Economy

Special Report

Highlights Since 2004, Sweden’s private sector leverage trend can be explained using a simple Taylor rule approach. The approach clearly highlights three distinct monetary policy phases, and underscores the singular role of inflation (not systemic risk from rising indebtedness) as a driving factor for Riksbank policy. Since 2015, the Riksbank has maintained interest rates well below what a Taylor rule approach would suggest, owing to the desire to raise inflation expectations and Sweden’s high trade exposure to the euro area. This highlights strong similarities between the experience of Sweden and Canada: both countries are in the orbit of a major neighboring central bank, which has created serious distortions in both economies. Given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, our assessment of the Riksbank’s reaction function suggests the odds appear to be high that the repo rate will move back into negative territory at some point this year (despite their reluctance to do so). Over the near-term, Swedish policy easing suggests that investors should avoid the krona versus both the US dollar and euro. Over a medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends, potentially to the benefit of Swedish consumer durable and apparel stocks. Finally, over the long-term, Sweden is very likely to face a period of domestic economic stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. The co-ordinated global response to the pandemic suggests that this is not the end of Sweden’s debt supercycle, but timing the transition from reflation to stagnation will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Feature One of the worrying legacies of the global financial crisis has been a substantial buildup in private sector debt in many economies around the world. This has most famously occurred in China, but private indebtedness is also very high in many developed economies. Among advanced countries, Sweden stands out as being particularly exposed to elevated private sector debt. Chart I-1 highlights that Sweden’s private sector debt-to-GDP ratio has ballooned to a massive 250% of GDP over the past 15 years, from a starting point of roughly average indebtedness. Chart I-1Sweden's Extremely Indebted Private Sector In this report we explore why Sweden has seen an explosion in private sector debt-to-GDP, and highlight that Sweden’s experience can be compared closely with that of Canada – both countries are in the orbit of a major neighboring central bank, which has created distortions in each economy. We also summarize what this implies for Riksbank policy, and what investment recommendations can be drawn from our analysis. We conclude that while the Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, it appears likely that they will forced to do so unless the negative economic impact from the COVID-19 pandemic abates very soon. Over the short-term, this suggests that investors should avoid the Swedish krona, versus either the US dollar or the euro. Why has Sweden seen such an explosion in private-sector debt? Over the medium-term, easy Riksbank policy and the probable absence of any additional macroprudential measures is likely to spur a renewed increase in Swedish house prices and household debt, which will likely benefit consumer durables and apparel stocks relative to the broad Swedish equity market.  But this will reinforce Sweden’s existing credit bubble, and similar to Canada will set the stage for domestic economic stagnation over the very long-term. Riksbank Policy and Sweden’s Private Sector Debt: A Tale Of Three Phases Much of the investor attention on Sweden's extremely high private sector debt load has occurred following the global financial crisis. But Chart I-1 clearly highlights that the process of private sector leveraging began in 2004, arguing that the Riksbank’s easy monetary policy stance following the global financial crisis is not the only cause of Sweden’s extremely elevated private debt-to-GDP ratio. In a previous Special Report for our Global Investment Strategy service,1 we investigated a similar experience in Canada and used a simple Taylor rule approach to show that the Bank of Canada’s decision to maintain interest rates below equilibrium levels for nearly two decades has contributed to a substantial buildup in private sector leverage. A similar approach for Sweden highlights similar conclusions, albeit with some complications: Chart I-2 shows our Taylor rule estimate for Sweden alongside the policy rate, and shows the deviation from the rule in the second panel. Chart I-2Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Compared with Canada’s experience, which has maintained too-low interest rates consistently for the past 20 years, Chart I-2 shows that the stance of Sweden’s monetary policy since 2000 falls into three distinct phases: Persistently easy policy from 2000 to 2008 A period of less easy and then relatively tight policy from 2009 to early-2014 A period of extremely easy policy from 2015 until today. The first phase noted above closely resembles the experience of Canada: policymakers in both countries simply kept interest rates too low during the last global economic expansion. In the second phase, the stance of monetary policy in Sweden became progressively less easy: the Taylor rule collapsed in 2009/2010, and trended lower again during the euro area sovereign debt crisis as well as its aftermath. In fact, Chart I-2 suggests that Sweden’s monetary policy stance was outrightly tight from 2012-2014, and in early-2014 the Taylor rule recommended negative policy rates while the actual policy rate was above 1%. In the third phase, the Riksbank appears to have overcompensated for the second phase of relatively less easy and eventually tight monetary policy. The Riksbank pushed policy rates into negative territory in late-2014, as had been recommended by the Taylor rule a year before, at a time when the rule was rising sharply. Roughly 2/3rds of the rise in the rule from early-2014 to late-2018 occurred due to the significant rise in Swedish inflation, with the rest due to a rise in Sweden’s output gap – which turned positive in late-2016 according to the OECD (Chart I-3). It is this third phase, featuring a massive and glaring gap between Swedish policy rates and a monetary policy rule that correctly recommended easy policy from 2010 – 2014, that has attracted global investor attention over the past few years. But Chart I-4 presents Sweden’s Taylor rule gap alongside its private sector debt-to-GDP ratio, and highlights that over 80% of the rise in the latter since 2000 actually occurred in the first phase described above – a period of persistently easy monetary policy as defined by our Taylor rule approach. The behavior of Sweden’s private sector debt-to-GDP ratio in the second and third phases also seems to validate our approach, as gearing essentially stopped during the second phase and restarted in the third phase. Chart I-3Since 2014, Sweden’s Rising Taylor Rule Has Been Driven Mostly By Inflation Chart I-4Sweden’s Monetary Policy Phases Explain Its Private Sector Leveraging The Riksbank: “Talk To Us About Inflation, Not Debt” Chart I-5During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates It is crucial to understand the motivations of Sweden’s central bank during each of these phases in order to be able to forecast the likelihood of a return to negative interest rates this year, as well as the Riksbank’s likely policy response once the COVID-19 pandemic subsides. In the first monetary policy phase that we have described, Sweden was not the only country to maintain persistently easy monetary policy. Given the relative scarcity of private sector deleveraging events in the post-war era, most policy makers, academic economists, and market participants were regrettably unconcerned about rising private sector indebtedness during this period, and only came to understand the consequences during the crisis and its aftermath. Most advanced economies leveraged during the first of Sweden’s monetary policy phases, and Sweden really only stands out as a major outlier from 2007 – 2009 when nearly 60% of the country’s total 2000-2019 private sector leveraging occurred (most of which, in turn, occurred before the collapse of Lehman Brothers in September 2008). In essence, by the time that Swedish policymakers were given a vivid and painful demonstration of the dangers of elevated private sector debt, it was too late to prevent most of the increase in debt-to-GDP that is facing the country today. In the second phase of Sweden's modern monetary policy, our Taylor rule framework highlights that the Riksbank largely acted as appropriate. One complication, however, is the difference in the leverage trend between Sweden's nonfinancial corporate and household sectors. Chart I-5 clearly highlights that Sweden's household sector took advantage of low interest rates during the country’s second monetary policy phase. Household sector leveraging began to rise again starting in late-2011, whereas it was completely absent for the corporate sector during the period. A crucial reason why the Riksbank ignored this renewed household sector leveraging is also part of the reason that it has maintained extremely low policy rates in the third phase noted above. The Riksbank’s monetary policy strategy, which is published in every monetary policy report, includes the following: “According to the Sveriges Riksbank Act, the Riksbank’s tasks also include promoting a safe and efficient payment system. Risks linked to developments in the financial markets are taken into account in the monetary decisions. With regard to preventing an unbalanced development of asset prices and indebtedness however, well-functioning regulation and effective supervision play a central role. Monetary policy only acts as a compliment to these.” In other words, the Riksbank has been very clear that preventing excessive leveraging is not its responsibility, and that the job ultimately falls to the Swedish government. But if the Taylor rule was recommending meaningfully higher interest rates during phase 3, then why did the Riksbank continue to lower interest rates into negative territory until last year? In our view, their behavior can be explained by the confluence of three factors: 1. Sweden’s deflation scare in 2014: Sweden’s underlying inflation rate had been trending lower for four years by the time that it dipped briefly into negative territory in March 2014. By this point, the Riksbank appears to have become increasingly concerned about inflation expectations rather than the trend in actual inflation. Chart I-6 presents Sweden’s underlying inflation rate and an adaptive-expectations based estimate of inflation expectations alongside the repo rate, and shows that inflection points in the repo rate match inflection points in expectations. Specifically, the repo rate continued to fall until inflation expectations stabilized in early-2016, and the Riksbank did not raise the repo rate until expectations crossed above 1.5%, a level that was reasonably close to the central bank’s 2% target. Chart I-6During Phase 3, The Riksbank Focused On Low Inflation Expectations 2. Sweden’s high trade sensitivity: Chart I-7 highlights that Sweden’s economy, like Canada and other Scandinavian countries, is highly exposed to exports to top trading partners. The euro area accounts for a large portion of Sweden’s exports, and Chart I-8 highlights that nominal euro area imports from Sweden remained very weak from 2012-2016. In addition, Sweden’s import sensitivity is also very high, with total imports of goods and services accounting for over 40% of Sweden’s GDP. By our calculations, roughly 2/3rds of Swedish imports are for domestic consumption,2 and Chart I-9 highlights how closely (inversely) correlated imported consumer and capital goods prices are to Sweden’s trade-weighted currency index. By pushing the repo rate into negative territory, the Riksbank reinforced rising inflation expectations by supporting exports and importing inflation from its trading partners via a weaker krona. Chart I-7Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Chart I-8Euro Area Demand For Swedish Goods Remained Weak For Several Years Chart I-9To 'Import' Inflation, The Riksbank Had To Weaken The Krona 3. The euro area’s persistently weak inflation and extremely easy monetary policy: While this is related to Sweden's overall trade sensitivity, the fact that the euro area had to combat persistently weak inflation with negative interest rates and asset purchases from late-2014 to late-2018 has had a particularly strong impact on Riksbank policy given the latter’s goal of boosting Swedish inflation via higher import prices. Chart I-10 highlights the strong link between the SEK-EUR exchange rate and the real interest rate differential between the two countries, and in particular shows that the Riksbank had to lower the differential into negative territory in order to bring the krona below “normal” levels (defined here as the average of the past global economic expansion). When faced with a real euro area policy rate of roughly -1.5% during the period (Chart I-11), the only way to achieve a negative real rate differential was to maintain the repo rate at an extremely low level as Swedish inflation rose. Chart I-10To Weaken The ##br##Krona... Chart I-11…Deeply Negative Real Policy Rates Were Required Where Next For The Repo Rate? In February 2019 the Riksbank was forecasting that the repo rate would return into positive territory by the end of this year, and would rise as high as 80 basis points by mid-2022. They downgraded this assessment in April, and again in October, highlighting that they expected a 0% repo rate for essentially the entire three-year forecast period. In other words, the Riksbank had been moving in a dovish direction even before the COVID-19 pandemic began. Prior to the outbreak, we would have been inclined to argue that the Riksbank’s forecast of a 0% repo rate beyond 2020 was suspect, given the budding recovery in global growth. Chart I-12 highlights that the global PMI had been improving for several months prior to the outbreak, and the Swedish PMI and consumer confidence index had recently rebounded sharply. A negative repo rate was essential to “import” inflation. But, given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, and our description of the Riksbank mandate and reaction function, the odds appear to be high that the repo rate will move back into negative territory at some point this year. Besides the very negative direct impact to global trade from the pandemic, Chart I-13 highlights that Swedish inflation is now falling, and that our measure of inflation expectations has now peaked. Chart I-12Swedish Economic Momentum Was Building Prior To The Pandemic... Char I-13...But Inflation Is Falling And The Unemployment Rate Is Rising In addition, the Swedish unemployment rate has been trending higher since early-2018 (Chart I-13, second panel), in response to several factors: a shock to household wealth in late-2015/early-2016 due to sharply falling equity prices, a meaningful decline in house prices driven by newly introduced macroprudential policies, and a sharp albeit seemingly one-off decline in the contribution to Swedish economic growth from government expenditure (Chart I-14). These trends would have likely reversed at some point this year given the building economic momentum that was evident in January and early-February, but it is now clear that the pandemic will more than offset the budding improvement in economic activity. Chart I-14Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Over the past week the Riksbank has announced two policies: it will provide cheap loans to the country’s banks (500 billion SEK) to bolster credit supply to Swedish small & medium-sized enterprises, and it will increase its asset purchase program by 300 billion SEK. The Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, and has argued that strong liquidity support and stepped up asset purchases are more likely to be effective measures in the current environment. However, Charts I-10 & I-11 underscored the link between real interest rate differentials and the currency, and the Riksbank will risk having the krona appreciate versus the euro and other currencies if inflation continues to fall and the policy rate is kept unchanged. Chart I-15 shows that market participants have already begun to price in cuts to the repo rate, and our sense is that the Riksbank will be forced to act in a way that is consistent with the market’s view. Chart I-15The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. Investment Conclusions Over a cyclical (i.e. 6-12 month) time horizon, the Swedish krona is the asset with the clearest link to our discussion of Riksbank policy, and investors should recognize that the krona call is now a binary one based on the evolution of the COVID-19 pandemic. It is one of the cheapest currencies in the G10 space, but foreign exchange markets have recently ignored fundamentals such as interest rate differentials and valuation. This is particularly true in the face of a spike in US dollar cross-currency basis swaps, which have started to send the dollar higher even against the safe haven currencies. In such an a environment, selling pressure could continue to push SEK lower, especially if the Riksbank is pushed to reduce the repo rate sooner rather than later. The SEK is one of the most procyclical currencies in the FX space, suggesting that investors should stand aside until markets stabilize (Chart I-16). Right now, the Swedish krona is the clearest play on Riksbank policy. As for the EUR/SEK cross, any renewed ECB stimulus suggests that Sweden will act accordingly to prevent the SEK from appreciating too far, too fast. EUR/SEK will top out after global growth is in an eventual upswing, and the Riskbank has eased policy further. Over the medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends. House prices will likely decelerate in the near term given the shock to household wealth from falling equity prices, but we showed in Chart I-5 that Sweden’s household sector ultimately took advantage of low interest rates during Sweden’s second monetary policy phase. We expect a similar dynamic to unfold beyond the coming 6-9 months, and Chart I-17 highlights that overweighting Swedish consumer durable and apparel stocks within the overall Swedish equity market is likely the best way to eventually play a resumption of household leveraging and rising house prices. Chart I-16Avoid Krona Exposure ##br##For Now Chart I-17Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand With the exception of a selloff in 2013, the relative performance of the industry group has closely correlated with house price appreciation, and is now deeply oversold. The companies included the industry group earn a significant portion of their revenue from global sales, but the close correlation of relative performance with Swedish house prices and limited correlation with the global PMI suggests that domestic economic performance matter in driving returns for these stocks (Chart I-17, bottom panel). We are not yet prepared to recommend a long relative position favoring this industry group, but we are likely to view signs of policy traction and a relative performance breakout as a good entry point. Finally, the key long-term implication of our research is that Sweden will at some point likely face a period of stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. While regulators had begun to combat excessive debt with macroprudential measures, further measures to restrict household sector debt are extremely unlikely to occur until after another substantial reacceleration in Swedish house prices and another nontrivial rise in household sector leverage. This will be cyclically positive for Sweden coming out of the pandemic, but will ultimately make Sweden’s underlying debt problem meaningfully worse. Macroprudential control of rising nonfinancial corporate debt has not and is not likely to occur, and no regulatory control measure will be able to significantly ease the existing debt burden facing the private sector. Chart I-18 highlights that while Sweden’s private sector debt service ratio (DSR) is not the highest in the world, is it extremely elevated compared to other important DM countries such as the US, UK, Japan, and core euro area. Several other countries with higher private sector DSRs, such as Canada and Hong Kong, are also at serious risk of long-term stagnation. Chart I-18Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' We have not yet identified a specific list of assets that will be negatively impacted by Swedish domestic economic stagnation over the longer term. Our European Investment Strategy service recently argued that Swedish stocks are attractive over the very long term versus Swedish bonds, based on valuations and the fact that the Swedish equity market as a whole is heavily driven by the global business cycle. We plan on revisiting the question of which equity sectors are most vulnerable to domestic stagnation in a future report, as the onset of stagnation draws nearer. As we noted in our report on Canada,3 it is difficult to identify precisely when Sweden’s high debt load will meaningfully and sustainably impact Swedish economic activity and related equity sectors. The acute shock to global activity from the COVID-19 pandemic is an obvious potential trigger, but the fact that policymakers around the world are responding forcefully to the pandemic suggests that this is not the end of Sweden’s debt supercycle. In this regard, the prospect of globally co-ordinated fiscal spending is especially significant. Our best guess is that Sweden’s true reckoning will come once US and global activity contracts for conventional reasons, instigated by tight monetary policy to control rising and above-target inflation. This may mean that Sweden will avoid a balance sheet recession for some time, but investors exposed to domestically-linked Swedish financial assets should take heed that the eventual consequences of such an event are likely to grow in magnitude the longer it takes to arrive. In short, beyond the acute nearer-term impact of the pandemic, Sweden is likely to experience short-term gain for long-term pain. The short- to medium-term focus of investors should be on the former, but with full recognition that the latter will eventually occur. Timing the transition between these two states will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com 2 We assume that all services imports are consumed domestically. Among goods exports, we assume domestic consumption of all imports of food & live animals, beverages & tobacco, mineral fuels, lubricants, and related materials, miscellaneous manufactured articles, road vehicles, and other goods. 3 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Chart I-3B…But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis.  One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect.  As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Dear Client, Next week we will be publishing a joint Special Report on the Chinese infrastructure investment outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima, China Strategist Feature Chart I-1Chinese Non-Financial Corporations Are Heavily Indebted There are fears that the two-month hiatus in China’s business activities due to the COVID-19 epidemic has sparked acute cash shortages among Chinese companies. In turn, this has increased the danger that the highly leveraged Chinese corporate sector may be pushed into widespread insolvency (Chart I-1). The number of bankruptcies will undoubtedly climb, but small and micro firms are most at risk versus larger companies that have deeper cash reserves and easier access to financing. Our analysis shows that, before the outbreak hit China in January, companies listed in China’s onshore and offshore equity markets exhibited relatively healthy financial statements with adequate operating cash flows to cover debt obligations. This increases the probability that Chinese listed companies will survive the economic and financial shocks from the epidemic, and that their stock prices will rebound along with the expectations of a recovery in the Chinese economy. Chart I-2Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand It also appears that China’s domestic economy is relatively insulated from the global financial market turmoil and impending global recession. China’s corporate profit outlook is dominated by domestic economic conditions rather than external demands. This view is also reflected in the relative performance of Chinese onshore and offshore stocks (Chart I-2). Moreover, the charts in the Appendix illustrate that corporate financial ratios in almost all sectors of China’s onshore and offshore equity markets have somewhat improved from the previous economic down cycle that began in 2014. This underscores our view that if reflationary measures overcompensate for the economic slowdown, as in the 2015/2016 easing cycle, then Chinese stocks will likely rally in absolute terms, as well as outperform global benchmarks. We selected three categories of financial ratios to monitor profitability, leverage and operating cash flow conditions of Chinese domestic and investable listed non-financial companies (Table I-1).1 The financial data in our exercise are from Refinitiv Datastream Worldscope. Its corresponding stock price indexes for China’s overall market and sectors most closely resemble the MSCI China Index and the MSCI China Onshore index. Table I-1 It is also noted that the Chinese investable index, excluding financial companies, is dominated by large technology companies such as Alibaba, Tencent, and Baidu.2 These tech companies generally have more adequate cash flows and lower debt ratios than the more capital intensive sectors such as industrial and energy. The analysis we present in this report on non-financial companies in the offshore market, therefore, is not indicative of China’s overall corporate financial health. Rather, our findings are indicative of how investors should view the listed companies and their sector performance within China’s investable market. Several observations from our analysis of the listed companies’ financial ratios are noteworthy: Chinese non-financial corporations are highly leveraged, and have not de-levered much despite the financial deleverage campaign that began in late 2017. Contrary to the belief that Chinese corporates’ financial health is significantly weaker than that in developed economies, the leverage ratio, profit margins, and debt-servicing ability among Chinese domestic and investable non-financial companies are actually in the range of their global peers (Chart I-3). Yet, Chinese companies trade at substantial discounts to global benchmarks. This is particularly evident in the offshore market, whereas domestic Chinese stocks were priced at a discount until the recent global market selloffs (Chart I-4). This underpins our view that, when China’s economy and corporate profits recover, Chinese stocks should outperform their global benchmarks on a cyclical time horizon. Importantly, with a stronger aggregate corporate financial health and a large price discount. Chinese investable non-financial stocks have more upside potential than their domestic counterparts. Chart I-3Financial Health Among Listed Chinese Companies Comparable With DMs Chart I-4Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks   Utilities, machinery, industrials and construction materials are among the sectors with the lowest cash flow-to-interest expense ratios, in both China’s domestic and investable markets. In particular, machinery, industrials and construction materials are pro-cyclical sectors and their profit growth is positively correlated with economic growth. Their low profitability and high leverage contribute to their poor cash flows. Those sectors have been severely impacted by the stoppages in manufacturing and construction activities due to the COVID-19 epidemic in China, making them vulnerable to cash shortages. However, there is a low risk of a broad-based default among these firms, because state-owned enterprises (SOEs) dominate these sectors in the Chinese equity market. The stock performance in these sectors is also extremely sensitive to shifts in China’s monetary and policy stance, and thus should benefit from the recent loosening in monetary conditions and the push for a substantial increase in infrastructure investment this year. Chart I-5Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones The leverage ratio in the real estate sector has doubled in the past 10 years. The sector’s cash flow-to-total liabilities ratio has also declined sharply since 2017, when the authorities tightened lending standards to property developers. However, the sector’s aggregate cash flow situation is still an improvement from its lowest point in 2014, in both China’s domestic and investable markets. The countrywide lockdowns in January and February will undoubtedly have severe impacts on Chinese property developers’ cash flows. But the real estate sector is perhaps the best example in exhibiting a pronounced divergence in cash flow conditions between larger and smaller firms. Chart I-5 shows that, while the median ratio of cash-to-total liabilities tuned negative among 76 domestic listed real estate developers, the average ratio from total companies in the same sector suggests that the cash situation has actually improved since mid-2018. This divergence indicates that larger developers have more solid financial fundamentals and easier access to liquidity compared with their smaller counterparts, even before the lockdowns. We expect the divergence in cash flow conditions to widen in the coming months, and smaller property developers will face intensifying pressure to consolidate. China’s domestic healthcare companies have a much better cash balance than the investable healthcare sector, which has the lowest ratio of cash-to-interest expenses among all sectors. The poor cash flow conditions in investable healthcare companies are due to high leverage and low profitability, as well as high operating costs and R&D expenses. Chinese domestic healthcare sector has outperformed the broad market since the epidemic broke out in January. While we think the overall Chinese investable stocks have more upside than their domestic peers, domestic healthcare companies’ lower leverage ratio, stronger cash flows, and much higher profit margin make the sector a better bet than investable healthcare stocks on a cyclical time horizon (Chart I-6).  Chart I-6Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Chart I-7Energy Stocks Will Remain Depressed Until Oil Prices Rebound Historically, there has been a strong positive correlation between the energy sector’s profitability, cash flow conditions, stock performance and crude oil prices (Chart I-7). In the past two years, the sector’s leverage ratio has risen, profit margins have thinned and the cash flow situation has sharply deteriorated to the same level as in 2014 when oil prices collapsed. The ongoing oil price rout will generate powerful deflationary forces in the energy sector and will likely further deteriorate energy firms’ profitability and cash flow. While we stay long cyclical stocks versus defensives on both a 0-3 month and a 6-12 month view, we recommend a cautious stance towards energy stocks until the evolving oil price war situation is clarified.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Appendix Overall Markets Excluding Financials Consumer Discretionary Sector Consumer Staples Sector Real Estate Sector Automobile Sector Machinery Sector Industrials Sector Construction Materials Sector Telecommunications Sector Technology Sector Healthcare Sector Energy Sector   Utilities Sector   Footnotes 1    We exclude banks and financial institutions from this analysis, due to discrepancy in Chinese banks’ accounting measures from those of non-financial corporations’. 2   Alibaba, Tencent, Baidu, and JD together account for nearly 40% of the non-financial market cap in Chinese investable index. Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: We are not prepared to say that bond yields have troughed, even with the fed funds rate now back to the zero bound. Investors should keep portfolio duration close to benchmark. We do not rule out longer-maturity Treasury yields falling to 0% during the next couple of months, but negative bond yields in the US are not possible. TIPS: Current low TIPS breakeven inflation rates signal a rare buying opportunity. Though price swings will be volatile for the next few months, investors with horizons of 1-year or longer would be well advised to go long TIPS versus equivalent-maturity nominal Treasuries. Corporate Bonds: Corporate spreads are widening rapidly but still don’t offer above-average compensation if we adjust for likely future default scenarios. We will wait for a better entry point before recommending a shift back to overweight. Feature Does The Fed’s Bazooka Signal The Bottom In Yields? Chart 1Back To The Zero-Lower-Bound In response to liquidity stresses witnessed in Treasury and MBS markets last week, the Fed decided to move this month’s FOMC meeting up to Sunday afternoon. It then took the opportunity to roll out a massive amount of easing. First the facts: The Fed cut the policy rate by 100 bps, back to the effective lower bound of 0% - 0.25%. Chair Powell also made it clear at his press conference that negative rates are not on the table. The Fed announced purchases of at least $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months.” The Fed cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by 150 bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” (more on this below). The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS + 25 bps. The first major question for bond investors is whether this move will mark the bottom in yields (Chart 1). We aren’t so sure. As we write this on Monday morning the 2-year yield is 0.35%, down 14 bps from Friday’s close and the 10-year yield is 0.79%, down 15 bps from Friday. Obviously, further rate cuts won’t be the catalyst for lower bond yields, but investors can still push long-dated yields down if they start to price-in a longer period of time at the zero bound. In contrast, long-dated bond yields will only move up if we start to price-in an eventual economic recovery and exit from zero-bound rate policy. The fact that S&P futures went limit down immediately after the Fed’s big announcement suggests we aren’t at that point yet. Further rate cuts won’t be the catalyst for lower bond yields, but investors can still push long-dated yields down if they start to price-in a longer period of time at the zero bound. In last week’s report we introduced four criteria to monitor to decide when to call the trough in bond yields.1 Even with the Fed’s move back to zero, these four factors remain the most important things to watch. First, we want to see signs that the COVID-19 pandemic is becoming contained. That is, we want to see the daily number of new cases fall close to zero. We are still far away from that point (Chart 2), but evidence from China shows that containment is possible if the rest of the world follows a similar roadmap. Second, we want to see evidence of improving global growth, particularly in China. We showed last week how the Global and Chinese Manufacturing PMIs plunged in February. Since then, higher frequency global growth indicators – such as the performance of cyclical equities over defensives and the CRB Raw Industrials index – have not recovered at all (Chart 3). With very few new COVID cases in China and a large amount of stimulus on the way, we expect Chinese growth indicators to rebound in the coming months. Chart 2Tracking ##br##COVID-19 Chart 3Waiting For A Stronger Global Growth & Weaker US Growth Third, we want to see some bad economic data coming out of the US. As of today, the US Economic Surprise Index is a robust +74 and last week’s initial jobless claims and Consumer Sentiment releases were healthy (Chart 3, bottom 2 panels). We know the weak economic data are coming, but they haven’t arrived yet. Until they do, there is an elevated risk of another downleg in bond yields. We expect the time to call the bottom in bond yields will be when the US data are very weak and the Global and Chinese data are improving. Investors will use the global rebound as a roadmap for the US and start to push yields higher. Finally, we would like to see signals from some technical trading rules that have good track records of calling bottoms in bond yields. The technical rules we examined last week are all based on identifying periods when bond market sentiment is extremely bullish and when bond yield momentum hooks up. Chart 4Technical Trading Rules So far, none of the technical rules we identified have been triggered. Our Composite Technical Indicator remains in deeply “overbought” territory (Chart 4), but to generate a sell signal we also need one of our momentum measures to turn positive (Chart 4, bottom 3 panels). This hasn’t happened yet. All in all, none of our four criteria have been met. We are therefore inclined to think that it is too soon to call the bottom in bond yields. Investors should keep portfolio duration close to benchmark. Negative Yields In The US? We think it’s entirely possible that the 10-year Treasury yield could fall as low as 0% during the next couple of months. With the front-end of the curve already pinned at zero, any further market panic will be disproportionately felt at the long-end, and another spate of bad news could easily push the 10-year yield down to 0%. However, if the 10-year yield were to fall to 0%, we would declare that the trough in yields. In other words, negative bond yields will not occur in the US. Why is this the case? We can think of the 10-year Treasury yield as the market’s expected average fed funds rate for the next decade.2 That being the case, the 10-year yield would only turn negative if the market believed that the Federal Reserve was willing to take the policy rate below zero. On Sunday, Chair Powell was adamant that negative interest rates won’t be considered. He said that any further easing would take the form of forward guidance and asset purchases. The strongest form of that would involve caps on intermediate- and/or long-maturity bond yields. Please note that Powell didn’t mention yield caps specifically on Sunday, this is our inference based on past Fed communications. But the main point is that negative bond yields are a policy choice, one that the Federal Reserve is not inclined to make any time soon. It’s highly notable that no country without a negative policy rate has seen negative bond yields further out the curve. One result of the Fed’s “lower for longer” bias is that, coming out of the current crisis, we would expect the equity market to bottom and corporate bond spreads to peak before Treasury yields move higher.  Another factor that will weigh on how low long-end Treasury yields fall is whether the market thinks that the Fed views its recent rate cut as an “emergency measure” that will be quickly reversed when the COVID crisis passes, or as a more long-lasting policy change. The Fed was deliberately vague on this question in its statement, saying that it will maintain the current fed funds rate “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.” The Fed was deliberately vague precisely because it doesn’t know how quickly it will tighten policy. But given that the result of this year’s Strategic Review will likely be an explicit targeting of above-2% inflation, we can be fairly certain that the Fed will be slow to remove accommodation. We continue to view inflation expectations and financial conditions as the two most important indicators to track to determine the pace of eventual tightening.3 One result of the Fed’s “lower for longer” bias is that, coming out of the current crisis, we would expect the equity market to bottom and corporate bond spreads to peak before Treasury yields move higher. Bottom Line: We are not prepared to say that bond yields have troughed, even with the fed funds rate now back to the zero bound. So far, none of the four triggers we will use to call the bottom in yields have sent a signal. In fact, we do not rule out longer-maturity Treasury yields falling to 0% during the next couple of months, but negative bond yields in the US are not possible. The Fed’s Emergency Liquidity Measures Chart 5A Lack Of Liquidity On Sunday, Fed Chair Powell said that the reason for moving the FOMC meeting forward was because of worrying signs of deteriorating liquidity in Treasury and Agency MBS markets. Specifically, many observed that the spreads between short-term financing rates (both secured and unsecured) and the risk-free OIS curve jumped last week (Chart 5). Also, mortgage rates didn’t follow Treasury yields lower (Chart 5, bottom panel) and bid/ask spreads widened in the Treasury market. Diagnosing The Problem Our assessment of last week’s liquidity problems is that they arose because, in this post Dodd-Frank/Basel III world, dealer banks are still not sure how to respond during periods of stress. Last week, a lot of nonfinancial firms tapped their revolving credit lines in an attempt to weather the upcoming downturn. This caused an outflow of cash from the banking system. With banks now holding less cash than they were comfortable with, the price of cash in money markets (repo, LIBOR, etc…) started to spike. Because repo is a commonly used tool for financing Treasury trades, the knock-on effect of a spike in the repo rate is a loss of liquidity in the Treasury market. But are banks really short of cash? We got a small taste of the confusion around this issue when repo rates spiked last September. The Fed assumed that it had plenty of room to shrink its balance sheet and drain cash from the banking system because the banks were operating with large liquidity buffers, in excess of what was mandated by regulations like the Liquidity Coverage Ratio (LCR). However, it turned out that banks wanted to hold much more cash than was required by the LCR, in large part because they worried about the Fed’s periodic stress tests, the criteria of which can change over time. The Fed’s Solutions Fortunately, the Fed has taken a lot of aggressive action to help mitigate these problems. First, it announced a large quantity of repo operations last week, then followed that up by announcing direct Treasury and MBS purchases on Sunday. The Fed also lowered the discount window rate to a mere 0.25%, and is encouraging banks to tap that facility if necessary. But, in our view, perhaps the most important measure the Fed announced is simply that policymakers will encourage banks to “use their capital and liquidity buffers”. The fact of the matter is that banks are carrying large amounts of cash but have been hesitant to deploy it because they are worried about regulatory backlash from the Fed. If the Fed can effectively assure banks that it won’t be aggressively enforcing any regulatory action against them for the foreseeable future, then there is already a lot of liquidity in the system waiting to be deployed. Though we expect the Fed’s measures will have a significant positive impact on market liquidity, it will be important to monitor money market spreads going forward. The Fed has still not taken the extreme step of re-launching its crisis-era commercial paper facility and lending directly to nonfinancial corporates. This would be a likely next step if liquidity conditions continue to deteriorate. A Rare Opportunity In TIPS Together, the COVID-induced global demand shock and the OPEC-induced oil supply shock have taken TIPS breakeven inflation rates down to extraordinarily low levels. As of Friday’s close, the 10-year TIPS breakeven inflation rate was a mere 0.92%, the 5-year rate was 0.56% and the 1-year rate was an absurd -0.49%. In fact, both the 1-year and 2-year breakeven rates were negative! For buy and hold investors, this presents an outstanding opportunity to buy TIPS and short the equivalent-maturity nominal bond. For example, a buy and hold investor will make money by going long TIPS and short nominals as long as headline CPI inflation averages above 0.56% per year for the next five years or above 0.92% per year for the next decade (Chart 6). The fact that the 1-year and 2-year breakeven rates are negative is an even greater mispricing because TIPS come with embedded deflation floors. That is, TIPS principal is adjusted higher by the rate of headline CPI inflation but it is never adjusted lower if headline CPI inflation turns negative. The deflation floor means that a negative 1-year or 2-year TIPS breakeven inflation rate represents risk-free profit for anyone who can commit capital for the entire 1-year or 2-year investment horizon. A buy and hold investor will make money by going long TIPS and short nominals as long as headline CPI inflation averages above 0.56% per year for the next five years or above 0.92% per year for the next decade. But abstracting from deflation floors, is it even realistic to expect negative headline CPI during the next 12 months? Even in a worst-case scenario, it is difficult to imagine. First, let’s assume that the Brent crude oil price falls to $20 during the next month and then stays there. The second panel of Chart 7 shows that this would cause year-over-year Energy CPI to hit -20% before recovering. Second, let’s assume that core CPI follows the path implied by our Pipeline Inflation Pressure Gauge, falling from its current 2.4% to 1.8% for the next 12 months (Chart 7, panel 4). Third, let’s assume that year-over-year food inflation collapses all the way to 0% (Chart 7, panel 3). Chart 6TIPS Breakeven Inflation Rates Are Too Low Chart 7Worst-Case Scenario For CPI This worst-case scenario would result in 12-month headline CPI of +0.09% for the next 12 months (Chart 7, bottom panel). Now, core CPI inflation did fall below 1% during the last recession, an occurrence that would certainly lead to headline CPI deflation if it happened again. However, shelter makes up 42% of core CPI. Without a significant slowdown in the housing market, such a large decline in core inflation is unlikely. Bottom Line: Current low TIPS breakeven inflation rates signal a rare buying opportunity. Though price swings will be volatile for the next few months, investors with horizons of 1-year or longer would be well advised to go long TIPS versus equivalent-maturity nominal Treasuries. Corporate Bond Spreads:Too Soon To Buy Corporate bond spreads have widened dramatically during the past few weeks. Within the investment grade space, the overall index spread and the average spread excluding the energy sector have both broken above their 2016 peaks. The investment grade energy spread is still 56 bps below its 2016 peak (Chart 8A). In high-yield, the overall index spread is still 112 bps below its 2016 peak. The energy spread is 23 bps below its 2016 peak and the ex-energy spread is 112 bps below its 2016 peak (Chart 8B). Chart 8AInvestment Grade Corporate Bond Spreads Chart 8BHigh-Yield Corporate Bond Spreads Obviously, spreads are widening quickly and value is returning to the sector. This raises the important question of: When will it be a good idea to step in and buy? To answer this question we need to view current spread levels relative to the magnitude of the upcoming economic shock. During the past 12 months, the speculative-grade corporate default rate was 4.5% and our macro model already anticipates a rise to 6.2%. This would bring the default rate above the 5.8% peak seen in 2017, but is probably still too low of an estimate given that the upcoming corporate profit hit is not yet reflected in our model (Chart 9). Gross leverage – the ratio of total debt to pre-tax profits – enters our default rate model with a roughly six month lag, meaning that we wouldn’t expect any current hit to profits to impact the default rate for another six months. For further context, we note that the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. Chart 9An Above-Average Default-Adjusted Spread Signals A Buying Opportunity The bottom panel of Chart 9 shows our High-Yield Default-Adjusted Spread. This is a measure of the excess spread in the high-yield index after subtracting ex-post default losses. Its historical average is around 250 bps. We shocked our Default-Adjusted Spread to see what it would be in four different scenarios for the default rate: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 9 indicates where the Default-Adjusted Spread will be if each scenario is realized. For example, if the default rate comes in at 6% for the next 12 months then the Default-Adjusted Spread will be +347 bps, above its historical average. If the default rate is 9% during the next 12 months the Default-Adjusted Spread will still be positive, at +108 bps, but will be below historical average. A default rate similar to what was seen during past recessions (11% or 15%) would lead to a negative Default-Adjusted Spread. Right now, our best estimate of a short-lived recession would suggest a peak default rate of somewhere between 6% and 9%, probably closer to 9%. Such a scenario would be consistent with a positive Default-Adjusted Spread and likely positive excess returns for corporate bonds (both investment grade and high-yield) relative to Treasuries on a 12-month horizon. However, we also note that periods of spread widening usually culminate with our Default-Adjusted Spread measure well above its historical average. This was the case in 2016, 2009 and 2002. As of now, this sort of attractive valuation will only be achieved if the default rate is 6% or lower during the next 12 months, a forecast that seems overly optimistic. The bottom line is that we are inclined to wait for a more attractive entry point before recommending a shift back to an overweight allocation to corporate bonds versus Treasuries. Though it is probably too late for investors with long time horizons (12 months or more) to sell. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 Technically, the 10-year yield is equal to 10-year rate expectations plus a term premium to compensate investors for locking up funds for 10 years instead of rolling over a series of overnight investments. The term premium is difficult to estimate in practice, but it is likely to be quite close to zero at present. 3 For further details on why investors should focus on these two measures to assess the pace of eventual policy tightening please see US Bond Strategy / Global Fixed Income Strategy Special Report, “The Fed In 2020”, dated December 17, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification