart 12A Significant Increase In Corporate Defaults Is Coming As with the PMCCF, we note that the Main Street facilities offer loans, not grants. While they will address firms’ immediate liquidity issues, they will do so at the cost of more indebted balance sheets. Downgrade risk remains high for BB- and B-rated companies. Paycheck Protection Program Liquidity Facility (PPPLF) The Paycheck Protection Program (PPP) is a component of the CARES Act that was designed to forestall layoffs by small businesses.  PPP loans are fully guaranteed by the Small Business Association (SBA), which will forgive them if the borrower maintains its employee headcount for eight weeks. The size of the PPPLF has yet to be announced, along with the details of its funding, but its intent is to get PPP loans off of issuers’ balance sheets so as to free up their capital and allow them to make more loans, expanding the PPP’s reach. The Fed will lend on a non-recourse basis at a rate of 0.35% to any depository institution making PPP loans,2 taking PPP loans as collateral at their full face value. PPP loans placed with the Fed are exempt from both risk-weighted and leverage-based capital adequacy measures (please see “Easing Up On The Regulatory Reins,” below). PPP is meant to be no less than a lifeline for households and small businesses, but the devil is in the details. Banks were reportedly overwhelmed with demand for PPP loans over the first five business days that they were available, suggesting that many small businesses still qualify, despite 17 million initial unemployment claims over the last three weeks. Media reports about the program highlighted that there are quite a few kinks yet to be worked out, and it has arrived too late to stave off the first waves of layoffs. Success may be most easily measured by the size of the PPPLF, which should eventually translate into fewer layoffs and bankruptcies than would otherwise have occurred. Municipal Liquidity Facility (MLF) Chart 13State & Local Governments Need Support The Municipal Liquidity Facility is similar in structure to the PMCCF, only it is designed to support state and local governments. The MLF SPV will be funded by a $35 billion equity investment from the Treasury, and the Fed will lever it up to a maximum size of $500 billion to purchase newly issued securities directly from state and local governments that meet the following criteria: All states (including D.C.) are eligible, as are cities with populations above 1 million and counties with populations above 2 million. The newly issued notes will have a maximum maturity of 2 years. The MLF can buy new issuance from any one state, city or county up to an amount equal to 20% of that borrower’s fiscal year 2017 general revenue. States can request a higher limit to procure funds for political subdivisions or instrumentalities that aren’t eligible themselves for the MLF. The MLF’s goal is to keep state and local governments liquid as they deal with the COVID-19 pandemic. The large size of the facility – $500 billion is five times 2019’s aggregate muni issuance – should allow it to meet its goal. However, as with the Fed’s other facilities, the support comes in the form of loans, not grants. The lost tax revenue and increased pandemic expenditures cannot be recovered. State and local government balance sheets will emerge from the recession weaker. We can track the program’s success by looking at the spread between municipal bond yields and comparable US Treasury yields. These spreads widened to all-time highs in March, but have since come in significantly, even for longer maturities (Chart 13). If this tightening does not continue, the Fed may eventually enter the secondary market to purchase long-maturity municipal bonds. Supporting such a fragmented market will be tricky, and the Fed may be hoping that more aid will come from Capitol Hill. Central Bank Liquidity Swaps Chart 14US Dollar Debt Is A Global Problem The global economy is loaded with USD-denominated debt issued by entities outside of the US. As of 3Q19, there was roughly $12 trillion of outstanding foreign-issued US dollar debt, exceeding the domestic nonfinancial corporate sector’s total issuance (Chart 14). As the sole provider of US dollars, the Fed has a role to play in supporting foreign dollar-debt issuers during this tumultuous period. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. For example, once the Fed exchanges dollars for euros using its swap line with the European Central Bank (ECB), the ECB can then direct those US dollars toward USD-denominated borrowers within the Euro Area. Widening cross-currency basis swap spreads are a tried-and-true signal that US dollars are becoming too scarce. The Fed responded to widening basis swap spreads by instituting swap lines during the financial crisis and again during the Eurozone debt crisis of 2011. In both instances, the swap lines eventually calmed the market and basis swap spreads moved back toward zero (Chart 15). Chart 15The Cost Of US Dollars Since 2013, the Fed has maintained unlimited swap lines with the central banks of the Euro Area, Canada, UK, Japan and Switzerland. On March 19th, it extended limited swap lines to the central banks of Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden. These swap lines will help ease stresses for some foreign issuers of US dollar debt, but not all. One potential problem is that the foreign central banks that acquire dollars via the swap lines may be unwilling or unable to direct those dollars to debtors in their countries. Another problem is that several emerging markets (EM) countries do not have access to the Fed’s swap facility. EM issuers account for roughly one-third of foreign-issued dollar debt (Chart 14, bottom panel). For example, the governments of the Philippines, Colombia, Indonesia and Turkey all carry large US dollar debt balances, not to mention US dollar debt issued by the EM corporate sector in non-swap line countries. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. The swap lines that are already in place have led to basis swap spread tightening in developed markets. If global growth eventually rebounds and the dollar weakens, EM dollar-debt burdens will become easier to service. However, until that happens, a default by some foreign issuer of US dollar debt remains a non-trivial tail risk. The Fed may need to extend swap lines to more countries to mitigate this risk in the months ahead. Easing Up On The Regulatory Reins As we’ve argued in US Investment Strategy Special Reports the last two weeks, the largest US banks are extremely well capitalized.3 The Fed agrees, and over the last 30 days, it has issued six separate statements encouraging the banks to lend or to work with struggling borrowers, all but one of them in concert with its fellow banking regulators. Although the largest banks have amassed sizable capital cushions that would support increased lending, post-GFC regulations often crimp incentives to deploy them. Over the last 30 days, the Fed and the other federal regulators have granted banks relief from the key binding constraints. Those constraints fall into two broad categories: risk-based requirements, which are based on risk weightings assigned to individual assets, and leverage requirements, which are based on total assets or total leverage exposure. All banks are required to maintain minimum ratios of equity capital to risk-weighted assets under the former and to total leverage, which includes some off-balance-sheet exposures, under the latter. The three federal banking regulators have amended rules to exclude MMLF and PPP exposures from the regulatory capital denominator used to calculate risk-weighted and leverage ratios. The Fed also made a similar move by excluding Treasury securities and deposits held at the Fed from the denominator of the supplementary leverage ratio large banks must maintain (3% for banks with greater than $250 billion in assets, 5% for SIFIs). Reducing the denominators increases the banks’ ratios and expands their lending capacity. Community banks’ capital adequacy is determined by their leverage ratio (equity to total assets), and regulators have temporarily cut it to 8% from 9%. We expect that easing capital constraints will spur the banks to lend more in the coming weeks and months, but it’s not a sure thing. A clear lesson from the Bernanke Fed’s three rounds of quantitative easing is that the Fed can lead banks to water, but it can’t make them drink. A considerable amount of the funds the Fed deployed to buy Treasury and agency securities was simply squirreled away by banks, and wound up being neither lent nor spent. Lending is not the Fed’s sole focus, though: it hopes that easing capital regulations will also encourage banks and broker-dealers to ramp up their market-making activity, improving capital market liquidity across a range of instruments. Investment Implications While all of the programs discussed above have expiration dates, they can be extended if necessary. Flexible end dates illustrate the open-ended nature of the Fed’s (and Congress’) support, and help underpin our contention that more aid will be forthcoming at the drop of a hat. Confronting the most severe recession in 90 years and an especially competitive election, policymakers can be counted upon to err to the side of providing too much stimulus. That is not to say, however, that the measures amount to a justification for loading up on all risk assets. Every space will not be helped equally. Spreads for all corporate credit tiers are cheap compared to history, but only BB-rated and higher benefit from the Fed’s programs. Within US fixed income, investors should look for opportunities in sectors that offer attractive spreads and directly benefit from Fed support. In the corporate bond market this means owning securities rated BB or higher and avoiding debt rated B and below. Spreads for all corporate credit tiers are cheap compared to history (Charts 16A & 16B), but only BB-rated and higher benefit from the Fed’s programs. Some B-rated issuers will be able to access the MSELF, but Fed support for the B-rated credit tier is limited. Fed support is non-existent for securities rated CCC or lower. Chart 16AInvestment Grade Valuation Chart 16BHigh-Yield Valuation Elsewhere, several traditionally low-risk spread sectors also meet our criteria of offering attractive spreads and benefitting from Fed support. AAA-rated Consumer ABS spreads are wide and will benefit from TALF. Agency CMBS spreads are also attractive and those securities are being directly purchased by the Fed (Chart 17). We also like the opportunity in Agency bonds (the debt of Fannie Mae and Freddie Mac) and Supranationals, where spreads are currently well above historical levels (Chart 17, third panel). Chart 17Opportunities In Low-Risk Spread Product Chart 18Not Enough Value In Agency MBS Agency MBS are less appealing. Spreads have already tightened back to pre-COVID levels and while continued Fed buying should keep them low, returns will be much better in the investment grade corporate space (Chart 18).  Meanwhile, we would also advocate long positions in municipal bonds. Spreads are wide and the Fed is now providing support out to the 2-year maturity point (see Chart 13). We also see potential for the Fed to start purchasing longer-maturity municipal debt if spreads don’t tighten quickly enough. Chart 19Look For Attractive Spreads In Countries With Swap Lines Finally, we would also consider the USD-denominated sovereign debt of countries to which the Fed has extended swap lines, with Mexico offering a prime example. Its USD-denominated debt offers an attractive spread and it has been extended a swap line (Chart 19). In equities, agency mortgage REITs – monoline lenders that manage MBS portfolios 8-10 times the size of their equity capital – are a levered play on buying what the Fed’s buying. They were beaten up quite badly throughout March, and have been de-rated enough to deliver double-digit total returns as long as the repo market doesn’t flare up again, and agency MBS spreads do not widen anew. We see large banks as a direct beneficiary of policymakers’ efforts to limit credit distress and expect that their loan losses could ultimately be less than markets fear. While lenders have an incentive to be the first to push secured borrowers into default in a normal recession to ensure they’re first in line to liquidate collateral, they now have an incentive to keep borrowers from defaulting lest they end up having to carry the millstone of seized collateral on their balance sheets for an indefinite period. Regulatory forbearance may end up being every bit as helpful for bank book values as the ability to move securities into the Fed’s non-recourse facilities. Footnotes 1 This calculation uses 2019 EBITDA and includes undrawn loan commitments in total debt. 2 The Fed plans to expand the program to include non-bank SBA-approved lenders in the near future. 3 Please see the US Investment Strategy Special Reports, “How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study,” and “How Vulnerable Are US Banks? Part 2: It’s Complicated,” published March 30 and April 6, 2020, respectively, available at usis.bcaresearch.com. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com

Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. 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. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month spread volatility, and credit rating - the primary risk factors for any corporate bond. 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 is our valuation metric used to inform our sector allocation ranking. The latest output from the euro area relative value spread model can be found in Table 2. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation We can 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. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The near-term is fraught with risk for US equities and global risk assets. Investors concerned over uncertainty, a slow recovery, and economic aftershocks must also guard against geopolitics. COVID-19 is not a victory for dictatorship over democracies. Democracies face voters and will ultimately improve government effectiveness. President Trump is likely to lose the US election. As this becomes increasingly likely, his policy will turn more aggressive, increasing geopolitical risks – particularly in US-China relations. Stay short CNY-USD. Stay long defense stocks. Feature Chart 1Another Downdraft Is Likely US equity prices have risen 26% since their March 23 low point, but our review of systemic global crises suggests that a re-test of the bottom would not be surprising (Chart 1). A range of mitigating health policies – plus still-growing policy stimulus – will most likely prevent a depression. But a longer than expected economic trough, due to some persistent level of social distancing pre-vaccine, and negative second-order effects, such as emerging market crises, could trigger another wave of selling. Moreover we expect another shoe to drop: geopolitics. A Light At The End Of The Tunnel Governments are starting to get a handle on the COVID-19 pandemic. The number of daily new cases in the European Union, which is most clearly correlated with global equities, has subsided (Chart 2). Chart 2Any Setbacks Will Hit Equity Market Hard The US is also seeing new cases crest. To be safe one should count on a subsidiary spike that could easily set back US equities after a notable stock market rally (Chart 2, second panel). But Europe has shown that social distancing works, which US investors will recognize. Italy’s Prime Minister Giuseppe Conte is expected to begin the gradual loosening of social controls to restart the economy. Since Italy is the hardest hit of the western nations (second only to Spain), its leaders will not relax lockdown measures unless they are sure they can do so safely (Chart 2, bottom panel). Still, if governments loosen controls too soon, they may have to tighten them again. Uncertainty will therefore persist regarding the pace of economic normalization, which is bound to be slow due to the fact that discretionary spending will remain suppressed, as it is today in China, and the special precautions that at-risk populations like the elderly will have to take. Economic stimulus measures are still growing in size. Japan’s stimulus, which we count at 16% of GDP, is smaller than the headline 20% but still very large. We have long argued that Japan was on the forefront of the move toward debt monetization among developed markets, but COVID-19 has accelerated the paradigm shift. The United Kingdom has now explicitly stated that the Bank of England will directly finance government debt. The Spanish government is proposing Universal Basic Income (UBI), which it hopes to make permanent, rather than merely for the duration of the pandemic. The jury is still out on whether the weak Pedro Sanchez government will be able to pass it but the current is in favor of “whatever it takes.” Italy’s Five Star Movement has long advocated universal basic income and is part of a ruling coalition that has received a wave of popular support to combat the crisis. At present only a more limited “income of emergency” is being legislated, in keeping with the more centrist Democratic Party, a coalition partner. But Italy’s devastation creates the impetus for bolder moves, either by this government or a subsequent government in 2021 or after. The European institutions are backstopping these states, at least for now, so any deeper disagreements about climbing down from stimulus will have to wait until the coming years. The EU itself is likely to announce additional fiscal measures, via the European Stability Mechanism, whose austerity requirements will be waived, and the European Investment Bank. We can see a token agreement on “coronabonds” (joint debt issuance by the Euro Area), but investors should not fixate on the eurobond debate. These would require a new mechanism, which is inexpedient, whereas the existing mechanisms are already sufficient to bankroll the huge deficit spending plans that the member states are already rolling out. The United States is negotiating an additional “phase four” package that could range between $500 billion and $2 trillion, meaning anywhere from 2.5% to 10% of GDP in new measures (Chart 3). Our estimate would err on the high side because it will largely consist of the same key elements as the “phase three” $2.3 trillion package: unemployment benefits and cash to households, plus a larger dollop for local governments than in the last package. Chart 3Fiscal Tsunami Is Still Building Congress is scheduled to return to vote the week of April 20, but an early return is entirely possible if the pandemic worsens. If the infection curve is flattening, then Republican Senators may hold out longer in negotiations. Squabbling would cause temporary agitation in equity markets. The Democrats and the Republicans still have a mutual interest in spending profusely: the Republicans to try to salvage their seats through economic improvement by November; the Democrats to prove their election proposition that a larger role for government is necessary. Finally, China is preparing to announce more stimulus. So far Chinese measures amount to only 3% of GDP but this is insufficient given the weakness in China’s economic rebound thus far. The expansion in quasi-fiscal spending (government-controlled credit expansion) is an open question, but we would guesstimate a minimum of 3% of GDP. Dramatic measures should be expected because China is undergoing the first recessionary environment since the Cultural Revolution and President Xi Jinping risks a monumental economic destabilization if he hesitates to shore up aggregate demand, which would ultimately threaten single-party rule. We see little chance of him making this mistake. The problem is that animal spirits and external demand will remain weak regardless, an occasion for disappointments among bullish equity investors. Moreover US-China geopolitical risks are rising again, as discussed below. Our updated list of fiscal measures for 25 countries can be found in the Appendix. Bottom Line: The pandemic is peaking in the US and EU, while more stimulus is coming. This is positive for equity investors with a 12-month time frame but the near-term remains vulnerable to another selloff. Democracies Are Not Less Effective Than Dictatorships The pandemic has given rise to wildly misleading narratives in the financial community and mainstream media about the political ramifications for different nations. Getting these narratives right is important for one’s investment strategy. The most popular is that China “won” – is expanding its global influence – while the United States “lost” – is failing at global leadership. More broadly the authoritarian eastern model is said to be triumphing over the western democratic model. The real distinction among states is whether they were familiar with pandemics emanating from China, the unreliability of China’s transparency and communications, and the need to track and trace infections from the beginning. Thus South Korea, Taiwan, Singapore, Vietnam, and Japan have all had relatively benign experiences and all but Vietnam are democracies, with varying degrees of representation and contestation. Nor is COVID-19 an “eastern” versus “western” thing. Germany did an effective job testing, tracking, and tracing infections as well. Germans are relatively law-abiding and trust Chancellor Angela Merkel and the state governments to “do the right thing.” Canada, with its experience of SARS, has also reacted effectively. Denmark, Austria, and the Czech Republic are already tentatively reopening their economies. Yet the number of new confirmed cases per million people shows that Germany is not wildly different from the US and Italy (Chart 4). The truth is that Italy’s bad fortune alerted the US and G7 states to take the threat more seriously – the US has had good outcomes in Washington State but bad outcomes in highly populated New York. Nor is it true that the American health care system is uniquely terrible in treating patients, as is so widely claimed. US deaths per million are worse than Germany but better than Italy (Chart 5) – and Italy’s health system is also not to blame. Failure of ruling parties to spring into decisive action is the main differentiator. Chart 4US In Line With Italy In New Cases … Chart 5… But Better In Limiting Deaths Chart 6Dictatorships Good At Halting Freedoms Dictatorships have had fewer cases and deaths, if their statistics can be trusted – which is a big if.1 This does not suggest that their governance model is better, but rather that they are better at halting freedoms, such as free movement (Chart 6). North Korea has zero cases of COVID-19. People were already under lockdown. Variation within the dictatorships stems from their policy responses and experience fighting pandemics. China, the origin of several recent outbreaks, has extensive experience. It also has a functional health system, fiscal resources, and a heavily centralized power structure. Iran, however, has less experience and capability. The question now is Russia, which was slow to react and has a growing outbreak, yet has a heavily centralized power structure to flatten the curve. Incidentally domestic risk is an important reason for Russia to cooperate with OPEC on oil production cuts, as we have argued. These points can be demonstrated by comparing COVID-19 deaths per million to each nation’s health capabilities and underlying vulnerability to the disease. Note that our intention is to highlight the role of policy in outcomes, not to attempt a full explanation of an epidemiological phenomenon. In Chart 7A, we judge health capacity by health spending per head and life expectancy at the age of 60. Nations that spend a lot per person, and whose people live longer, have better health systems. Yet many of these states are seeing the highest number of deaths because they are European and Europe was the epicenter of the outbreak. Chart 7ARich, Healthy Countries Got Hit Hardest Because Unprepared The US ranks right along with Germany and Sweden.2 Policy responses – early testing, tracking, and tracing – explain why South Korea has far fewer deaths than Italy and Spain on a population-weighted basis. However, the underlying conditions still matter, as the US’s health system, travel bans, and distance from the crisis produced better outcomes than its other policy responses would have implied. These data will be more accurate once the infection curve has flattened across the world. The situation is changing rapidly. If the US rises up in deaths per capita, it will be because of its slow responses, or subsequent policies. The same goes for emerging market economies that are ranking low in deaths but either have not seen the full effect of the pandemic, or had more time to adjust policy due to the crisis in Europe. Emerging market economies have lower health capacity, but also younger and hence healthier populations. The older the society, and the higher proportion of severe illnesses like heart and lung disease, the more susceptible to COVID-19 deaths, as Chart 7B shows. But yet again, the policy response still proves decisive. China has more deaths than some countries that are more vulnerable, because it got hit first. If Brazil and Turkey rise higher and higher above China in deaths, as is likely, it is because of policy failure, not basic vulnerability. Chart 7BEurope And US: Vulnerable Populations, Governments Slow To React Russia stands out as especially vulnerable in this Chart 7B. Here is where authoritarian measures may pay off, as with China, but only in the short term – since Russia will still be left with an elderly population highly prone to severe illness and a creaking health system. As mentioned above, the risk to Russian stability is a factor pushing for geopolitical cooperation in oil market cartel behavior to push prices up and improve the fiscal outlook to enable better domestic stability management. Bottom Line: Government policy, particularly preparedness and rapid action, have been the decisive factors in containing COVID-19, not dictatorial or democratic government types. The richest countries have the most freedoms and the most vulnerable elderly demographics. Within the rich countries, southern Europe reacted slowly and got hit hardest, with some exceptions. The US’s incompetence has been overrated, based on deaths, probably because of President Trump’s general unpopularity. These results are preliminary but they suggest that the US and EU will experience political change to address their lack of rapid action. Non-democracies will still have to deal with the recession and the consequences on social stability. Democracies Face Voter Blowback Democracies will face the wrath of voters once the immediate crisis dies down. The crisis has driven people to rally around the flag, creating polling bounces for national leaders and ruling parties. In some cases the trough-to-peak increase in popular support is remarkable – President Trump's approval reached 10 percentage points briefly, and he rose over 50% approval in some polls for the first time in his presidency (Chart 8A). Yet these initial bounces are already subsiding, as in Trump’s case (Chart 8B). Chart 8ADemocracies Are Accountable To Voters Chart 8BAnd Polling Bounces Are Fading By this measure, the US, Italy, France, and Spain all face serious political reckonings going forward. Trump is the first in the firing line. Our quantitative election model relies on state-level leading economic indicators that are lagging and show him still winning with 273 Electoral College votes (Chart 9A). However, if we introduce a 2008-magnitude economic shock to these indexes, the Democrats flip Michigan, Wisconsin, Pennsylvania, and New Hampshire, yielding 334 Electoral College votes for former Vice President Joe Biden (Chart 9B). This is assuming Trump’s approval rating stays the same, which, at 46%, is strong relative to the whole term in office. Chart 9AOur Quant Election Model Will Turn Against Trump When Data Catches Up Chart 9BA 2008-Style Shock To States Gives Democrats The White House Our qualitative judgement reinforces our election model. Historically, US elections are referendums on the ruling party. An incumbent president helps the party win reelection. But a recession is usually insurmountable. George Bush Sr lost in 1992 despite a shallow recession that ended the year before. While Joe Biden is a flawed candidate in numerous ways, the question voters face in November is whether they are better off than they were four years ago. With thousands of deaths and an unemployment rate at or above 20%, it is hard to see swing state voters answering “yes.” Not impossible, but we subjectively put the odds at 35%, and that could easily be revised downward if Trump’s polling falls back down to the 42% range. Trump will also be responsible for the handling of the pandemic itself. His administration obviously made several policy mistakes. A paper trail will highlight intelligence warnings as early as November, and warnings from his inner circle as early as January, that will hurt him.3 Objectively, the Republican Party’s greatest policy flaw, prior to COVID-19, was health care – and this will connect with COVID-19 even if the Affordable Care Act (Obamacare) has little to do with crisis response. Bottom Line: The first and most important political casualty of the pandemic will be Trump’s presidency. Not because the US is uniquely incompetent in the face of the pandemic – although it obviously could have done better, judging by several of the other democracies – but because this year happens to be an election year and democracies hold governments accountable. Major Risk Of Clash With China Chart 10China Likely To Depreciate The Renminbi There are two downside geopolitical risks that follow directly from the above. First, while the Democratic candidate Joe Biden is a “centrist,” his position will move to the left of the political spectrum. This is to energize the progressive faction of the party – which is already energized. The market will be taken aback if Biden produces major leftward shifts, in the direction of Senator Bernie Sanders, on taxes, regulation, health care, pharmaceuticals, banks, energy, or tech. This is not a problem when the market is down 36%, but as the market rallies, it becomes more relevant. While US taxes and regulation will go up, Biden will still have to win over the Midwestern Rust Belt voter through trade protectionism, a la Trump and Bernie. This will be exacerbated by the pandemic, which has supercharged American popular enmity toward China and fear of supply chain vulnerability toward China. When Biden reveals that he is protectionist too, US equities will react negatively. Second, more immediately, the clash with China may happen much sooner. As President Trump comes to realize he is losing his grip on power, he will have an incentive to retaliate against China for its mishandling of the pandemic, shift the blame, and achieve long-term strategic objectives as well. This makes Trump’s approval rating a critical indicator – not only of his reelection odds, but of whether he determines he has lost and therefore adopts more belligerent foreign or trade policy. We view the danger zone as anything less than 43%. If Trump becomes a lame duck, he could target China, or other countries, such as Venezuela. The advantage of the latter is that it could have the desired political effect without threatening the economic restart. A conflict with Iran would have bigger consequences – particularly negative for Europe. But in the COVID-19 context, Venezuela and Iran are not relevant to American voters. A conflict with North Korea, however, is part of the strategic conflict with China and would be hard to keep separate from broader tensions. This is only likely if Kim Jong Un stages a major provocation. At present, Washington and Beijing are keeping a lid on tensions. Presidents Trump and Xi are in communication. Beijing has rebuked the foreign minister who accused the US military of bringing COVID-19 to Wuhan. Trump has stopped using inflammatory rhetoric about the “Chinese virus.” China is not depreciating the renminbi, it is upholding other aspects of the trade deal, and it is sending face masks and ventilators to assist the US with the health crisis. But this could change. With its economy under extreme pressure, Beijing must take greater moves to stimulate. An obvious victim will be the renminbi, which is arguably stronger than it should be, especially if China cuts interest rates further, no doubt in great part because of the “phase one” trade deal with the United States (Chart 10). If and when Beijing decides that it must ease the downward pressure on exports and the economy, the renminbi will slide. This will provoke Trump. If he is convinced he cannot salvage the economy anyway, then he has an incentive to channel American anger toward China into new punitive measures over currency manipulation. Finally, the ingredients for our “Taiwan black swan” scenario are falling into place. Taiwan has long attempted to gain representation in the World Health Organization but has been blocked by Beijing’s assertion of the One China principle. However, Taiwan is now caught in an escalating tussle with the WHO leadership that involves both Washington and Beijing. Taipei warned the WHO as early as December that COVID-19 could be transmitted by humans and that the pandemic risk was high.4 Both China and the WHO leadership are simultaneously under pressure from the Trump administration for failing to share information and sound the alarm to prepare other nations. Bottom Line: If President Trump decides to prosecute China for its handling of the virus, and/or promote US-Taiwan relations in a way that aggravates China, then the trigger for a major geopolitical incident will have arrived. Investment Implications It is impossible to predict the precise catalyst or timing of such a crisis. We observe that the US and China are each experiencing historic economic dislocation, their strategic relationship has broken down over the past decade, and their populations are incensed at each other over grievances relating to the trade war, COVID-19, and various disinformation campaigns. Taiwan is at the epicenter of this conflict, due to its defense relationship with the United States and renewed political tensions with China under Xi Jinping. But the Chinese tech sector, North Korea, the South and East China Seas, Xinjiang, and Iran are also potential catalysts. Geopolitics is the other shoe to drop in the wake of COVID-19. Presidents Trump and Xi Jinping are the biggest sources of geopolitical risk, as we outlined in our 2020 forecast. They are cooperating in the immediate crisis, but in the aftermath there will be recriminations. A worsening domestic situation, a loss of prestige for either leader, or a foreign policy provocation could trigger punitive measures, saber rattling, or even military incidents. Risk assets are rallying on the light at the end of the tunnel. We are reaching and in some countries passing the peak intensity of the (first wave of the) pandemic. But the economic aftermath is extremely uncertain and the political fallout has hardly begun. In the US, the implication is clearly negative for Trump. But if that implication is realized, it points to much higher geopolitical risks within 2020 than are currently being considered as the world focuses on the virus. If President Trump chooses to wag the dog with Venezuela, that is obviously a much more positive outcome for global risk assets than if he attempts to achieve American strategic objectives of curbing China’s global assertiveness. Tactically, we remain defensive and recommend defensive US equity sectors and the Japanese yen. On a 12-month and beyond time frame we are more bullish on global growth and are long gold and oil. We remain strategically short CNY-USD and short Taiwanese equities relative to Korean.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Appendix Appendix TableThe Global Fiscal Stimulus Response To COVID-19 Footnotes 1 Given that one of Iran’s top health officials has criticized China for its questionable data and lack of transparency, one does not need to trust the US Intelligence Community’s assessment that China misled the world in the early days of the outbreak. See Matthew Petti, "Even Iran Doesn't Believe China's Coronavirus Stats," April 6, 2020. 2 Readers accustomed to the apocalyptic view of the US health system may wonder that the US comes out looking very well on health capacity. This is because we combine and standardize the scores for per capita spending and longevity. However our data also show that the US is inefficient on health: its life expectancy scores are slightly lower than those of the Europeans, yet it spends more per head. 3 See Josh Margolin and James Gordon Meek, "Intelligence report warned of coronavirus crisis as early as November: Sources," ABC News, April 8, 2020, and Maggie Haberman, "Trade Adviser Warned White House in January of Risks of a Pandemic," New York Times, April 6, 2020. 4 See "Taiwan says WHO failed to act on coronavirus transmission warning," Financial Times, March 19, 2020.

Highlights Oil prices are up strongly from their lows, but conditions for a durable bottom may not yet be in place. The main hiccup is that an air pocket will likely remain under global oil demand until most social-distancing measures are lifted. That said, most petrocurrencies offer a significant valuation cushion, making them attractive for longer-term investors. We will look to buy a basket of petrocurrencies on further weakness. The Asian economies that were closer to the epicenter of the epidemic are likely to recover faster than the West. Transport and electricity energy demand should pick up in these economies faster. AUD/CAD and AUD/EUR should benefit from this dynamic. CAD/USD is likely to weaken in the short term as Canadian crude remains trapped in Alberta, but then strengthen as the global economy recovers. Feature Chart I-1Massive Liquidation In Crude Oil Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $20 (Chart I-1). The extraordinary drop has sent many petrocurrencies, including the Norwegian krone, Mexican peso, and Canadian dollar, into freefall. The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Meanwhile, the trading of petrocurrencies is also complicated by a shifting production landscape among many oil producers. For investors, three key questions will determine whether petrocurrencies are a buy: Have we approached capitulation lows in oil prices? If so, what will be the velocity and magnitude of the demand recovery? Will the correlation between oil and petrocurrencies still hold once the dust settles? Have We Approached Capitulation Lows? In terms of magnitude and duration, yes. Over the last two decades, oil price drawdowns have tended to last between 8 and 20 months before a durable rally ensues. The oil price collapse from July 2008 to February 2009 lasted around 8 months. The decline from June 2014 to February 2016 was much longer, around 20 months. Given the October 2018 peak in oil prices, we should be very close to the bottom in terms of duration. Remarkably, in all episodes, the peak-to-trough decline in the West Texas Intermediate (WTI) blend has been around 75% (Chart I-2).   However, since the 1970s, oil has moved in a well-defined pattern of a 10-year bull market, followed by a 20-year bear market (Chart I-3). Assuming the bear market in oil began just after the global financial crisis, it does suggest that even if prices do recover, it will most likely be a bear-market rally. That said, history also suggests that these bear market rallies in oil can be quite powerful, with prices often doubling or trebling. As we go to press, oil prices are up a remarkable 18% from their lows Chart I-2Similar In Magnitude To Prior Oil Crashes Chart I-3Oil Prices Are Close To Capitulation Lows What is different this time? Aside from a breakdown in OPEC+, a few other factors are in play. This alters the timing and duration of an intermediate-term bottom: Any coordinated supply response will need to involve the US to be viable.1 The OPEC+ cartel, specifically the alliance between Russia and Saudi Arabia, is broken. Chart I-4 illustrates why. While being the stewards of global oil production discipline, there has been one sole benefactor – the US. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces around 15% of global crude, having grabbed market share from many other countries. Chart I-4US Is The Big Winner From OPEC Cuts As we go to press, there are reports that Saudi Arabia and Russia have come to an agreement. However, the history of OPEC alliances suggests that it is fraught with broken promises.  Oil still trades above cash costs for many producing countries, meaning the incentive to boost production in times of a demand shock is quite strong (Chart I-5). Ditto if oil prices are recovering. Oil futures are in a massive contango, with WTI trading close to $40 per barrel two years out. This incentivizes players with strong balance sheets to keep the taps open. The oil curve needs to shift significantly lower, probably pushing some blends into negative spot territory, in order to force production discipline on some players.   Chart I-5Oil Still Trading Above Cost Of Production The dollar has been strong, meaning the local-currency revenues of oil producers have been cushioning part of the downdraft in oil prices. This could sustain production longer than would otherwise be the case, especially in a liquidation phase. The New York Fed’s model suggests that most of the downdraft in oil prices since 2010 has been due to rising supply (Chart I-6). Chart I-6Oil Downdraft Driven By Supply Both Saudi Arabia and Russia have low public debt and ample foreign exchange reserves. This buys them time in terms of dealing with a prolonged period of low prices. We know there will be massive economic pain from the oil price collapse (Chart I-7). The good news is that with the economic slowdown already in place, it may well be the catalyst needed to enforce any agreement put into effect. Chart I-7The Coming Economic Pain For Oil Producers While the positive correlation between oil prices and petrocurrencies has weakened in recent years, it has been re-established during the current downturn. More importantly, should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit. Should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-8). Since then, that correlation has fallen from around 0.9 to about 0.3. Chart I-8Falling Correlation Between Petrocurrencies And The US Dollar Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter (Chart I-9). This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Chart I-9A Shifting Export Landscape That said, in the case of Canada and Norway, petroleum still represents over 20% and 50% of total exports. For Russia, Saudi Arabia, Iran or Venezuela, the number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast. Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. This correlation should remain in place if oil prices put in a definitive bottom, and it should strengthen if production cuts are led by the US. When Will Oil Demand Recover? Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a sudden stop in economic activity. Transport constitutes the largest share of global petroleum demand. Ergo the economic lockdowns have brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt. Encouragingly, passenger traffic in China has started to pick up as the number of new Covid-19 cases flattens, and the country is gradually reopening for business. There has also been an improvement in the manufacturing data. All eyes will be watching if the relaxation of measures in China lead to a second wave of infections. Otherwise, should the Western economies follow the Chinese recovery path, then the world will be open for business by the end of the summer (Chart I-10). One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro.  Part of the slowdown in global demand is being reflected through elevated oil inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-11). Chinese oil imports continue to hold up well, and should easier financial conditions continue to put a floor under the manufacturing cycle, overall consumption will follow suit. Chart I-10Some Optimism For The West Chart I-11Watch For A Peak In Inventories One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro. There are three key reasons which support this trade: Liquefied natural gas will become the most important component of Australia’s export mix in the next few years (Chart I-12). As Beijing restarts its economy and electricity production picks up, Aussie exports will benefit. Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. The massive drop in pollution resulting from the shutdown will all but assure that this push occurs sooner rather than later. Chart I-12LNG Will Be A Game-Changer For Australia There was already pent-up demand in the Australian economy going into the crisis, given the destruction of the capital stock from the fires. With an economy that was already running well below capacity, construction activity should see a V-shaped rebound once social distancing measures are relaxed. As the currency of the now largest oil producer in the world, the US dollar is becoming a petrocurrency itself. In this new paradigm, a better strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. AUD/EUR benefits from this. Chart I-13 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. Chart I-13Buy Oil Producers Versus Oil Consumers Eventually, a pickup in manufacturing activity will be a global phenomenon rather than localized within Asia. When this happens, other petrocurrencies will begin to benefit. This will especially be the case for producers where production is more landlocked. Bottom Line: A recovery in global transport will help revive oil demand. This should be positive for oil prices in general and petrocurrencies in particular. One way to play the recovery in Asia relative to the West for now is to go long AUD/CAD and AUD/EUR. On CAD, NOK, MXN, RUB And COP Chart I-14NOK Will Outperform CAD While Canadian crude is likely to remain trapped in the oil sands, North Sea crude will face less transportation bottlenecks in the near term. This suggests the path of least resistance for CAD/NOK is down (Chart I-14). We were stopped out of our short CAD/NOK trade, but still recommend this position as a play on this dynamic. We are already long the Norwegian krone versus a basket of the euro and dollar. CAD/USD has been displaying a series of higher lows since the March 18 bottom, but the double-top formation in place since then suggests we could see some weakness in the near term. Should CAD/USD retest its recent lows, driven by a relapse in oil prices, we will be buyers.  Many petrocurrencies, including the Mexican and Colombian pesos, have become quite cheap and are attractive on a longer-term basis (Chart I-15). Given the uncertainty surrounding the nearer-term outlook, we a placing a limit buy on a broad basket of these currencies at -5%. Should oil prices retest the lows in the coming weeks/months, it will imply an 18% drop. Given the correlation between petrocurrencies and oil of 0.3, this suggests a 5.3% move lower.  Chart I-15ASome Petrocurrencies Are Very Cheap Chart I-15BSome Petrocurrencies Are Very Cheap Bottom Line: Place a limit buy on a petrocurrency basket at -5%.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, “The Birth Of WOPEC,” dated April 9, 2020, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: The unemployment rate soared from 3.5% to 4.4% in March. Nonfarm payrolls recorded a total loss of 701K jobs, the first decline in payrolls since September 2010. The NFIB business optimism index plunged from 104.5 to 96.4 in March. Initial jobless claims surged by 6.6 million last week, higher than the expected 5.3 million. Michigan consumer sentiment declined to 71 from 89.1 in April. The DXY index fell by 0.7% this week. Risk assets have recovered, fueled by an extra USD $2.3 trillion stimulus from the Federal Reserve. The lesson we are learning is that the deeper the perceived slowdown, the more the Fed will do to assuage any economic damage. As for currencies, what matters is relative monetary policies. The key variable to stem the rise in the USD is that the liquidity crisis does not morph into a solvency one. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly negative: Markit services PMI fell further to 26.4 in March from 28.4 the previous month. The Sentix investor confidence dived to -42.9 from -17.1 in April. Moreover, the Sentix current situation index fell from -15 to -66 in April, while the outlook index moved up slightly from -20 to -15. EUR/USD appreciated by 0.5% this week. The euro zone members failed to reach an agreement on the joint EU debt issuance. On the other hand, the ECB adopted an unprecedented set of collateral measures to mitigate the negative impacts from COVID-19 across the euro area, including easing collateral conditions for credit claims, reduction of collateral valuation haircut, and waiver to accept Greek sovereign debt instruments as collateral.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Consumer confidence fell to 30.9 from 38.4 in March. Labor cash earnings grew by 1% year-on-year in February, but slowed from 1.2% in January. The Eco Watchers Survey current index fell from 27.4 to 14.2 in March. The outlook index also declined from 24.6 to 18.8. The Japanese yen fell by 1% against the US dollar this week. On Wednesday, the BoJ announced that it would scale back some non-urgent operations such as long-term research and studies for academic papers, following the government’s decision to declare a state of emergency. The Reuters poll forecasted the Q1 GDP to shrink by 3.7% quarter-on-quarter and Q2 by 6.1%. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been dismal: Markit construction PMI plunged to 39.3 from 52.6 in March. GfK consumer confidence crashed to -34 from -9 in March. Total trade balance (including EU) shifted to a deficit of £2.8 billion from a surplus of £2.4 billion in February. The goods trade deficit widened from £5.8 billion to £11.5 billion. GBP/USD rose by 0.6% this week. After being told to cut dividends last week, the UK banks are now pressuring the BoE on fresh capital relief to help fight the COVID-19. The BoE has also agreed to temporarily lend the government money, funded through money printing. The details suggest the operations are temporary, but the BoE might be the first central bank to formally step closer to MMT. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The AiG services performance index fell from 47 to 38.7 in March. Imports and exports both slumped 4% and 5% month-on-month respectively in February. The trade surplus narrowed from A$5.2 billion to A$4.4 billion.  The Australian dollar surged by 3.8% against the US dollar, making it the best performing G10 currency this week. The RBA held interest rate steady at 0.25% on Tuesday, while warning the country is in for a “very large” economic contraction. Lowe also suggested that the economy will “much depend on the success of the efforts to contain the virus and how long the social distancing measures need to remain in place”. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been dismal: NZIER business confidence survey reported that a net 70% of firms expect general business conditions to deteriorate in Q1, compared to 21% in the previous quarter. Electronic card retail sales contracted by 1.8% year-on-year in March, down from 8.6% growth the previous month. The New Zealand dollar recovered by 1.7% against the US dollar this week. In addition to the NZ$30 billion purchases of central government bonds, the RBNZ is stepping up the QE program by offering to buy up to NZ$3 billion of local government bonds to support liquidity. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been dismal: Bloomberg Nanos confidence fell further from 46.9 to 42.7 the week ended April 3. Housing starts increased by 195K year-on-year in March, down from 211K in February. Building permits contracted by 7.3% month-on-month in February. On the labor market front, the pandemic has caused the unemployment rate to rise sharply from 5.6% to 7.8% in March, higher than the expected 7.2%. Employment fell by more than one million (-1,011,000 or -5.3%). The Canadian dollar rose by 1.2% against the US dollar this week, supported by the tentative rebound in oil prices. The BoC spring Business Outlook Survey shows that business sentiment had softened even before COVID-19 concerns intensified in Canada. The overall survey indicator fell below 0 to -0.68 in Q1. Businesses tied to the energy sector were hit the most due to falling oil prices. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Total sight deposits were little changed at CHF 627 billion for the week ended April 3. The unemployment rate jumped from 2.5% to 2.9% in March, above expectations of 2.8%. The number of total unemployed increased by 15%, now reaching 136K. The Swiss franc appreciated by 0.6% against the US dollar this week. The Swiss government forecasted the output to slump 10% this year under the worst-case scenario, given the incoming data proved worse than expected. On the positive side, the government said it would gradually relax restriction measures later this month should the current situation improve. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate surged to 10.7% in March from 2.3%. Manufacturing output fell by 0.5% month-on-month in February. Headline inflation fell from 0.9% to 0.7% year-on-year in March, while core inflation remained unchanged at 2.1%.  The Norwegian krone rose by 2.8% against the US dollar this week, up 18% from its recent low three weeks ago. Norway will likely relax some restrictions later this month while the ban on public gatherings will still remain in place. The loosening of COVID-19 measures, together with oil prices recovering and cheap valuations all underpin the Norwegian krone in the long run. Please refer to our front section this week for more detailed analysis. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1   Chart II-20SEK Technicals 2   Recent data in Sweden have been mixed: Industrial production fell by 0.2% year-on-year in February. Manufacturing new orders increased by 6% year-on-year in February. Household consumption increased by 2.3% year-on-year in February, up from 1.6% the previous month. The Swedish krona increased by 1% against the US dollar this week. The recent efforts in buying up bonds by the Riksbank to increase liquidity amid COVID-19 is likely to increase the debt burden in Sweden. The stock of Swedish Treasury bills held by the Riksbank is estimated to be SEK 300 billion by the end of this year, compared to only 55 billion in February. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights A World Organization of the Petroleum Exporting Countries (WOPEC) looks set to emerge after today’s OPEC 2.0 video conference to discuss production cuts in the wake of the COVID-19 pandemic, and the market-share war between the leaders of the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. WOPEC will not be memorialized by a Declaration of Cooperation as OPEC 2.0 was.  Oil exporters globally will cooperate on harmonizing policy to meet demand. In our latest scenario concentrating on likely supply responses, we show cuts of ~ 8mm b/d will be sufficient to clear the storage overhang caused by COVID-19-induced demand destruction of close to 4mm b/d this year. Based on this modeling, we see Brent prices averaging $36/bbl and $64/bbl this year and next, with WTI trading $2-$6/bbl lower, depending on US Gulf storage availability. This is roughly in line with our previous scenario (Chart of the Week).1 Demand destruction over 4mm b/d would require additional production cuts. Feature The 2020 oil price collapse brought on by COVID-19 – and super-charged by the market-share war declared by Russia following the breakdown of OPEC 2.0’s March 6 meeting – has spurred oil-producing states globally to action. Chart of the WeekExpect A Sharp Oil Price Recovery Chart 2The Oil-Price Collapse Of 2020 WOPEC is bigger than OPEC 3.0 – an unofficial grouping we hypothesized at the end of March to encompass the expected future cooperation of KSA, Russia and the Texas Railroad Commission (RRC) – our shorthand for US oil-producing interests – succeeding OPEC 2.0. Today’s OPEC 2.0 video conference originally was called by KSA for Monday, but was moved to today – presumably – to give member states time to agree production cuts. The conference most likely was delayed by the acrimonious public exchange between its leaders this past weekend.2 On the heels of the OPEC 2.0 video conference comes a hastily called video conference on Friday of G20 energy ministers to discuss energy security. The G20 is led by KSA this year.3 The 2020 oil price collapse brought on by COVID-19 – and super-charged by the market-share war declared by Russia following the breakdown of OPEC 2.0’s March 6 meeting – has spurred oil-producing states globally to action (Chart 2). KSA, Russia and their respective OPEC 2.0 allies all are fully invested in this meeting, as are producers in the US, Canada, Norway and Brazil.4 Supply Destruction Vs.Production Cuts Oil producers face a stark choice: Either cut production voluntarily to counter the global demand destruction of a pandemic, or have the market do it for them by driving prices through cash costs toward zero (i.e., $0.00/bbl), as global crude oil and product storage fills. Prices in some basins have fallen close to zero after accounting for the basis differentials to benchmark prices and transport costs (e.g., WTI-Midland), which, in the US has begun to force shut-ins (Chart 3).5 Continued weak pricing close to zero risks shutting older, high-cost landlocked production in permanently, and many states simply cannot afford to lose the critical revenue provided by oil exports. Chief among these states are the non-Gulf members of OPEC, excluding Russia, US onshore, and Canada, which we identify as “The Other Guys” (Chart 4).6 Chart 3Some Crude Grades Priced Close To $0.00/bbl Chart 4"The Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal We expect The Other Guys in OPEC 2.0 will lose 700k b/d, with 400k b/d of that realized over the course of 2021. The chief contribution of The Other Guys to the OPEC 2.0 coalition’s production-management scheme is their managed production decline. These states were only starting to recover from the Global Financial Crisis (GFC) beginning in 2010 when the OPEC market-share war of 2014-16 was declared. The COVID-19 price collapse, coupled with the knock-on effects of the 2020 KSA-Russia market-share war likely accelerates the rate of production decline for the Other Guys, as capital continues to avoid developing their resources. We expect The Other Guys in OPEC 2.0 will lose 700k b/d, with 400k b/d of that realized over the course of 2021. Core OPEC and Russia can increase (and decrease) production, and we expect they will deliver the largest part of the OPEC 2.0 production cuts. In this week’s simulation, we project KSA will cut 2mm b/d, from their April level of from 12mm b/d; and Russia will cut 1.1mm b/d, down from 11.6mm b/d. We then project Iraq will cut 460k b/d; Kuwait 280k b/d; and the UAE 315k b/d. Outside OPEC 2.0, a lot of the production we expect will be cut is out of necessity. Canada, for example, will be forced to either shut in high-cost tar-sands production or go back to pro-rating production as it did last year, owing to a lack of storage in Alberta and pipeline takeaway capacity to move their crude south to US refiners. We expect Canada to cut 350k b/d this year, as a result. Brazil’s Petrobras already has shut in 100k b/d, and US producers have begun shutting in shale-oil production.7 US Production Cuts Some of the more efficient producers in The Great State of Texas have been calling for pro-rationing of up to 20%, which would push the cuts in Texas’s Permian and Eagle Ford shale basins alone to 1.23mm b/d. Production cuts most likely will be focused on the US, as this is the most easy-to-adjust output in the world. It also still is higher up the global cost curve, although, as we have noted earlier, this will change in the event bankruptcies pick up.8 In the US, production cuts already have begun. They are and will continue to be focused on the shales. We continue to project cuts in the US shales of ~ 1.5 mm b/d this year. However, this number could be higher: If producers respond to the collapse in prices by not sending any new rigs to the field in the next 12 months, production will fall by 2.9mm b/d from production declines alone. Just to keep production flat, the US shales will need an average of ~ 520 rigs per month (assuming no drilled-uncompleted wells are finished). The risk on our rig-count estimates are straightforward: If rig counts go much lower, we could see a large decline in shale production in the coming months (Chart 5). Chart 5US Shale Output Falls This Year And Next Some of the more efficient producers in The Great State of Texas have been calling for pro-rationing of up to 20%, which would push the cuts in Texas’s Permian and Eagle Ford shale basins alone to 1.23mm b/d. Including the Anadarko Basin, most of which is in Oklahoma, which also permits pro-rationing, 20% pro-rationing would push TX-OK cuts to ~ 1.33mm b/d. As we have been writing over the past month, we could see a return of pro-rationing in the states of Texas and Oklahoma. In the Great State, producers have filed a petition before the Texas RRC asking the Commission to reprise its 1928-73 production-management role.9 The Texas RRC will hold a video conference Tuesday, April 14, to consider this petition. We’re expecting this petition to be granted, and for pro-rationing to begin in the near future. On the demand side, we are staying with the scenario we presented March 30, with 2Q20 demand falling ~ 12mm b/d (y/y vs. 2Q19). In 2H20, we project demand to grow at a rate of 800k b/d by 4Q20. For all of 2020, we model average demand losses equal to 3.8mm b/d. For 2021, massive fiscal and monetary stimulus globally will lift demand 5.3mm b/d. With the supply cuts projected above and our demand view, we see balances tightening over the course of the year and moving into a physical deficit in 4Q20 (Chart 6). While near-term oversupply will force inventories to grow sharply, we expect them to draw as sharply beginning by September and continuing into next year (Chart 7). Chart 6Supply-Demand Imbalance Will Tighten Into 2021 Chart 7Inventories Will Build Sharply, Then Draw Sharply in 2021 Investment Implications Our projections for supply presented this week and our demand scenario presented at the end of March are evolving into our base case for oil and gas. We still do not know with certainty the OPEC 2.0 coalition will agree to production cuts today, or whether the Texas RRC will return to the business of pro-rationing. If either or both of these outcomes does not materialize, markets will take over and savagely destroy supply. This will be extremely volatile. For our part, we expect OPEC 2.0, the Other Guys outside the coalition, and the US shales to deliver something that looks like voluntary cuts. This will occur via voluntary cuts, “managed” declines, and pro-rationing and shut-ins. Unlike many of our economist colleagues who argue against such jointly coordinated policies – invoking a free-market, pure-competition paradigm that has not existed for any meaningful period in the modern history of the oil market – we believe producers are intelligently pursuing their interests by jointly coordinating the boom-bust mayhem of unfettered oil markets. Similarly, we believe consumers are better served by diversified sources of energy vs. an over-reliance on large concentrated supplies who can use their low-cost endowment to monopolize supply and set up barrier to entry to competition. Given our view, we remain constructive to the oil market, expecting a rally that will look a lot like the Chart of the Week and the balances we show in Chart 7. As a result, we are getting long 2H21 Brent vs. short 2H22 Brent futures.   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 Defying the global rush to cut oil production, Mexico apparently is moving toward increasing production. Petroleos Mexicanos (PEMEX) is looking to drill 423 wells this year, according to Bloomberg. A March 26 Journal of Petroleum Technology survey suggests capex by E&P companies will fall by up to 35% this year. Base Metals: Neutral This week Japan’s Nippon Steel became the latest producer to idle blast furnaces, halting about 15% of the company’s total capacity. More generally an iron ore surplus in other parts of Asia and in Europe is expected as steel mills idle furnaces amidst lower demand for their output. However, diminished activities in mines – severely impacted by lockdowns – will offset some of the demand loss. COVID-19 induced shutdown in South Africa, Iran, India and Canada have curtailed exports from those countries until late April. Additionally, bad weather in Brazil led iron ore exports to fall on a yoy basis for the third month in a row in March. A decline of ~ 2% vs. last year’s already depressed – following the Vale dam incident – levels. China’s anticipated infrastructure stimulus will support iron ore demand, drawing down inventories and pushing up prices, but it, too, will be tempered by the pace of the recovery in its export markets. Precious Metals: Neutral A strong US dollar remains an important risk for precious metals. The dollar rose 1.6% since March 28 despite the Fed’s actions to calm the global dollar liquidity squeeze. This signals the funding crisis has not been thoroughly controlled and that swap lines will have to be extended to additional EM central banks. However, a large share of outstanding foreign exchange swaps/forwards resides in non-bank financial corporations and institutions with limited access to dollar funding via central bank swap lines. Over the short-term, our gold price recommendation remains vulnerable to deterioration, due to uncertain liquidity conditions (Chart 8). Ags/Softs:  Underweight This week we begin tracking the lumber market. Lumber consumption fell sharply as the coronavirus spread in the United States, pushing front-month futures down 44% from February highs. With housing starts already weak in February – down 1.5% month on month – and expected to be even weaker in March (Chart 9), continued lumber supply curtailments will stabilize prices in the short term and eventually push prices up once lower interest rates kick in and demand resumes. Chart 8 Chart 9       1     Please see OPEC 3.0 In the Offing?, published March 30, 2020, which focused on demand destruction. 2     Please see OPEC+ meeting delayed as Saudi Arabia and Russia row over oil price collapse: sources, and G20 energy ministers to hold video conference on Friday: document published by reuters.com April 4 and April 7, 2020. 3    The G20 consists of Argentina, Australia, Brazil, Canada, China, Germany, France, India, Indonesia, Italy, Japan, Mexico, the Russian Federation, Saudi Arabia, South Africa, South Korea, Turkey, the UK, the US and the EU. 4    Please see A look at the major players in this week’s “OPEC++” meeting, a Bloomberg analysis published by worldoil.com April 7, 2020. 5    Please see Can the world agree a deal to boost oil prices? Published by Wood MacKenzie April 3, 2020.  6    The Other Guys is our moniker for all producers excluding core-OPEC, US shale, Russia and Canada. Production from this group of producers has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. 7     In its latest Short-Term Energy Forecast, the EIA estimates US crude oil production will fall 500k b/d this year and 700k b/d next year, driven by market forces. 8    For a discussion, please see How Long Will The Oil-Price Rout Last?, a Special Report we published with BCA Research’s Geopolitical Strategy March 9, 2020. It is available at ces.bcaresearch.com. 9    Please see Oil Prorationing in the Spotlight at Texas Railroad Commission, published by Baker Botts, a Texas law firm, on March 30, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades