Economy

Highlights Our baseline view foresees a U-shaped recovery, as economies slowly relax lockdown measures. There are significant risks to this forecast, however. On the upside, a vaccine or effective treatment could hasten the reopening of economies and recovery in spending. On the downside, containment measures could end up being eased too quickly, leading to a surge in new cases. A persistent spell of high unemployment could also permanently damage economies, especially if fiscal and monetary stimulus is withdrawn too quickly. In addition, geopolitical risks loom large, with the US election likely to be fought on who sounds tougher on China. Earnings estimates have yet to fall as much as we think they will, making global equities vulnerable to a near-term correction. Nevertheless, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon. Is It Safe To Come Down? We published a report two weeks ago entitled Still Stuck In The Tree where we likened the current situation to one where an angry bear has chased a hiker up a tree.1 Having reached a high enough branch to escape immediate danger, the hiker breathes a sigh of relief. As time goes by, however, the hiker starts to get nervous. Rather than disappearing back into the forest, the bear remains at the base of the tree licking its chops. Meanwhile, the hiker is cold, hungry, and late for work. Like the hiker, the investment community breathed a collective sigh of relief when the number of cases in Italy and Spain, the first two major European economies to be hit by the coronavirus, began to trend lower. In New York City, which quickly emerged as the epicentre of the crisis in the United States, more COVID patients have been discharged from hospitals than admitted for the past three weeks (Chart 1). Chart 1Discharges From New York Hospitals Have Exceeded Admissions For The Past Three Weeks Deepest Recession Since The 1930s Yet, this progress has come at a very heavy economic cost. The IMF expects the global economy to shrink by 3% this year (Chart 2). In 2009, global GDP barely contracted. Chart 2Severe Damage To The Global Economy This Year The sudden stop in economic activity has led to a surge in unemployment. According to the Bloomberg consensus estimate, the US unemployment rate rose to 16% in April. The true unemployment rate is probably higher since to be considered unemployed one has to be looking for work, which is difficult if not impossible in the presence of widespread lockdowns. Regardless, even the official unemployment rate is the worst since the Great Depression (Chart 3). Chart 3Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression   Unshackling The Economy A key difference from the 1930s is that today’s recession has been self-induced. Policymakers want workers to stay home as much as possible. The hope is that once businesses reopen, most of these workers will return to their jobs. How long will that take? Our baseline scenario envisions a slow but steady reopening of the global economy starting later this month, which should engender a U-shaped economic recovery. Since mid-March, much of the world has been trying to compensate for lost time by taking measures that would not have been necessary if policymakers had acted sooner. As Box 1 explains, some loosening of lockdown measures could be achieved without triggering a second wave of cases once the infection rate has been brought down to a sufficiently low level. To the extent that economic activity tends to move in tandem with the number of interactions that people have, a relaxation of social distancing measures should produce a modest rebound in growth. New technologies and a better understanding of how the virus is transmitted should also allow some of the more economically burdensome measures to be lifted. As we have discussed before, mass testing can go a long way towards reducing the spread of the disease (Chart 4).2 Right now, high-quality tests are in short supply, but that should change over the coming months.  Chart 4Mass Testing Will Help Increased mask production should also help. Early in the pandemic, officials in western nations promulgated the view that masks do not work. At best, this was a noble lie designed to ensure that anxious consumers did not deprive frontline workers of necessary safety equipment. At worst, it needlessly led many people astray. As East Asia’s experience shows, mask wearing saves lives. A recent paper estimated that the virus could be vanquished if 80% of people wore masks that were at least 60% effective, a very low bar that even cloth masks would pass (Chart 5).3  Chart 5Masks On! Recent research has also cast doubt on the merits of closing schools. The China/WHO joint commission could not find a single instance during contact tracing where a child transmitted the virus to an adult. A study by the UK Royal College of Paediatrics provides further support to the claim that children are unlikely to be important vectors of transmission. The evidence includes a case study of a nine year-old boy who contracted the virus in the French Alps but fortunately failed to transmit it to any of the more than 170 people he had contact with in three separate schools.4  Along the same lines, there is evidence that the odds of adults catching the virus indoors is at least one order of magnitude higher than outdoors.5 This calls into question the strategy of states such as California of clearing out prisons of dangerous felons in order to make room for beachgoers.6 Upside Risks To The U: Medical Breakthroughs While a U-shaped economic recovery remains our base case, we see both significant upside and downside risks to this outcome. The best hope for an upside surprise is that a vaccine or effective treatment becomes available soon. There are already eight human vaccine trials underway, with another 100 in the planning stages. In the race to develop a vaccine, Oxford is arguably in the lead. Scientists at the university’s Jenner Institute have developed a genetically modified virus that is harmless to people, but which still prompts the immune system to produce antibodies that may be able to fight off COVID. The vaccine has already worked well on rhesus monkeys. If it proves effective on humans, researchers hope to have several million doses available by September. On the treatment side, Gilead’s remdesivir gained FDA approval for emergency use after early results showed that it helps hasten the recovery of coronavirus patients. Hydroxychloroquine, which President Trump has touted on numerous occasions, is the subject of dozens of clinical trials internationally. While evidence that hydroxychloroquine can treat the virus post-infection is thin, there is some data to suggest that it can work well as a prophylactic.7 Research is also being conducted on nearly 200 other treatments, including an improbable contender: famotidine, the compound found in the heartburn remedy Pepcid.8  Downside Risk: Too Open, Too Soon Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First As noted above, once the number of new cases drops to sufficiently low levels, some relaxation of containment measures can be achieved without reigniting the pandemic. That said, there is a clear danger that measures will end up being relaxed too aggressively and too soon. This is precisely what happened during the Spanish Flu (Chart 6). It has become customary to talk about the risk of a second wave of infections; however, the reality is that we have not even concluded the first wave. While the number of cases in New York has been falling, it has been rising in many other US states. As a result, the total number of new coronavirus cases nationwide has remained steady for the past five weeks (Chart 7). It is the same story globally: Falling caseloads in western Europe and East Asia have been offset by rising cases in countries such as Russia, India, and Brazil (Chart 8). Chart 7The Spread Of COVID-19 Has Not Been Contained Everywhere (I) Chart 8The Spread Of Covid-19 Has Not Been Contained Everywhere (II)   Chart 9Widespread Social Distancing Has Dampened The Spread Of All Flus And Colds At the heart of the problem is that COVID-19 remains a highly contagious disease. Most studies assign a Reproduction Number, R, of 3-to-4 to the virus. As a point of comparison, the Spanish flu is estimated to have had an R of 1.8. An R of 3.5 would require about 70% of the population to acquire herd immunity to keep the virus at bay.9 As discussed in Box 2, the “true” level of herd immunity may be substantially greater than that. At this point, if you come down with a cough and fever, you should assume you have COVID. As Chart 9 shows, social distancing measures have brought the number of viral respiratory illnesses down to almost zero in the United States. Up to 30% of common cold cases stem from the coronavirus family. Just like it would be foolhardy to assume that the common cold has been banished from the face of the earth, it would be unwise to assume that COVID will not return if containment measures are quickly lifted.   Downside Risk: Permanent Economic Damage Chart 10No Spike In Bankruptcies For Now There are a lot of asymmetries in economics: It is easier to lose a job than to find one; starting a new business is also more difficult than going bankrupt.  The good news so far is that bankruptcies have been limited and most unemployed workers have not been permanently laid off (Chart 10 and Chart 11). Thus, for the most part, the links that bind firms to workers have not been severed.   Chart 11Temporary Layoffs Account For Most Of The Recent Increase In Unemployment   Unfortunately, there is a risk that the economy will suffer permanent damage if unemployment remains high and economic activity stays depressed. For some sectors, such as airlines, long-term damage is nearly assured. It took a decade for real household spending on airlines to return to pre 9/11 levels (Chart 12). It could take even longer for the physiological scars of the pandemic to fade. While businesses outside the travel and hospitality sectors will see a quicker rebound, they could still experience subdued demand for as long as social distancing measures persist. Chart 129/11 Was A Big Shock For US Air Travel There is not much that fiscal policy can do to reverse the immediate hit to GDP from the pandemic. If people cannot work, they cannot produce. What fiscal stimulus can do is push enough money into the hands of households and firms to enable them to meet their financial obligations, while hopefully creating some pent-up demand that can be unleashed when businesses reopen. For now and for the foreseeable future, there is no need to tighten fiscal policy. The private sector in the major economies is generating plenty of savings with which governments can finance budget deficits. Indeed, standard economic theory suggests that if governments tried to “save more” by reducing budget deficits, total national savings would actually decline.10   Nevertheless, just as fiscal policy was prematurely tightened in many countries following the Great Recession, there is a risk that austerity measures will be reintroduced too quickly again. Likewise, calls to tighten monetary policy could grow louder. Just this week, Germany’s constitutional court ruled that the EU Court of Justice had overstepped its powers by failing to require the ECB to conduct an assessment of the “proportionality” of its controversial asset purchase policy. The German high court ordered the Bundesbank to suspend QE in three months unless the ECB Governing Council provides “documentation” showing it meets the criteria of proportionality. Among other things, the ruling could undermine the ECB’s newly launched €750 billion Pandemic Emergency Purchase Programme (PEPP). Downside Risk: Geopolitical Tensions Had the virus originated anywhere else but China, President Trump could have made a political case for further deescalating the Sino-US trade war in an effort to shore up the US economy and stock market. Not only did that not happen, but the likelihood of a new clash between China and the US has gone up dramatically. Antipathy towards China is rising (Chart 13). As our geopolitical team has stressed, the US election is likely to be fought on who can sound tougher on China. With the economy on the ropes, Trump will try to paint Joe Biden as too passive and conflicted to stand up to China. Indeed, running as a “war president” may be Trump’s only chance of getting re-elected. Chart 13US Nationalism Is On The Rise Amid Broad-Based Anti-China Sentiment At the domestic political level, the pandemic has exacerbated already glaringly wide inequalities. While well-paid white-collar workers have been able to work from the comfort of their own homes, poorer blue-collar workers have either been furloughed or asked to continue working in a dangerous environment (in nursing homes or meat-packing plants, for example). It is not clear what the blowback from all this will be, but it is unlikely to be benign. Investment Implications Global equities and credit spreads have tracked the frequency of Google search queries for “coronavirus” remarkably well (Chart 14). As coronavirus queries rose, stocks plunged; as the number of queries subsided, stocks rallied. If there is a second wave of infections, anxiety about the virus is likely to grow again, leading to another sell-off in risk assets. Chart 14Joined At The Hip Chart 15Negative Earnings Revisions Will Weigh On Stocks In The Near Term   Earnings estimates have come down, but are still above where we think they ought to be. This makes global equities vulnerable to a correction (Chart 15). Meanwhile, retail investors have been active buyers, eagerly gobblingup stocks such as American Airlines and Norwegian Cruise Lines that have fallen on hard times recently (Chart 16). They have also been active buyers of the USO oil ETF, which is down 80% year-to-date. When retail investors are trying to catch a falling knife, that is usually an indication that stocks have yet to reach a bottom. As such, we recommend that investors maintain a somewhat cautious stance on the near-term direction of stocks. Chart 16Retail Investors Keen To Buy The Dip   Chart 17Favor Equities Over Bonds Over A 12-Month Horizon   Chart 18USD Is A Countercyclical Currency Looking further out, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon (Chart 17). If global growth does end up rebounding, cyclicals should outperform defensives. As a countercyclical currency, the dollar will probably weaken (Chart 18). A weaker greenback, in turn, will boost commodity prices (Chart 19). Historically, stronger global growth and a softer dollar have translated into outperformance of non-US stocks relative to their US peers (Chart 20). Thus, investors should prepare to add international equity exposure to their portfolios later this year.   Chart 19Commodity Prices Usually Rise When The Dollar Weakens Chart 20Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening   Box 1The Dynamics Of R Box 2Why Herd Immunity Is Not Enough Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 2 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 3 Philip Anfinrud, Valentyn Stadnytskyi, et al., “Visualizing Speech-Generated Oral Fluid Droplets with Laser Light Scattering,” nejm.org (April 15, 2020); Jeremy Howard, Austin Huang, Li Zhiyuan, Zeynep Tufekci, Vladmir Zdimal, Helene-mari van der Westhuizen, et al., “Face Masks Against COVID-19: An Evidence Review,” Preprints.org, (April 12, 2020); and Liang Tian, Xuefei Li, Fei Qi, Qian-Yuan Tang, Viola Tang, Jiang Liu, Zhiyuan Li, Xingye Cheng, Xuanxuan Li, Yingchen Shi, Haiguang Liu, and Lei-Han Tang, “Calibrated Intervention and Containment of the COVID-19 Pandemic,” arxiv.org (April 2, 2020). 4 “COVID-19 – Research Evidence Summaries,” Royal College of Paediatrics and Child Health; and Alison Boast, Alasdair Munro, and Henry Goldstein, “An evidence summary of Paediatric COVID-19 literature,” Don’t Forget The Bubbles (2020). 5 Hiroshi Nishiura, Hitoshi Oshitani, Tetsuro Kobayashi, Tomoya Saito, Tomimasa Sunagawa, Tamano Matsui, Takaji Wakita, MHLW COVID-19 Response Team, and Motoi Suzuki, “Closed environments facilitate secondary transmission of coronavirus disease 2019 (COVID-19),” medRxiv (April 16, 2020). 6 “Coronavirus: Arrests as California beachgoers defy lockdown,” Skynews (April 26, 2020); and “High-risk sex offender rearrested days after controversial release from OC Jail,” abc7.com (May 1, 2020). 7 Sun Hee Lee, Hyunjin Son, and Kyong Ran Peck, “Can post-exposure prophylaxis for COVID-19 be considered as an outbreak response strategy in long-term care hospitals?” International Journal of Antimicrobial Agents (April 25, 2020). 8 Brendan Borrell, “New York clinical trial quietly tests heartburn remedy against coronavirus,” Science (April 26, 2020). 9 In the simplest models, the herd immunity threshold is reached when P = 1-1/Ro, where P is the proportion of the population which has acquired immunity and Ro is the basic reproductive number. Assuming an Ro of 3.5, heard immunity will be achieved once more than 71.4% of the population has been infected (1-1/3.5). For further discussion on this, please refer to Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. 10 It is easiest to understand this point by considering a closed economy where savings, by definition, equals investment. Savings is the sum of private and public savings. Suppose the economy is depressed and the government increases public savings by either raising taxes or cutting spending. Since this action will further depress the economy, private investment will fall even more. But, since investment must equal total savings, private savings must decline more than proportionately with any increase in public savings. This happens because tighter fiscal policy leads to lower GDP. It is difficult to save if one does not have a job. To the extent that lower GDP reduces employment, it also tends to reduce private-sector savings. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights Base metals are rebounding faster than oil in 2Q20, reflecting China’s first-in-first-out recovery from the global GDP hit caused by the COVID-19 pandemic (Chart of the Week). By 3Q20, the rebound in oil markets could be stronger than expected and surpass the base metals’ recovery, if the IMF’s latest EM GDP growth projections prove out. We examine a higher-growth scenario for non-OECD oil consumption – our proxy for EM demand – using the Fund’s projections. In it, EM oil consumption rises to 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021, if realized. Stronger EM consumption, coupled with global crude-oil production cuts would cause crude and product inventories to draw sooner and faster than expected, if these trends continue. Global policy uncertainty – economic and political – remains the critical risk to our metals and oil price outlooks, as it could retard a revival of growth and trade. The US and China appear to be on a collision course once again. Serious risks to global public health remain, particularly in light of a recently disclosed mutation to COVID-19. Feature Base metals are rebounding faster than oil in 2Q20, reflecting China’s first-in-first-out recovery from the global GDP hit caused by the COVID-19 pandemic. Prices for base metals likely will continue rebounding from the global hit to GDP caused by COVID-19 and its associated lockdowns, recovering more of the ground lost to the pandemic in 2Q20 than crude oil prices. This is largely a reflection of China’s first-in-first-out recovery from the global pandemic and the aggregate demand destruction following in its wake. This is the signal coming from our updated market-driven indicators shown in the Chart of the Week.1 China accounts for ~ half of the demand for refined base metals worldwide, and a comparable share of the supply side for refined metals and steel (Chart 2). Chart of the WeekBase Metals Rebounding Faster Than Crude Oil We use principal components analysis to extract common factors driving industrial commodity prices in real time from trading markets, which allows us to get a preliminary estimate of the recovery in base metals and crude oil demand. The two indicators shown in the Chart of the Week use daily stock and commodity prices, and other daily economic data. These indicators are called the Metals Demand Component and the Oil Demand Component. The former is largely dependent on the recovery in China/EM industrial activity, and also affects all cyclical commodities, including oil. Chart 2China Dominates Base Metals Supply And Demand Chart 3Policy Stimulus Will Restore Profitability In China The base metals’ rebound likely will continue throughout 2H20 as China’s economic activity gradually normalizes, fiscal and monetary stimulus kick in, and firms’ profitability recovers (Chart 3). “China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3,” based on the analysis of our colleagues in BCA’s China Investment Strategy.2 A weaker USD will start showing up in stronger indications of global growth – particularly in the EM markets – which will reverse the downtrend in our data-driven indicators of economic activity (Chart 4). However, given the lags in the release of these data, this will take time. Currently, our Metals Demand Component suggests the trend in base metals demand is upward and established, while our Oil Demand Component is still quite volatile and not yet decisively upward. Nonetheless, our oil indicator does highlight what appears to be a bottom in oil demand. Chart 4A Weaker USD Will Reverse Lagging Indicators Of Activity EM Demand Surge Will Revive Oil Prices The EM oil-demand growth forecast derived from the IMF’s GDP projections indicate growth could rise to as much as 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021, if realized. Over the short term, oil prices could diverge from demand until storage builds are contained and the market moves into a deficit. The logistics of moving and storing oil remains the primary driver of its price over the very short term, especially for landlocked crudes. The drain in storage could occur earlier than we expected in our forecast last month, if the IMF’s global growth trajectory play out in line with its latest projections.3 Using the Fund’s projections for EM GDP, we examine a scenario in which non-OECD oil demand grows significantly more than we estimated last month. Indeed, the EM oil-demand growth forecast derived from the IMF’s GDP projections indicate growth could rise to as much as 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021 (Chart 5), if realized. EM growth is the critical variable for global oil-demand growth, accounting for ~ 80% of global consumption growth in the past five years. As we’ve noted for some time, the massive fiscal and monetary stimulus being deployed globally will fuel the recovery of commodity demand (Chart 6). The oil-demand scenario driven by the IMF’s latest GDP projections, and the EIA’s April forecast share a common view of a sharp recovery in the level of non-OECD demand, with the former seeing demand destruction reversed by September, and the latter expecting EM consumption to return to pre-COVID-19 levels toward the end of this year, slightly ahead of us.4 Chart 5EM Oil Demand Could Surge On The Back Of Massive Global Stimulus Chart 6Global Fiscal and Monetary Stimulus Will Surge In 2020 And 2021 A surge in EM oil-demand growth – should it play out as expected – will occur against the backdrop of sharply lower global production levels this year. OPEC 2.0 pledged to cut ~ 8mm b/d starting this month vs. its 1Q20 levels, with its putative leaders – KSA and Russia – accounting for ~ 1.5mm b/d and 2mm b/d, respectively, of the reductions. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to almost 10mm b/d for May-June, and 7.7mm b/d for 2H20).5 In addition, the US likely will lose close to 2.5mm b/d from involuntary cuts between now and the end of 2021 due to the global oil price collapse (Chart 7).6 Chart 7US Shale-Oil Output Could Fall ~ 2.5mm b/d OPEC 2.0 Might Have To Lift Production The demand surge implied by the IMF’s expected EM GDP recovery this year and next almost surely would be met by higher output in OPEC 2.0 production. The demand surge implied by the IMF’s expected EM GDP recovery this year and next almost surely would be met by higher output in OPEC 2.0 production, to keep prices from charging ahead too sharply in 2H20 and in 2021. The increase in the coalition’s spare capacity – consisting of the production taken off the market through production cuts and the 2.5mm b/d or so that it had prior to the COVID-19-induced demand destruction – will allow OPEC 2.0 to quickly meet any supply shortfalls as demand recovers before the US shale-oil producers can ramp production. All the same, the market could experience episodic volatility on the upside, if our EM demand calculations based on IMF GDP projections and those of the EIA are correct. It is highly likely, in our view, OPEC 2.0 will be the direct beneficiary of the massive fiscal and monetary stimulus of the DM and EM economies– oil being a derived demand that depends on the income available to firms and households. This means the odds of seeing $80/bbl Brent is more likely than not next year: Importantly, EM and DM consumers will be better equipped to absorb higher oil prices with the massive stimulus sloshing around the global economy next year. For now, we are maintaining our expectation of $65/bbl average prices for Brent next year, but we will continue to watch EM GDP growth in upcoming World Bank and IMF research (Chart 8). Chart 8Upside Risks in Oil Prices As GDP Growth Prospects Improve Oil Price Risks Abound An upside surprise in EM oil-demand growth – consistent with the IMF’s revised GDP projections – could cause us to increase our demand expectation when we update balances and forecasts this month. Two-way price risk abounds in the oil markets. Even if options volatility on the CBOE is considerably lower than its recent record-setting peak, it still is close to 100% on an annualized basis (Chart 9). On the upside, as we’ve discussed above, if EM GDP growth is in the neighborhood projected by the IMF, demand could surge, based on our calculations. We have no doubt OPEC 2.0 can cover any shortfall, but it can’t do it immediately, so we would expect episodic volatility this year and next. Chart 9Oil Price Risk Abounds On the downside, the COVID-19 pandemic could enter a second wave just as governments around the world are removing lockdown orders and phasing in a return to normal commerce. Of particular note in this regard is the emergence of a mutation of the original strain of the COVID-19 virus that is more contagious, and now constitutes the dominant strain in the world. The mutated form of the virus appeared in Europe and quickly spread to the US east coast, and then the rest of the planet.7 Also, the risk that “animal spirits” will not re-emerge in businesses and consumers globally remains elevated. Despite the large increase in global money supply, confidence needs to be restored for the money multiplier to move up. In addition to that, signs of another round in the Sino-US trade war in the offing could restrain growth and trade. Bottom Line: Our base case remains a resumption in global growth in 2H20, with base metals recovering most of their lost ground in 2Q20 and oil following in 3Q20. An upside surprise in EM oil-demand growth – consistent with the IMF’s revised GDP projections – could cause us to increase our demand expectation when we update balances and forecasts this month. However, serious risks to global public health remain, and trade tensions between the US and China once again are percolating.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Refinery runs in the US collapsed by 25% this year in the wake of the COVID-19-induced economic shutdown. Still, WTI prices rose 30% this week – from a very low level – as oil supply in the US – and globally – is adjusting rapidly to lower demand (Chart 10). Wells shut-ins are accelerating throughout North America. In the Bakken Basin, shut-ins reportedly reached 400k b/d this week.8 Moreover, the effect of the 50% YTD decline in US rig count will be visible over the coming weeks. The rig count is now well below the level necessary to keep production flat. Precious Metals: Neutral Gold prices remained above $1,700/oz as of Tuesday’s close, supported by elevated economic uncertainty. Virus-related uncertainty will gradually wane as economies reopen. This could pull gold down temporarily as safe-asset demand is reduced. Nonetheless, our Geopolitical team believes risk and uncertainty will partly shift to the geopolitical arena in the run-up of the US election.9 Additionally, the massive stimulus by the US Fed and Treasury will become an important driver of the yellow metal’s price going forward. Gold will trend higher as US rates remain stuck at zero, as it did in 2008 (Chart 11). Ags/Softs:  Underweight Following lockdown easing measures in different parts of the world, hopes of a rebound in ethanol demand helped push CBOT Corn futures 0.5% higher on Tuesday. Additionally, continuing drought conditions in Brazil will limit the country’s yields and support corn prices in the near term. Soybeans climbed 3¢/bu on Tuesday, backed by China’s booking of 378k tons of the oilseed as it seeks to fulfill the US trade deal obligations. Gains throughout corn and soybeans were mitigated by a strong planting progress as reported by the USDA. Wheat ended slightly higher after field assessments conducted by Oklahoma State University Extension projected the state harvest down by 13.5 Mn bushels year-on-year. Chart 10Crude Recouping Some Ground Chart 11Fed Rates Stuck At Zero Will Push Gold Higher   Footnotes 1     Given the importance of the daily prices in these indicators, we are explicitly assuming trading markets are continually processing fundamental information on supply, demand, inventories, and financial and economic conditions in industrial commodity markets and reflecting them in prices. This is especially important when an exogenous event like the COVID-19 pandemic hits global markets. Market participants have to work out the implications of the shock and its resolution in real time, which can make for exceptionally volatile prices. Lags in the economic data provided by the likes of the World Bank, the IMF, EIA, IEA and OPEC make the time series we typically rely on to model fundamentals and their expected evolution less effective in estimating the current state of commodity markets. Their forecasts, however, remain extremely useful, as they are developed by analysts with particular expertise in global macroeconomic forecasting, in the case of the World Bank and IMF, and oil markets, in the case of the EIA, IEA and OPEC. 2     Please see A Slow And Rocky Path To Recovery published by BCA Research’s China Investment Strategy April 29, 2020. It is available at cis.bcaresearch.com. 3    Please see US Storage Tightens, Pushing WTI Lower for our most recent supply-demand balances and oil price forecasts, which were published April 16, 2020. We use the global growth forecasts of the IMF and the World Bank as inputs to our fundamental modeling to estimate oil demand. In particular, we’ve found a parsimonious relationships between OECD, non-OECD and world oil demand and DM and EM GDP. Chapter 1 of the Fund’s advance forecast was published last month in its World Economic Outlook under the title “The Great Lockdown.” 4    Assuming the Fund’s projections of EM GDP are approximately correct, the impact on oil demand is quite large as can be seen in the comparisons shown in Chart 5. However, the IMF’s estimate for oil prices is sharply below our estimate, which was made last month assuming lower levels of EM oil demand. We expect Brent crude oil prices to average $39/bbl this year and $65/bbl next year, vs. the Fund’s estimate of $35.61/bbl in 2020 and $37.87/bbl in 2021. The EIA’s estimate of non-OECD demand is comparable to our, as seen in Chart 6, but its price forecasts for this year and next – $33/bbl and $46/bbl – also are below ours. 5    Please see US Storage Tightens, Pushing WTI Lower, where we outline OPEC 2.0’s cuts. 6    Please see our April 30 report entitled Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl for additional discussion. 7     Please see The coronavirus has mutated and appears to be more contagious now, new study finds published by cnbc.com May 5, 2020. 8    Please see 'Like watching a train wreck': The coronavirus effect on North Dakota shale oilfields published by reuters.com May 4, 2020. 9    Please see #WWIII published by BCA Research’s Geopolitical Strategy May 1, 2020. It is available at gps.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades

Special Report

Highlights If the current low oil price environment is transitory, temporary fiscal tightening can be used to preserve the exchange rate peg. In our view, low oil prices are structural - crude prices will likely average $40 and lower in the coming years. In such a scenario, fiscal tightening cannot be a solution because it will unleash eternal economic malaise. Hence, currency devaluation will become necessary. Even though Saudi Arabia’s currency devaluation is not imminent, the risk-reward of selling the SAR/USD in the forward market is attractive. We recommend investors sell Saudi Arabian riyals in the forward market as a long-term bet. Feature The plunge in oil prices has revived the debate on the sustainability of the Saudi currency peg. This report argues that currency devaluation is not imminent, given that Saudi authorities have sufficient foreign currency reserves to fund balance of payment (BoP) deficits for some time. Beyond that, if oil prices average $40 and lower, Saudi’s exchange rate peg will come under pressure. Depleting Foreign Exchange Reserves Chart I-1Saudi Arabia: Oil Prices And Balance Of Payments In this section, we estimate how oil prices will impact the level of Saudi Arabia’s gross foreign exchange (FX) reserves. Odds are that oil prices have experienced a structural breakdown and will average no more than $40 per barrel in the next three years.1 To preserve the riyal’s peg to the US dollar, the Saudi authorities will have to plug the gap in foreign funding requirements (FFR). We define the FFR as the sum of the current account balance and the capital account balance without taking into account government external borrowing. The nation’s current account balance and FFR along with oil prices are shown in Chart I-1. For the purpose of this simulation, we assume an average oil price of $40, $40, and $35 a barrel in 2020, 2021 and 2022, respectively. Our full set of assumptions for Table I-1 are provided in Box I-1. Our findings from the simulation are as follows: Saudi Arabia’s FFR deficits will amount to $94 billion in 2020, $96 billion in 2021 and $82 billion in 2022 (Table I-1, row G). We assume the government’s external (US dollar) borrowing will cover 50% of FFR in 2020, 2021, and 2022. The rest will be financed by drawdowns from the Saudi Arabian Monetary Authority’s (SAMA) gross FX reserves. The latter will decline by $47 billion in 2020, $48 billion in 2021 and $41 billion in 2022. Indeed, over the first three months of this year, the monetary authorities’ FX reserves have already dropped by around $26 billion. Hence, our forecasts for annual change in the central bank’s FX reserves are reasonable. Saudi Arabia’s gross FX reserves will drop to $360 billion by the end of 2022 from the current $471 billion (Table I-1, row J). This roughly represents a 23% decline. In terms of fiscal dynamics, the fiscal balance will register deficits of 14%, 16% and 17% of GDP in 2020, 2021 and 2022, respectively (Table I-1, row C). Assuming the government decides to fund 75% of the deficits by issuing bonds and the other 25% by drawing on FX reserves at SAMA, the public debt-to-GDP ratio will rise from around 23% currently to 61% by the end of 2022 (Table I-1, row D). Box I-1Simulation: Estimating Potential Drawdowns In Foreign Currency Reserves The Money Supply Coverage Ratio The Saudi Currency Law of 1959 stipulates that currency issued by SAMA must be backed by foreign currencies and gold. Indeed, Chart I-2 reveals that SAMA is in compliance with that law. Its holdings of gold and foreign currencies closely track the sum of currency in circulation and the cash stored in SAMA’s and banks’ vaults. This monetary construct made sense in the 1960s when much of the money supply was made up of cash currency, meaning that electronic money/bank deposits were still too small to matter. Odds are that oil prices have experienced a structural breakdown and will average no more than $40 per barrel in the next three years. Currently, currency in circulation makes up only 11% of the broad local currency money supply, hereafter referred to as the broad money supply. The latter is calculated as M3 minus foreign currency deposits and includes cash in circulation and all local currency deposits (electronic money). Demand deposits make up 63% of the broad money supply, while savings and time deposits account for 25% (Chart I-3). In a nutshell, the currency in circulation amounts to SAR 199 billion, while the broad money supply stands at SAR 1866 billion. Chart I-2The Monetary Rule That SAMA Follows Chart I-3Composition Of Broad Money Supply   Individuals, companies and foreigners can use the entire broad money supply - cash in circulation and all local currency deposits (electronic money) - to buy foreign currency in Saudi Arabia. In nutshell, time and savings deposits can be converted into demand deposits upon the expiration of their term or immediately after the payment of a penalty. Therefore, the proper formula for calculating the international FX reserves-to-money supply coverage ratio is as follows: Money coverage ratio = (central bank’s foreign exchange reserves) / (broad local currency money supply). For the reasons elaborated above, the denominator should be the broad money supply, not just the amount of currency in circulation. To calculate the Saudi Arabia’s money coverage ratio, we use not only SAMA’s holdings of gold and foreign currencies, but also all its foreign currency securities, including bonds, stocks and other foreign assets, including private equity investments. The top panel of Chart I-4 illustrates that the broad money supply is now equal to the central bank’s gross foreign exchange reserves, i.e., the nation’s money coverage ratio is currently close to one. Hence, in short, the level of FX reserves is currently adequate. Chart I-4Saudi Arabia: FX Reserves And Broad Money Supply Crucially, if SAMA chooses to maintain the economy’s broad money supply such that it is equal to its holdings of gross international FX reserves, then it will have to shrink the money supply substantially as its foreign exchange reserves are depleted considerably over the course of the next three years. Our projections in Table I-1 suggest that SAMA’s gross foreign exchange reserves will likely drop by about 25% between January 1, 2020 and the end of 2022. If Saudi authorities attempt to maintain the money coverage ratio at around one, the broad money supply will also have to shrink by the same order of magnitude. We reckon that it will be very painful economically and, thereby, socially and politically undesirable to follow a monetary regime that requires a 25% contraction in the nominal broad money supply over the next three years. Money supply will likely be allowed to exceed the authorities’ gross foreign exchange reserves. This will prompt doubts about the sustainability of the exchange rate peg. For instance, in 2015-2016, the broad money supply in Saudi Arabia actually expanded by 6% over a two year period even though gross international FX reserves declined by 27% (please refer to Chart I-5 on page 7). The difference between then and now is that gross international reserves in the 2015-2016 period were greater than the broad money supply, which means that the money coverage ratio was well above one (Chart I-4, bottom panel). Chart I-5Bank Credit/Money Growth Can Diverge From FX Reserves In brief, in 2015-16, SAMA had leeway to tolerate a major drop in its gross foreign exchange reserves without needing to shrink the broad money supply. However now with the money coverage ratio close to one, SAMA does not have that much room to maneuver. Odds are that the money supply will not be allowed to drop as low as the forthcoming drop in the central bank’s gross foreign exchange reserves given the enormous deflationary pressures that would be unleashed. Consequently, the nation’s money coverage ratio will likely drop well below one. This will likely prompt doubts about the sustainability of Saudi Arabia’s exchange rate peg. Bottom Line: Attempts by SAMA to maintain the money coverage ratio at or close to one – to ensure a solid currency peg –will entail a substantial shrinkage in the broad money supply. The latter will herald immense contractionary and deflationary pressures in the real economy. This scenario is economically, socially and politically unviable. Hence, money supply will likely be allowed to exceed the authorities’ gross foreign exchange reserves. This will prompt doubts about the sustainability of the exchange rate peg. A New Era Of Higher Currency Risk Premiums The simulation in Table I-1 projects that KSA’s foreign exchange reserves will drop by about 25% by the end of 2022. If the broad money supply grows even 5% per annum over the next three years (the current annual growth rate being 11%), the money coverage ratio will drop from its current 0.95 to about 0.61. As Saudi Arabia’s foreign exchange reserves increasingly fall short of its broad money supply, the currency peg will enter a new era where doubts about the currency peg’s sustainability will begin to grow. Consequently, currency forwards will start pricing in higher chances of devaluation. Given that a central bank’s sale of international FX reserves to non-banks shrinks the banks’ excess reserves and broad money supply,2 a pertinent question is: how and why can broad money supply still grow? The broad money supply can still expand even when the central bank sells its foreign exchange reserves. The local currency money supply expands when the central bank or commercial banks lend to or purchase assets from non-bank entities. This includes their purchases of government bonds on both the primary and secondary markets. Chart I-5 reveals that broad money supply growth in Saudi Arabia correlates with commercial banks’ assets and is not always aligned with SAMA’s gross FX reserves. Chart I-6Money Multiplier = Broad Money Supply / Banks' Excess Reserves Overall, it is possible for the broad money supply to expand in Saudi Arabia even if SAMA depletes its FX reserves to fund BoP deficits. For this to occur, banks and/or SAMA need to lend to or purchase securities from non-banks (including from the government) in greater amounts than SAMA’s sales of its FX reserves. Besides, the central bank may or may not need to provide funding (excess reserves) to the banking system to accommodate an expanding money supply (Chart I-6). Going forward, KSA’s broad money supply will be shaped by the following dynamics. On the one hand, sales of SAMA’s foreign exchange reserves will reduce its broad money supply. On the other hand, commercial banks’ lending to non-banks, alongside their purchase of government securities, will expand the money supply. In aggregate, the money supply might grow modestly even as the country’s foreign currency reserves plummet. However, this implies that the FX reserves-to-money supply coverage ratio will drop well below one. This is unlikely to break the currency peg in the medium term. There is no theory or historical precedent to indicate the level at which the money coverage ratio causes the peg to crumble. It is often much more about confidence in the exchange rate regime than about the precise level of this ratio. Chart I-7 illustrates the money coverage ratio for different economies. KSA has the highest money coverage ratio among emerging markets. Chart I-7The Money Coverage Ratio: A Cross-Country Perspective However, there are several reasons why this ratio should structurally be higher in Saudi Arabia than in other EM economies: First, unlike the majority of EMs, KSA runs a currency peg and the latter warrants different standards regarding the money coverage ratio. Foreign exchange reserves falling well below the broad money supply will gradually undermine the integrity of its monetary regime and shake confidence in its sustainability. Chart I-8Saudi Arabia: FX Reserves And Interest Rates Second, the Impossible Trinity thesis suggests that in an economy with an open capital account, the central bank is forced to choose between controlling either the currency or interest rates. Since there are no capital controls in Saudi Arabia and the central bank fixes the riyal to the US dollar, SAMA has little control over interest rates. The country is therefore forced to import US interest rates. Provided US interest rates are now close to zero and the plunge in oil revenues has unleashed a recession in Saudi Arabia, the very low interest rates that Saudi Arabia imports from the US are currently adequate. This, however, does not mean that Saudi interest rates cannot deviate from US ones. Chart I-8 illustrates that SAMA’s sales of FX reserve assets could lead to a rise in local interbank rates in absolute terms or relative to US ones. This is because when the central bank is selling US dollars, it tends also to shrink the banking system’s excess reserves, which forces commercial banks to bid the price of inter-bank liquidity higher. Third, a central bank cannot simultaneously control the exchange rate and the quantity of monetary aggregates. In other words, SAMA cannot both peg the currency to the US dollar and have control over the level of money supply. This constraint is similar but not identical to the above point about the relationship between exchange and interest rates. To illustrate this trade-off: when SAMA draws down its international reserves to fund a BoP deficit, the money supply will shrink. If the authorities simultaneously encourage and allow the banks to lend to or purchase securities from non-banks, including the government, the money supply will expand. This newly created money could find its way to the currency market (in the form of greater imports or capital outflows) and could bid up the price of the US dollar versus SAR. To defend the peg, SAMA will have to sell more of its foreign currency reserves and purchase SAR, thereby, contracting the money supply again. In short, because of the currency peg, SAMA might not be able to simultaneously control the level of money supply and defend the peg. Finally, unlike many other EM economies, KSA has little domestic productive capacity and relies heavily on imports to satisfy domestic demand for goods and services. Given the nation’s high propensity to import, new riyals created by the banking system have a higher chance of flowing to the foreign exchange market, weighing on the value of the currency and jeopardizing the peg. In Saudi Arabia, fiscal policy is of paramount importance to upholding the currency peg when oil revenues plunge. Other EM economies like the Brazilian or Russian ones do not face such a constraint because they do not have pegged currency regimes. Other economies such as China’s and Korea’s have substantial domestic productive capacity to meet new domestic demand. So, in the latter economies only a small portion of new money creation flows to the foreign exchange market. Bottom Line: Given that it is operating a fixed exchange rate regime, KSA’s money coverage ratio should structurally be higher than that of many other emerging economies. As this ratio drops well below one in the next couple of years, the risk premium in SAR forwards will rise as the market moves to price a higher probability of devaluation. Fiscal-Monetary Nexus In Saudi Arabia, fiscal policy is of paramount importance to upholding the currency peg when oil revenues plunge (Chart I-9). The basis for this is the fact that in Saudi Arabia fiscal policy plays a larger role than monetary policy in driving domestic demand. Chart I-10 demonstrates that government spending amounts to 36% of GDP annually while new annual credit origination is only about 4% of GDP. Chart I-9Oil Prices And Government Spending Chart I-10Fiscal Spending Is Much More Important Than Credit Creation   Even though the government has already embarked on a considerable fiscal austerity program, the nation will continue to face very large fiscal deficits. Our simulation forecasts fiscal deficits of 14% of GDP in 2020, 16% in 2021 and 17% of GDP in 2022 (please refer to row C in Table I-1 on page 3). Chart I-11Fiscal Spending Drives Imports Saudi imports are very sensitive to government spending while government revenues correlate with exports (Chart I-11). Swelling fiscal deficits can be funded by issuing both foreign and local currency bonds. However, each type of borrowing has different implications for the exchange rate, interest rates and the money supply. There are several ways in which the fiscal-monetary nexus can play out in Saudi Arabia.3 The government can draw down on its FX reserves at SAMA to fund the fiscal deficit. This will quickly erode the central bank’s gross FX reserves and, consequently, undermine confidence in the currency peg. The government can borrow externally (in foreign currency) to cover both the budget and BoP deficits. However, in this case, the government’s foreign currency debt will mushroom and the nation’s sovereign credit risk and, thereby, cost of external borrowing will rise.  The fiscal deficit can be funded by issuing local currency bonds sold to non-banks only. Given the sheer size of required government funding over the next couple of years, local interest rates will rise significantly as the government competes to attract a limited amount of existing deposits. Overall, this will crowd out the private sector which will have negative ramifications on the economy. However, the currency peg will not be jeopardized as the money supply will shrink dramatically in this scenario. The government can fund itself by borrowing from domestic commercial banks, i.e., by issuing local currency paper to be bought by banks. The government will get new local currency deposits and will not compete for existing deposits. This will not produce a crowding out effect and interest rates will not rise. As we have discussed in past reports, commercial banks do not require deposits or savings to lend money or to purchase securities. Everywhere, commercial banks – with regulatory forbearance and shareholder consent – can purchase literally an unlimited amount of government bonds thereby financing the nation’s large fiscal deficits. Critically, when commercial banks buy local currency government bonds, they create new local currency deposits “out of thin air”. This scenario would be equivalent to the monetization of public debt. Money supply will expand briskly and the money coverage ratio will drop. The outcome will produce downward pressure on the currency’s value as new money/deposits created by commercial banks will end up eating into the country’s finite foreign exchange reserves via imports and capital outflows, as discussed above. While commercial banks can easily fund the fiscal deficit by creating money “out of thin air”, the former will likely bolster demand for dollars and endanger the currency peg. Bottom Line: The Saudi government will likely resort to all four mechanisms to fund itself. Given the large size of its fiscal deficit, financing it entirely via external borrowing or the depletion of FX reserves is unattainable. Therefore, issuance of local bonds will continue at a rapid pace, with the following implications: If local bonds are bought by non-banks, local interest rates will be pushed higher, crowding out the private sector with negative ramifications for the economy; or If local bonds are bought by commercial banks, the money supply will expand meaningfully, thereby drastically reducing the money coverage ratio and exerting substantial pressure on the currency peg. Neither of these scenarios can be sustained in the long run. Investment Conclusions Chart I-12SAR/USD Forwards And Oil Prices If the era of low oil prices is transitory, temporary fiscal tightening can be used to preserve the peg. In our view, low oil prices are structural – crude prices will likely average at most $40 per barrel in the coming years. In such a scenario, fiscal tightening cannot be a solution because it will unleash eternal economic malaise. Hence, currency devaluation will be unavoidable. Critically, the longer the authorities preserve the peg in the face of lower oil prices, the larger the devaluation will ultimately be. Based on historical experiences of other economies that delayed their own currency adjustments, the devaluations that they eventually faced were between 30-50%. Despite the collapse in oil prices, the SAR/USD long-term forwards are underpricing the risk of devaluation (Chart I-12). If the downshift in oil prices is more permanent than the one in 2015 – as we believe it will be – the SAR/USD long-term forwards offer a good opportunity. As a structural trade, we recommend investors to sell the 3-year SAR/USD forward. The current entry point is attractive. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes   1  This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2  Commercial banks’ excess reserves are not part of the broad money supply. This applies to all economies, regardless of their exchange rate regime. 3  By that we mean the interplay between government financing/borrowing and the resulting changes in money supply, interest rates and the exchange rate.  

Highlights The current pace in the recovery of China’s domestic demand has not been robust enough to fully offset the impact from the collapse in exports. The level of industrial inventory jumped to a five-year high, but it will likely be transitional. We expect the inventory overhang to subside when the recovery speed in demand catches up with supply in H2.  While the gap is widening between stock prices and economic fundamentals in the US, Chinese equity prices have been more “well behaved” in the past month. We continue to overweight Chinese stocks in the next 6 to 12 months and favor Chinese onshore corporate bonds overall and SOEs in particular. Feature China’s Caixin and official PMIs in April highlighted the knock-on effects on the Chinese economy from a collapse in external demand. Although China’s domestic economy continued its rebound, the pace of the improvement has not been robust enough to offset rapidly weakening exports. This was evident in the widening gap between supply and demand in April. The sharp contraction in the global economy in Q1 will likely deepen in Q2 because the lockdowns in Europe and the US started in the later part of Q1 and have mostly remained in place through end-April. We expect global demand to significantly worsen in April and May, generating strong headwinds to China’s near-term recovery. Chinese authorities have been prompted to step up their stimulus efforts due to a fast deterioration in global growth. The government recently approved an additional 1-trillion yuan in local government special-purpose bond issuance, which is scheduled to be fully dispersed by the end of May. China’s stimulus, strongly focused on boosting investment and economic growth, should fuel Chinese stock and industrial metal prices in the next 6 to 12 months. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Chart 1Construction Sector Has Seen The Strongest Rebound China’s domestic demand partially offset a collapse in exports in April. The official manufacturing PMI slipped to 50.8 in April from 52 in the previous month. The Caixin PMI survey, which is skewed towards smaller and more export-oriented firms, returned to contractionary territory in April following a brief rebound in March. The retreat in both PMI readings highlights how a worldwide lockdown of businesses has shaken China’s manufacturing sector (Chart 1, top panel). This exogenous negative impact will likely worsen in Q2. China's domestic economy continued its slow recovery through April. The official PMI’s new orders subcomponent declined by only 2 percentage points, despite a collapse of new export orders to 33.5. Moreover, the new orders subcomponent of the non-manufacturing PMI survey increased from 49.2 to 52.1, with the construction subcomponent reverting to its pre-pandemic level. The construction employment subcomponent also confirms that the industry has shown the strongest rebound among sectors in the Chinese economy (Chart 1, middle and bottom panels). Chart 2Home Sales Are Likely To Accelerate China’s housing market also continued to improve in April. Chart 2 (top panel) shows that the demand for both residential housing and floor space started rebounding in March. The high frequency data indicate the year-over-year growth rate in home sales in China’s 30 large- and medium-sized cities turned positive in April (Chart 2, middle panel). The rapid expansion in home sales in the past weeks may be due to recent discount promotions, but we anticipate housing prices to remain stable this year in line with the Chinese leadership’s policy direction (“houses are for living, not for speculation”). We also expect that the number of home sales will accelerate.  Local governments will significantly ramp up land sales this year to make up for their large revenue shortfalls.  The central government will continue to gradually relax real estate purchase restrictions. The more property market-friendly policies, coupled with extremely accommodative monetary conditions, will encourage a healthy rally in property market investment and housing demand in H2 (Chart 2, bottom panel). So far most improvement in China’s domestic demand seems to be concentrated in the construction sector.  The slow pace of manufacturers’ capacity utilization suggests that China’s industrial output growth is unlikely to return to its pre-pandemic rate in Q2. As of April 25, among the official PMI surveyed enterprises, the resumption rate of large- and medium-sized enterprises was 98.5%. However, only 77.3% of them reported that they were operating at 80% or higher of their usual capacity utilization rates.1 Chart 3Pressure On Inventory Should Start To Ease In H2 The imbalance in the recoveries of China’s supply and demand has led to a pileup in inventory, the highest level in five years (Chart 3).  The combination of excessive inventory and low demand has weakened China’s factory pricing power and profit growth. However, in our view, the inventory overhang will be temporary, and the factory price contraction is unlikely to turn into a deep deflation such as the one in 2009 or the long-lasting deflationary cycle from 2012-2015. The level of industrial inventory has been much lower than it was during the four years leading to the 2008/2009 global financial crisis (GFC) and the 2015/2016 deep deflationary cycle. The deflation in factory prices also has been relatively mild compared with the two previous phases. Moreover, an extremely tight monetary policy and protracted inventory destocking period that contributed to the collapse in global raw material prices in 2012 are not present. Declines in China’s manufacturing, raw material and mining prices are synchronized, echoing the GFC when global demands nose-dived and pushed international oil and raw material prices into deep contractions. Our baseline scenario of an incremental re-opening of the global economy, a peak in the US dollar, and a recovery in the oil market in H2, all support our view that the deflation in China’s producer prices should not last beyond Q3. Given that exports’ share to China’s GDP is currently half of what it was in 2008, the weakness in global demand will be much less of a drag on China’s domestic manufacturing sector than during the GFC. Chart 4Logistics Bottleneck Still In Place Additionally, the drawdown in April’s raw material inventory and an increase in the official PMI’s supplier delivery subcomponents suggest that some lingering logistical bottlenecks may be at play, preventing China’s domestic business operations from recuperating at full speed (Chart 4). We expect a further relaxation of intra- and inter-provincial travel restrictions following the National People’s Congress (NPC) on May 22 in Beijing. This easing should help to accelerate the normalization in both manufacturing activities and inventory levels. The outperformance of Chinese equity prices versus global stocks has eased significantly in the past month (Table 3 and Chart 5). The moderation suggests that investors may be starting to factor in a slower-than-expected economic recovery in China. Near-term risks are still high for further selloffs in both Chinese and global stocks. Nevertheless, we think the rapid advancement in global stock prices in the past month, particularly the SPX, means that Chinese stocks are not as overbought as in February and March. The widening gap between US equity prices and economic fundamentals makes the SPX more vulnerable to near-term uncertainties surrounding global economic recovery. We maintain our view that a combination of massive Chinese stimulus and the momentum in China’s economic recovery in H2 should support an outperformance in Chinese stocks in the next 6 to 12 months. Table 3Chinese Stocks Advanced Much Less Than SPX In April Chart 5Chinese Stocks Less Overbought Now The bull steepening in the government bond yield curve since March 23 flattened a bit in the last week of April, but it remains heightened with the short end of the yield curve falling much faster than the long end (Chart 6). This suggests that domestic investors expect China’s ultra-easy monetary policy to remain in place in the near term due to uncertainties surrounding the global pandemic and a slow economic upturn. At the same time, investors do not believe the weakness in the Chinese economy will persist long enough to warrant a sustained easy monetary policy regime. In addition, China’s 10-year government bond yield fell by 60bps so far this year, about half of the drop in the 10-year US Treasury bond yield (Chart 6, bottom panel). Even though we think the long end of the government bond yield curve has yet to bottom,2 the relatively stable return and RMB exchange rate make Chinese government bonds a safe bet for global investors seeking less risky assets. Chart 6Chinese 10-Year Government Bond Yield Has Not Capitulated Chart 7Chinese Onshore Corporate Bonds Still Offer Solid Returns Chart 7 highlights that the ChinaBond Corporate Bond total return index remains in a solid uptrend in both local currency and USD terms, despite the incredible strength in the USD since March. We continue to recommend onshore corporate bond positions in the coming 6-12 months.For domestic investors, we favor a diversified portfolio of SOE corporate bonds. Even though bond defaults will likely rise in the next 6-12 months, they will probably remain lower than what the market is  currently pricing in.     Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1NBS’s interpretation of China April PMI.  http://www.stats.gov.cn/tjsj/sjjd/202004/t20200430_1742576.html  2Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations