Emerging Markets

Highlights The coronavirus is a wild card that may have a significant impact on the global economy, … : The COVID-19 outbreak is unfolding in real time, half a world away, and its ultimate course is uncertain. For now, our China strategists think the worst-case scenarios are unlikely, but we will not remain constructive if the virus outlook materially worsens. … but as long as there is not a significantly negative exogenous event, the US economy will be just fine, … : From a domestic perspective, the US expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will give increasing numbers of households the confidence and wherewithal to ramp up consumption. … and if there’s no recession, there will not be a bear market: Recessions and equity bear markets coincide, with stocks typically peaking six months ahead of the onset of a recession. If the next recession doesn’t come before late 2021/early 2022, the bull market should remain intact at least through the end of this year. What We Do US Investment Strategy’s stated mission is to analyze the US economy and its future direction for the purpose of helping clients make asset-allocation and portfolio-management decisions. As important as the economic backdrop is, however, we never forget that we are investment strategists, not economic forecasters. We don’t belabor the state of every facet of the economy because neither we nor our clients care about 10- to 20-basis-point wiggles in real GDP growth in themselves. They do want us to keep them apprised of the general trend, though, and we are always trying to assess it. Ultimately, macro analysis benefits investors by providing them with timely recognition of the approach or emergence of an inflection point in the cycles that matter most for financial assets. We view investment strategy as the practical application of the study of cycles, and we are continuously monitoring the business cycle, the credit cycle, the monetary policy cycle and the squishy and only sporadically relevant sentiment cycle. This week, we turn our attention to the business cycle, and the ongoing viability of the expansion, which is already the longest on record at 128 months and counting. If it remains intact, risk assets are likely to continue to generate returns in excess of returns on Treasuries and cash. The Message From Our Simple Recession Indicator We have previously described our simple recession indicator.1 It has just three components, and all three of them have to be sounding the alarm to conclude that a recession is imminent. Our first input is the slope of the yield curve, measured by the difference between the yield on the 10-year Treasury bond and the 3-month T-bill.2 The yield curve inverts when the 3-month bill yield exceeds the 10-year bond yield, and a recession has followed all but one yield curve inversion over the last 50 years (Chart 1). The yield curve inverted from May through September last year, and the coronavirus outbreak (COVID-19) has driven it to invert again, but the unprecedentedly negative term premium (Chart 2) has made the curve much more prone to set off a false alarm. Chart 1An Inverted Curve May Not Be What It Used To Be ... An Inverted Curve May Not Be What It Used To Be ... An Inverted Curve May Not Be What It Used To Be ... Chart 2... When A Negative Term Premium Is Holding Down Long Yields ... When A Negative Term Premium Is Holding Down Long Yields ... When A Negative Term Premium Is Holding Down Long Yields The indicator’s second input is the year-over-year change in the leading economic index (“LEI”). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in the last 50 years with just one false positive (Chart 3). The LEI bounced off the zero line thanks to January’s strong reading, and the year-ago comparisons are much easier than they were last year, but we are mindful that it is flirting with sending a recession warning. Chart 3Leading Indicators Are Wobbly, ... Leading Indicators Are Wobbly, ... Leading Indicators Are Wobbly, ... It takes more than tight monetary conditions to make a recession, but you can't have one without them. To confirm the signal from the yield curve and the LEI and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA’s model calculates an equilibrium rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 4). Tight monetary policy isn’t a sufficient condition for a recession – expansions continued for six more years despite tight policy in the mid-‘80s and mid-'90s – but it is a necessary one. Our indicator will not definitively signal an approaching recession until monetary conditions turn restrictive. Chart 4... But The Fed Is Nowhere Near Inducing A Recession ... But The Fed Is Nowhere Near Inducing A Recession ... But The Fed Is Nowhere Near Inducing A Recession Bottom Line: In our view, the yield curve and the LEI both represent yellow lights, though the LEI has a greater likelihood of turning red, especially in the wake of COVID-19. Monetary policy is unambiguously green, however, and we will not conclude that a recession is imminent until the Fed deliberately attempts to rein in the economy. Bolstering Theory With Observation A potential shortcoming of our recession indicator is its reliance on a theoretical concept. The equilibrium (or natural) rate of interest cannot be directly observed, so our judgment of whether monetary policy is easy or tight turns on an estimate. To bolster our assessment of whether or not the expansion can continue, we have been tracking the drivers of the main components of US output. Going back to the GDP equation from Introductory Macroeconomics, GDP = C + I + G + (X - M), we look at the forces supporting Consumption (C), Investment (I) and Government Spending (G). (Because the US is a comparatively closed economy in which trade plays a minor role, we ignore net exports (X-M).) Consumption is by far the largest component, accounting for two-thirds of overall output, while investment and government spending each contribute a sixth. As critical as consumption is for the US economy, it is not the whole story; smaller but considerably more volatile investment is capable of plunging the economy into a recession on its own. The Near-Term Outlook For Consumption Chart 5Labor Market Slack Has Been Absorbed Labor Market Slack Has Been Absorbed Labor Market Slack Has Been Absorbed Consumption depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and “hidden” unemployment dwindling as the supply of discouraged (Chart 5, top panel) and involuntary part-time workers (Chart 5, bottom panel) has withered. The prime-age employment-to-population ratio trails only the peak reached during the dot-com era (Chart 6), which bodes well for household income. The historical correlation between the prime-age non-employment-to-population ratio and wage gains has been quite robust, and compensation growth has plenty of room to run before it catches up with the best-fit line (Chart 7). Chart 6Prime-Age Employment Has Surged, ... Prime-Age Employment Has Surged, ... Prime-Age Employment Has Surged, ... Chart 7... And Wages Will Eventually Follow Suit Back To Basics Back To Basics Chart 8No Pressing Need To Save, Or Pay Down Debt No Pressing Need To Save, Or Pay Down Debt No Pressing Need To Save, Or Pay Down Debt Households can use additional income to increase savings or pay down debt instead of spending it, but it doesn’t look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels (Chart 8, top panel); households have already run debt down to its post-dot-com bust levels (Chart 8, middle panel); and debt service is less demanding than it has been at any point in the last 40 years (Chart 8, bottom panel). The health of household balance sheets, and the recent pickup in the expectations component of the consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at or above trend.   Household balance sheets are healthy enough to support spending income gains; there's even room to borrow to augment them.           The Near-Term Outlook For Investment Table 1GDP Equation Recession Probabilities Back To Basics Back To Basics Chart 9A Budding Turnaround A Budding Turnaround A Budding Turnaround We previously identified investment as the individual component most likely to decline enough to zero out trend growth from the other two components (Table 1), and it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the NFIB survey of smaller businesses (Chart 9, top panel) and the regional Fed manufacturing surveys (Chart 9, bottom panel) have both pulled out of declines. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the Phase 1 trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 has been subdued. Government Spending In An Election Year Chart 10State And Local Revenues Are Well Supported State And Local Revenues Are Well Supported State And Local Revenues Are Well Supported Heading into the most hotly contested election in many years, we confidently assert that federal spending is not going to go away. Regardless of party affiliation, everyone in Congress sees the appeal of distributing pork to their constituents. Spending by state and local governments, which accounts for 60% of aggregate government spending, should also hold up well, as a robust labor market will support state income tax (Chart 10, top panel) and sales tax (Chart 10, middle panel) receipts. Healthy trailing home price gains will support property tax assessments, keeping municipal coffers full (Chart 10, bottom panel). Coronavirus Uncertainties The coronavirus epidemic (COVID-19) is unfolding in real time, generating daily updates on new infections, deaths and recoveries. Any opinion we offer on the economy’s future is conditioned on the virus' ongoing course. If it takes a sharp turn for the worse, with more severe consequences than we had previously expected, it is likely that we will downgrade our outlook. For now, we are operating under the projection that the virus will cause China’s first quarter output to contract sharply enough to zero out global growth in the first quarter. Our base-case scenario, following from the work of our China Investment Strategy service, is fairly benign from there. For now, we are expecting that the worst of the effects will be confined to the first quarter, and that the Chinese economy and the global economy will bounce back vigorously in the second quarter and beyond, powered by pent-up demand that will go unfilled until the outbreak begins to recede. Our China strategists continue to be heartened by Chinese officials' aggressive (albeit belated) measures to stem the outbreak, revealed in the apparent slowing of the rate of new infections in Hubei province, the epicenter of the outbreak (Chart 11, top panel), and in the rest of China (Chart 11, bottom panel). They also expect a determined policy response to offset the drag from the epidemic (Charts 12 and 13), as officials pursue the imperative of meeting their goal to double the size of the economy between 2010 and 2020. Chart 11Stringent Quarantine Measures May Be Gaining Traction Back To Basics Back To Basics Chart 12The PBOC Is Doing Its Part, ... The PBOC Is Doing Its Part, ... The PBOC Is Doing Its Part, ... Chart 13... By Easing Monetary Conditions ... By Easing Monetary Conditions ... By Easing Monetary Conditions If the economy is expanding, investors' bar for de-risking should be high. Bottom Line: Our China strategists’ COVID-19 view remains fairly optimistic, though it is subject to unfolding developments. Our US view is contingent on BCA’s evolving COVID-19 views. Investment Implications As we noted at the outset, we are not interested in the economy for the economy’s sake; we are only interested in its impact on financial markets. The key business-cycle takeaway for markets is that bear markets and recessions typically coincide, as it is difficult to get a 20% decline at the index level without a meaningful decline in earnings, and earnings only decline meaningfully during recessions. No recession means no bear market, and it also means no meaningful pickup in loan delinquencies and defaults. The bottom line is that it is premature to de-risk while the expansion remains intact. We reiterate our recommendation that investors should remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within fixed income allocations, though we may turn more cautious as we learn more about the progression of COVID-19.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the August 13, 2018 US Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com. 2 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed’s future actions.

Highlights Global equities have benefited from the fact that the number of new coronavirus (COVID-19) cases continues to drift lower. Falling bond yields have also supported stocks. Nevertheless, risks remain. Even if the outbreak recedes, global growth is still set to fall to zero in the first quarter, before bouncing back over the remainder of the year. Thus, a near-term hit to corporate earnings now looks unavoidable. More worryingly, the possibility remains that the number of new cases will spike again as Chinese workers return to their jobs over the next few weeks. While we and others have compared the current outbreak to the SARS episode, a more relevant comparison could be the H1N1 (swine flu) outbreak of 2009-2010. Despite early efforts to contain it, 61 million Americans ended up catching the H1N1 virus, resulting in about 12,000 US deaths over a 12-month period. Globally, at least 150,000 people perished. It appears that the fatality rate from COVID-19 is significantly higher than for H1N1, though well below that of SARS and MERS. A full-blown pandemic with a fatality rate of 2% could lead to 20 million deaths worldwide. This would likely trigger a global downturn as deep as the Great Recession of 2008/09. The only consolation is that the recovery would be much more rapid than the one following the financial crisis. Although we are inclined to lean on the side of optimism, the truth is that neither we nor anyone else knows what the likelihood of such a pandemic scenario is. Thus, while we continue to maintain our positive 12-month view on global stocks, we recommend a more cautious near-term stance. Global Growth Set To Grind To A Halt In Q1 Based on the SARS example, we noted three weeks ago that risk assets were likely to bottom once the number of new coronavirus cases peaked. Sure enough, Chinese shares troughed on January 31st, just as the number of confirmed infections had begun to level off. The S&P 500 has been on a tear since then, hitting one record high after another (Chart 1). Falling bond yields have also supported stocks. Despite the decline in new infections, we think it is too early for investors to breathe a sigh of relief. For one thing, the economic data out of China remains abysmal. Real-time indicators of economic activity have been off-the-charts bad – much worse than what we saw during the SARS outbreak. While there has been some recovery in recent days, road congestion remains well below normal levels. In Shanghai, property sales are currently about four times lower than what is usual for this time of  year. Movie ticket sales have all but disappeared. Daily coal consumption, which tracks electricity consumption, has fallen by 70% (Chart 2). More than three-quarters of companies surveyed last week by the American Chamber of Commerce in Shanghai said that they cannot run a full production line due to a lack of staff. Chart 1Just As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked Just As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked Just As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked   Chart 2Chinese Daily Activity Has Fallen Off A Cliff Markets Too Complacent About The Coronavirus Markets Too Complacent About The Coronavirus In our preliminary estimate of the impact of the virus on global growth, we penciled in zero growth for China on a quarter-over-quarter basis in Q1 of 2020, implying that the level of output in the first quarter would be the same as in the fourth quarter. Unfortunately, at this point, that looks far too optimistic. Chinese economic output will decline on a sequential basis. The only question is by how much. Despite the decline in new infections, we think it is too early for investors to breathe a sigh of relief. Chart 3 shows our updated baseline profile for global growth in Q1 and the remainder of this year. Assuming that production returns to normal over the coming weeks, it should be possible to limit the unannualized quarter-over-quarter decline in Chinese real GDP in Q1 to 1% (4% annualized). On a year-over-year basis (2020Q1 versus 2019Q1), this would drag Chinese growth down to 3.5%, the slowest pace in three decades. Relative to our earlier estimates, we expect larger spillover effects to the rest of the world, mainly stemming from the severe contraction in global tourism. Chart 3The Global Economy Will Come To A Standstill In Q1 Markets Too Complacent About The Coronavirus Markets Too Complacent About The Coronavirus The direct and indirect effects of the outbreak should be enough to push global growth down to zero on a quarter-over-quarter basis in Q1. Under our baseline scenario, growth will recover in the second quarter, leaving the level of global GDP down 0.5 percentage points for the year as a whole compared to what would have transpired if the virus had never emerged.   The Calm Before The Storm? Even after this downgrade to our assessment, we still see the risks to global growth from the COVID-19 outbreak as being tilted to the downside. This largely reflects our concern that contrary to our baseline scenario, the outbreak could reintensify over the next few weeks as more Chinese workers return to their jobs. As the dire situation on the Diamond Princess cruiseliner docked in the port of Yokohama illustrates, the COVID-19 virus remains highly contagious. Despite numerous efforts by medical authorities to keep those on board at a safe distance from one another, 621 of the 3,011 passengers and crew aboard the ship who have been tested have been infected with the virus. Worryingly, the virus also appears to be contagious even when carriers are not showing any symptoms. Just this week, the Japanese media reported on a case where the son of an infected doctor tested positive for the virus even though he had last seen his father three days before the doctor started displaying symptoms.  While the number of new infections has fallen in China, new clusters have appeared elsewhere. South Korea just reported 73 new cases in a little more than two days. Iran disclosed two deaths from the virus in Qom, a holy city just outside Tehran that receives 20 million visitors annually. This suggests that there are probably at least 100 infected people in the city. The World Health Organization has estimated RO, the average number of people someone with the COVID-19 virus will infect, to be between 1.4 and 2.5. A recent survey of 12 studies found a larger mean RO of 3.28.1  An RO above one would produce an exponential increase in the number of cases. Heavy-handed quarantine measures such as those imposed by China could probably drive RO below one. However, some governments may not be able to implement such measures, and even if they could, they might not be sustainable for months on end.  The H1N1 (Swine Flu) Template? All this raises the possibility that the COVID-19 outbreak could end up resembling the H1N1 (swine flu) pandemic of 2009-10. Despite initial hopes, early efforts to contain the H1N1 outbreak failed. The US Centers for Disease Control and Prevention calculated that 61 million Americans caught the virus over the course of the proceeding 12 months, resulting in over 12,000 deaths. Globally, an estimated 700 million-to-1.4 billion people contracted the virus. A paper published in the Lancet put the number of fatalities worldwide at 151,700-to-575,400.2 The reason one hears less about H1N1 than SARS is that the latter killed 5%-to-10% of those who contracted it, whereas the former killed 0.01%-to-0.08%. Based on very preliminary evidence, it appears that the fatality rate from COVID-19 is significantly higher than for H1N1, though well below that of SARS, and lower still than for MERS, a particularly nasty strain of the coronavirus that killed about one-third of those who contracted it. That said, COVID-19’s true fatality rate remains highly uncertain. In Hubei province, the fatality rate is running at 3.1%. Elsewhere in China, it stands at 0.9%. Outside China, the fatality rate appears to be 0.5%. Part of the gap between Hubei and elsewhere may be due to greater underreporting of mild and moderate cases in the stricken province. However, it is also likely that Hubei’s higher fatality rate reflects the tremendous pressures its medical system is currently under. If the COVID-19 outbreak were to morph into a pandemic, such pressures would only escalate since medical resources from less-afflicted areas could no longer be deployed to fight every local breakout. The Economic Impact Of A Pandemic: Deep But Brief Chart 4The Private-Sector Surplus In Developed Economies Is In Good Shape The Private-Sector Surplus In Developed Economies Is In Good Shape The Private-Sector Surplus In Developed Economies Is In Good Shape Assuming the COVID-19 virus infects a billion people with a fatality rate of 2%, this would translate into 20 million deaths worldwide. Such a pandemic would rattle the global economy, leading to a recession as deep as the one in 2008/09. Demand for most items other than necessities would collapse. Business and leisure travel would fizzle. The global supply chain would seize up. The only consolation is that the recession would likely be followed by a vigorous “V-shaped” recovery. Sluggish “U-shaped” recoveries tend to occur when there are many imbalances that need to be worked off. For example, the recovery in the US following the Great Recession was impeded by the need for households to pare back debt and for the excess supply of newly built homes to be run down. Today, the larger developed economies are in decent shape. The private-sector financial balance in advanced economies – the difference between what the private sector earns and spends – stands at a surplus of 3.4% of GDP. In 2007, the private-sector financial balance fell to 0.4%, hitting a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 4). Chinese debt levels have soared over the past decade. However, it is worth noting that China’s private-sector financial surplus reached 7.1% of GDP in 2019 – higher than in Japan or Germany (Chart 5). Rather than suffering from excess debt levels, China suffers from excess savings. It is these excess savings that have forced the authorities to push state-owned companies and local governments to engage in debt-financed investment spending in order to prop up aggregate demand and employment. It is also these savings that will allow the government to stimulate the economy to prevent an outright economic collapse. Chart 5The Private Sector Spends Less Than It Earns In Most Economies Markets Too Complacent About The Coronavirus Markets Too Complacent About The Coronavirus Life Goes On… For Most Chart 6'Til Death Do Us Part Markets Too Complacent About The Coronavirus Markets Too Complacent About The Coronavirus While it would take time, as horrific as a pandemic would be, most people would eventually adjust to living in a world where one’s longevity is less assured than it is today. That is the world in which humanity lived for centuries. It is also the world that prevailed during the Cold War. Keep in mind that in the US, an average 59 year-old man has a 1% chance of dying at some point within one year, and a 6% chance of dying over five years (Chart 6). Death is a part of life. As the virus circulates throughout the population, some people will perish. However, the vast majority will acquire immunity either by fighting off the disease or, if a vaccine becomes available later this year or in 2021, by being inoculated. All this will bring the pandemic to an end.  Investment Conclusions No one knows if the COVID-19 outbreak will recede or whether it will morph into a true pandemic. As macro strategists, all we can do is run through various scenarios and try to figure out the likely market impact. Chart 7Global Manufacturing Was On The Upswing Before The Outbreak Occurred Global Manufacturing Was On The Upswing Before The Outbreak Occurred Global Manufacturing Was On The Upswing Before The Outbreak Occurred If the number of new infections continues to decline, investors will likely look through the Q1 plunge in growth. Judging from the purchasing manager indices, global growth had already turned the corner in the weeks before the viral outbreak (Chart 7). With pent-up demand having accumulated in the intervening weeks, growth would bounce back in the second quarter. Under this benign scenario, equities still have upside, while bond yields will start rising again. As a countercyclical currency, the US dollar would also give up some of its recent gains. In a pandemic scenario, the recovery in growth will obviously be delayed. And when output does recover, it will be from significantly lower levels. Markets will end up going through their own version of Kubler-Ross' five stages of grief: denial, anger, bargaining, depression, and acceptance. Unfortunately, before we reach the acceptance stage, global equities could easily fall by 20% from current levels. On balance, while we continue to lean on the side of optimism by maintaining our positive 12-month view on global stocks, we recommend a more cautious near-term stance until there is greater clarity as to how the outbreak will evolve.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1Ying Liu, Albert A Gayle, Annelies Wilder-Smith, and Joacim Rocklöv, “The reproductive number of COVID-19 is higher compared to SARS coronavirus,” Journal of Travel Medicine, February 2020. 2 Please see Sundar S. Shrestha, et al., “Estimating the Burden of 2009 Pandemic Influenza A (H1N1) in the United States (April 2009–April 2010),” Clinical Infectious Diseases (52:1), January 2011; Peter Doshi, “The 2009 Influenza Pandemic,” The Lancet Infectious Diseases (13:3), March 2013; and Heath Kelly, et al., “The Age-Specific Cumulative Incidence of Infection with Pandemic Influenza H1N1 2009 Was Similar in Various Countries Prior to Vaccination,” PLoS ONE 6(8), August 2011. Global Investment Strategy View Matrix Markets Too Complacent About The Coronavirus Markets Too Complacent About The Coronavirus MacroQuant Model And Current Subjective Scores Markets Too Complacent About The Coronavirus Markets Too Complacent About The Coronavirus Strategic Recommendations Closed Trades

Highlights The COVID-19-induced demand shock in China – and a stronger USD – will reduce growth in global crude oil consumption to just over 1mm b/d this year, vs. earlier expectations of ~ 1.4mm b/d. Significant fiscal and monetary stimulus from China will be required to put economic growth back on track over the critical 2020-21 interval. An accommodative monetary-policy backdrop globally also will support demand. On the supply side, OPEC 2.0 likely will cut output by an additional 600k b/d in 2Q20, which will remove 2.3mm b/d off member states’ official quotas. For 2H20, we expect the coalition to revert to its 1.7mm b/d in cuts to keep markets balanced. US shale-oil output growth will continue to slow under market-imposed capital discipline. We are revising our baseline price forecasts in 2020 lower to $62/bbl and $58/bbl for Brent and WTI, respectively (Chart of the Week). This is down $5/bbl vs our previous forecast. Price risk is to the upside, however. 2021 Brent and WTI forecasts remain at $70/bbl and $66/bbl, respectively, as we do not expect long-lived demand destruction from the COVID-19 outbreak. A growing consensus around policy stimulus and production cuts makes us leery. Feature Chart of the WeekCOVID-19 Knocks Oil Forecasts Lower COVID-19 Knocks Oil Forecasts Lower COVID-19 Knocks Oil Forecasts Lower COVID-19 continues to hammer Chinese oil demand, forcing refiners there to drastically reduce output. This crude oil is ending up in inventories, but, so far at least, overall storage capacity in China is not being maxed out by the unintended accumulations of crude and product inventories. Data are difficult to come by, but there are a few observations that provide some insight into the state of the refining market in China as the COVID-19 episode unfolds. Platt’s reported independent refiners in Shandong Province, which has ~ 3.4mm b/d of refining capacity, cut runs to a four-year low of ~ 40% of capacity this month, down from a January rate of 63.5%. Shandong refiners represent 50%-60% of China’s independent refining capacity.1 We estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. Ursa Space Systems’ radar satellite monitoring of inventories close to coastal refineries indicated Chinese oil storage at the beginning of the month was at 60% of capacity.2 This figure likely is higher, given refinery runs remain low, but it does not yet suggest storage capacity in China will be exhausted in the near future. In our modeling of the COVID-19 impact on oil demand, we estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. This leads us to believe EM oil demand will increase by 1mm b/d this year, down from our earlier expectation of 1.26mm b/d pre-COVID-19. For DM economies, demand growth also will disappoint, revised down by 100k b/d on the back of a warmer-than-expected winter and stop-and-go growth in manufacturing induced by COVID-19. Policy Stimulus Will Revive Chinese Demand The COVID-19 outbreak will result in a significant hit to China’s GDP, which will require substantial stimulus to put growth back on a 6% p.a. track this year. This growth rate is required for the Chinese Communist Party (CCP) to deliver on its pledge to double GDP and per-capita income over 2010-20, a pledge that was memorialized in writing following the Party’s 2012 Congress. In addition, next year marks the 100th anniversary of the founding of the CCP, and, we believe, it is an all-but-foregone conclusion the Party’s leadership will not want a faltering economy on display as it celebrates this important milestone. Given these considerations, the possibility policymakers will over-stimulate the economy to get it back on track is a non-trivial upside risk.3 We do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. Our baseline 2020 forecast envisions prices will falter somewhat versus our previous expectation – with Brent averaging $62/bbl this year, and WTI trading $4/bbl below that, vs. $67/bbl and $63/bbl previously. We are mindful of the impact Chinese policy stimulus can have on the global oil markets. The effects on GDP growth following demand shocks of past stimulus can be seen in the response of China’s GDP following the 2003 SARS outbreak; the 2008-09 GFC; the 2011-12 eurozone debt crisis; and even in China’s 2015-16 slowdown (Chart 2). For this reason, we do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. And it is for this reason that we believe price risk tilts to the upside this year. Our updated Ensemble price forecast includes two additional demand-side simulations to assess its sensitivity to changes in EM oil demand: Chart 2Chinese Stimulus Will Support Oil Demand Chinese Stimulus Will Support Oil Demand Chinese Stimulus Will Support Oil Demand Higher EM demand scenario (20% weight): We model the impact of the coronavirus as short-lived, with only a temporary impact on China’s economy. Consumer demand and industrial production in China converge to pre-COVID-19 levels rapidly in 2H20. Chinese policymakers overstimulate in 2Q20, over fears the virus could have severe long-term consequences on the economy. This scenario assumes EM demand increases by 100k b/d vs. our base case in 2020 and 2021. Lower EM demand scenario (10% weight): We model the impact of the coronavirus as a severe and long-lasting event. This triggers a negative feedback loop for EM oil demand; collapsing demand forces production lower, which reduces employment and pushes demand further down. This reverberates to other EM economies and affects global supply chains. This scenario assumes EM demand decreases by 240k b/d in 2020 and returns to our base case in 2021, supported by China stimulus. Oil-Demand Reduction (Not Destruction) The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). The COVID-19 outbreak in China caused us to reduce our expectation for global oil demand growth by ~ 360k b/d, taking 2020 year-on-year growth to ~ 1.04mm b/d, versus our earlier expectation of 1.4mm b/d. The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). Dollar strength produces a headwind for EM GDP growth, which suppresses oil-demand growth. The combination of the COVID-19-induced demand reduction and the stronger USD TWIB likely will compel OPEC 2.0 to maintain its production discipline until the global policy uncertainty abates and the USD TWIB retreats. Such a reversal in trend would become a tailwind for commodity demand (Chart 3). Chart 3Global Economic Uncertainty Keeps A Bid Under USD TWIB Global Economic Uncertainty Keeps A Bid Under USD TWIB Global Economic Uncertainty Keeps A Bid Under USD TWIB Global supply growth will continue to be constrained by demands from investors to return capital to shareholders. We expect the hit to global demand to be offset by increased production cuts from OPEC 2.0, which will be agreed next month. OPEC 2.0 production also will be impacted by continued output losses in Iran and Venezuela, which have seen y/y production fall by ~ 1.8mm b/d in 2019. Global supply growth will continue to be constrained by demands from investors to return capital to shareholders – via stock buybacks – and for steady and increasing dividends to make their equity competitive with alternative sectors (e.g., tech). These capital-market pressures – in addition to growing pressure from Environmental, Social and Governance (ESG) investors – will continue to have a profound effect on capital availability for oil and gas E+P companies for decades to come. This is a theme we will return to often in future research. We summarize these supply-demand dynamics in Chart 4. For OPEC 2.0, the 1.7mm b/d reduction in output the coalition agreed for 1Q20 remains in place, as do losses from Iran and Venezuela. For 2Q20, we assume the coalition adds another 600k b/d of production cuts. After that, we assume OPEC 2.0 reverts to its earlier production cuts of 1.7mm b/d for 2H20. In 2021, we assume OPEC 2.0 takes production cuts back down to 1.2mm b/d in January 2021, then gradually increases its production over 1H21 to balance the market and to avoid spiking prices. We also expect the Kingdom of Saudi Arabia (KSA) to remove 300k b/d of overcompliance next year, as markets tighten. In 2H21, we see OPEC 2.0 production levels remaining flat at ~ 44.8mm b/d (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Oil Demand Should Recover In 2H20 Oil Demand Should Recover In 2H20 Chart 4Supply-Demand Balances Supply-Demand Balances Supply-Demand Balances Chart 5Global Oil Inventories Will Resume Drawing Global Oil Inventories Will Resume Drawing Global Oil Inventories Will Resume Drawing For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. For the US, we reduced our Lower 48 production assumptions, and now have 740k b/d growth in 2020 and 300k b/d in 2021. Shales account for almost all of this increase. We also include a scenario in which US production comes in lower in our ensemble forecast. These fundamentals combine to put global oil inventories back on a downward trajectory in 2H20 (Chart 5). That said, there is an important caveat going into 2H20: If the US Economic Policy Uncertainty Index starts rising in 2H20 on the back of US election risks, markets will continue to price in a stronger USD in 2020 vs. what we now expect. For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. Odds favor a return to the pre-COVID-19 price trajectory for oil next year, with continued upside risk from Chinese fiscal and monetary stimulus, and a globally accommodative monetary-policy backdrop. Higher Spare Capacity Reduces Risk Premium The market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. The risk premium in oil prices evaporated following the drop in demand and the increase in spare capacity due to the large OPEC 2.0 cuts. When China’s economy resumes its normal activity, demand will pick up and the market will balance, increasing the impact of possible supply disruptions. However, the market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. In addition, if production capacity of ~ 300k-500k b/d in the Neutral Zone shared by KSA and Kuwait is restored, the risk premium could drop even lower, given this production is expected to be retained as spare capacity. If this is the case we could have lower prices in 2020 vs. our current forecast (down to ~ $60/bbl). We will be exploring the changes in OPEC 2.0 spare capacity and the consequences for overall production in future research. Bottom Line: Assisted by Chinese policy stimulus, oil demand will recover this year from the COVID-19-induced demand shock. On the supply side, the combination of deeper OPEC 2.0 production cuts – which we expect will be settled at the upcoming March meeting – and capital-market-imposed reduction in US oil production will push oil markets to a supply deficit. The ongoing demand shock forces us to reduce our 2020 Brent price forecast to $62/bbl from $67/bbl previously. For 2021, we maintain our $70/bbl target. Risks to our view are mounting. Three crucial pieces to our 2020 and 2021 expectations remain uncertain: The duration and magnitude of the impact of the coronavirus shock, The level of production cuts by OPEC 2.0 and the degree of compliance by all members, and The trajectory of the US dollar – if global economic policy uncertainty remains elevated the USD could remain well bid, which would continue to pressure EM GDP growth – and commodity demand – at the margin. Our base case remains that prices will rise from here, but our conviction level is slightly lower. One reason for this is the apparent consensus emerging around the likelihood of Chinese stimulus and OPEC 2.0 production cuts. If either of these assumptions prove wrong, oil prices likely would move lower.   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 As of Tuesday’s close, Brent prices were up 8% from their Feb 10 low of $53.27/bbl, supported by receding COVID-19 fears and rising expectations OPEC 2.0 will deepen its production cuts at its March meeting. Earlier this week, oil prices received an additional lift from the newly-imposed US sanctions on Rosneft Trading SA – a subsidiary of Russia’s state-own company – for its activities with Venezuela’s PDVSA. Rosneft Trading intensified its involvement in Venezuela’s oil sector and now handles the majority of the country’s crude exports, providing vital support to the Maduro government. The US restrictions include a 90-day wind-down period for companies to end their activities with Rosneft Trading. Base Metals: Neutral Chinese steel consumption – which accounts for ~50% of global demand – has been hit hard by the coronavirus outbreak. Steel and iron ore prices in China plunged 11% and 3% YTD (Chart 6). Steel mills’ inventories increased to record levels, reaching full capacity. Mills are now forced to export their surplus at reduced prices – flooding seaborne steel markets – or to cut output. Accordingly, more than 33% of steel mills are considering cutting steel production, according to a recent Platts survey. Margins at producing mills are declining and could harm high-grade iron ore prices. This is a short-term risk to our view. Precious Metals: Neutral Gold prices surged past $1,600/oz on Tuesday – overlooking positive manufacturing data in the US. Silver shadowed gold’s movement, closing at $18.13/oz. Precious metals are bought as insurance against risks of a wider-than-expected spread of the coronavirus and should remain well bid until uncertainty dissipates. Gold is somewhat overbought based on sentiment, momentum and technical indicators (Chart 7). If, as we expect, the daily increase in confirmed cases ex-Hubei slows meaningfully over the coming months, gold and silver prices will lose some steam. Ags/Softs:  Underweight CBOT March wheat futures surged 4.4% on Tuesday after Australia’s government sharply lowered its estimate of the country’s wheat harvest as severe drought affected crops. The Australian agricultural agency said the crop totaled 15.17 mm MT, the lowest since 2008, paving the way for stronger US exports. Corn also moved higher, with the prompt contract gaining 1.26% on the back of a new round of Chinese tariff exemptions on US goods. A USDA report showed US soybean export inspections bound for China were still half of last year's volumes. Soybeans futures closed 1.25 cents lower at $8.915/bu as markets await large Chinese purchases of US soybeans. Chart 6Increasing Inventories Pressure Steel and Iron ore Prices Increasing Inventories Pressure Steel and Iron ore Prices Increasing Inventories Pressure Steel and Iron ore Prices Chart 7Gold Technical Indicators Signal Overbought Market Gold Technical Indicators Signal Overbought Market Gold Technical Indicators Signal Overbought Market     footnotes 1     Please see China's Shandong independent refiners cut run rates to 4-year low of 40% in Feb, published by S&P Global Platts February 13, 2020. 2     Please see Oil demand falls on coronavirus: how much will inventories rise? posted by Ursa Space Systems February 7, 2020. 3     Please see Iron Ore, Steel Poised For Rally, published January 13, 2020, for a discussion of the significance of 2020 vis-à-vis the Communist Party’s pledge to double GDP and per-capita income vs. 2010 levels, memorialized by the CCP at its 2012 Peoples Congress.  We also discuss the 100th anniversary of the Party’s founding next year, which also will be a significant milestone for the CCP – and another reason the Party will not want the Chinese economy faltering as it is celebrated.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Oil Demand Should Recover In 2H20 Oil Demand Should Recover In 2H20 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Oil Demand Should Recover In 2H20 Oil Demand Should Recover In 2H20

Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively.  In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market   Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices   First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone   The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Downside Risks to Bond Prices Downside Risks to Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish   Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese policymakers will deliver more growth-supporting measures in the coming months, but Chinese government bond yields have already priced in a much weaker economic slowdown and a more aggressive policy response. While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. The PBoC’s recent liquidity injections are mostly a preventive measure to avoid an acute cash crunch in the real economy, and the historical path following the 2003 SARS outbreak suggests the additional monetary easing action is unlikely to be sustained over the coming 6-12 months. As such, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. On a cyclical basis, we continue to overweight Chinese equities over government bonds. Feature Chinese bond yields have declined sharply over the past two weeks, as investors weighed both the economic consequences of the Covid-19 outbreak and the likelihood of more accommodative monetary policy. Following the extended Chinese New Year holiday, China’s central bank (PBoC) has carried out five cash injections, pumping nearly 3 trillion yuan into the interbank market (Chart 1). It also lowered the de jure policy rate - the 7-day reverse repo rate - by 10bps to cut the cost of funding for commercial banks. The 3-month SHIBOR (which trades very closely to the 3-month repo rate), which we have long viewed as China’s de facto short-term policy rate, quickly reversed its January rise and fell back to its July-2018 low (Chart 2). Chart 1Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Chart 2Monetary Conditions Turned Much Easier In Just Three Weeks Monetary Conditions Turned Much Easier In Just Three Weeks Monetary Conditions Turned Much Easier In Just Three Weeks The PBoC’s aggressive easing measures of late have sparked market speculation that China is entering another major monetary and credit easing cycle, and that a government bond rally is well underway with even lower yields to come. Chart 3Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields In our January 29 Special Report1 on China’s government bond market, we discussed how there has been a strong relationship in the past decade between unexpected changes in the 3-month SHIBOR and the long-end of China’s government bond yields. In order for the current rally in government securities to be sustained, investors need to believe that the PBoC’s easing measures are here to stay and that there will be additional policy rate cuts in the months to come (Chart 3). There are indications that Chinese policymakers are looking to deliver more growth-supporting measures over the coming months. However, it is likely that the current bond rally will be a near-term event rather than a cyclical (6-12 months) trend. Therefore, on a cyclical time horizon, we continue to recommend overweighting Chinese stocks versus Chinese government bonds and would advise against an aggressively long duration stance. Has The Covid-19 Epidemic Peaked? The fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained.  Chart 4Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Investors appear to concur with our view that the Covid-19 outbreak has largely become a Hubei-specific crisis.2 Chinese stocks in the onshore and offshore markets have recovered more than half of the losses from their bottom on February 3, when the number of new cases outside of the Hubei epicenter reached a tentative peak. The 12-month change in the yields of Chinese 3 and 10-year government bonds also inched up since then (Chart 4). While the Chinese government’s rollout of supportive measures, including liquidity injections and policy rate cuts since early February might have helped improve market sentiment, the fact the epidemic outside Hubei province seems to be contained also helps explain the bottom in equity prices and bond yields. In addition, the number of new suspected cases outside Hubei province has trended down since February 9 (Chart 5). The diagnosis methodology was recently revised to include suspects with clinical symptoms, regardless of whether they had a history of contact with infected cases from Wuhan. This new methodology has lowered the bar for registering newly suspected cases. While the situation surrounding the Covid-19 outbreak is still fluid, the fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained. Bottom Line: Outside of the epicenter, the Covid-19 outbreak may have peaked. This means the fear element driving down Chinese government bond yields may soon end. Chart 5The Situation Continues To Get Better Outside Of The Epicenter Don’t Chase China’s Bond Yields Lower Don’t Chase China’s Bond Yields Lower Current Bond Rally Unlikely A Cyclical Play Bond yields now appear to have largely priced in a delayed economic recovery and more aggressive policy response. We think the current rally in Chinese government bonds will thus only be a short-term event rather than a cyclical (6-12 month) play. The rally in China’s government bond market since mid-2018 was largely driven by market expectations of a significant slowdown in the Chinese economy, and a much easier monetary policy in responding to a slowing Chinese domestic demand and a protracted Sino-US trade war. Bond market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. Cyclically, we think both of these factors are absent from the current situation, and a normalization back to the pre-outbreak monetary stance may come earlier than the market expects. In the last two weeks, Chinese government bond markets have discounted a sharp slowdown in economic activity; 10-year Chinese government bond yields are back below 3.0% for the first time since 2016 and the 3-month SHIBOR is now 25bps lower than the bottom in 2015-2016 (Chart 6). This suggests the market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. The nature of the current situation, as we pointed out in our previous reports,3 represents a temporary delay rather than a derailing of an economic recovery in China.  The Covid-19 outbreak and the unprecedented containment measures paused the Chinese economy in the first quarter, just as it was coming off of a two-year soft patch. But domestic demand was not nearly as weak as in 2015-2016 before the outbreak (Chart 7). Chart 6Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Chart 7A Chinese Economic Recovery Was Budding Pre-Outbreak A Chinese Economic Recovery Was Budding Pre-Outbreak A Chinese Economic Recovery Was Budding Pre-Outbreak Chart 8The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing If the virus is contained outside of the epicenter in the next couple of weeks and the hit to China’s overall economy is limited to Q1, then the PBoC will likely normalize policy back to its pre-outbreak stance. While the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, it was proactive in normalizing its monetary policy following short-term shocks. Chart 8 shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015.  In all three economic slowdowns, there has not been a significant rise in interbank rates in the first nine months of an economic recovery. Following the SARS outbreak, however, the PBoC reversed its easy stance and significantly tightened liquidity conditions in the banking system only four months after the peak of the SARS outbreak. While we do not expect the PBoC to shift into a tightening mode this year, a shift back to the pre-outbreak policy trajectory sometime in Q2 is highly likely, provided the Covid-19 outbreak is contained outside of Hubei province.  In turn, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. PBoC is also unlikely to open a liquidity floodgate. Despite large liquidity injections in the past two weeks, we are not convinced that the PBoC intends to fully open the liquidity tap in the interbank market.  So far, most of the financial support measures have been a combination of targeted low-cost funding to non-financial corporations and fiscal subsidies to local governments and businesses. This differs from 2015-2016 when the PBoC aggressively cut interbank rates and the 1-year benchmark lending rate, and kept excessive liquidity in the interbank system for a prolonged period (Chart 9). As Chart 9 (bottom panel) shows, PBoC’s net fund injections have been extremely volatile since Covid-19 erupted in January. This suggests that while the PBoC has added large doses of liquidity into the interbank market, demand for financial support in the banking system has mostly matched or even outstripped supply. In other words, the PBoC is not flooding the interbank system with cash, rather it is preventing an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  The PBoC is trying to prevent an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  Chart 9Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Chart 10Private Sector Highly Leveraged... Private Sector Highly Leveraged... Private Sector Highly Leveraged... This approach is warranted. Small businesses have been disproportionally hit by the outbreak and are reporting a severe shortage of cash. China’s private sector is particularly vulnerable to cash flow restrictions because many businesses are highly leveraged (Chart 10).  A joint survey of 995 small and mid-size companies by Tsinghua and Peking universities showed that more than 60% of respondents said they can survive for only one to two months with their current savings (Chart 11).   Chart 11…Making Small Businesses Especially Vulnerable To Cash-Flow Constraints Don’t Chase China’s Bond Yields Lower Don’t Chase China’s Bond Yields Lower Additionally, there is a risk that the PBoC is underestimating the demand for cash in the banking system, particularly from small- and medium-sized banks. This underestimation could lead to a rise in the interbank lending rate. This occurred in 2017 when the crackdown of shadow bank lending caused a funding squeeze for China’s small and mid-sized banks, which led to a material rise in interbank lending rates and government bond yields (shown in Chart 6). It is also the reason that we primarily track the 3-month SHIBOR over the 7-day rate, as the former tends to capture the effects of these funding squeezes whereas the latter does not. The demand for cash in the interbank market in the current quarter will be higher than in the same period last year. The government has announced an additional debt quota of 848 billion yuan, on top of the previously authorized quota of 1 trillion yuan worth of local government bonds that would be frontloaded in Q1. This is a 32% increase from a total of 1400 billion yuan of bonds that local government frontloaded in Q1 2019. This implies the demand for cash in the interbank market will remain high as commercial banks account for about 80% of local government bond purchases.4 A temporary spike in corporate bond defaults leading to a jump in the interbank rate could also push up government bond yields. Additionally, the delayed resumption of work, the loss of production and the cash crunch facing small companies raise the risk of a surge in overdue bank loans and defaults. This could also escalate the demand for cash from smaller banks, because large commercial banks may be unwilling to lend to riskier borrowers in the interbank market. The 3-month SHIBOR has inched up since the takeover of Baoshang Bank in May 2019. Chart 12Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields We expect the PBoC to lower the loan prime rate (LPR), following the 10bps cut in the medium lending facility rate (MLF) on February 17. As we pointed out in our January 29 Special Report, this easing by the PBoC will reduce corporate lending rates, but not necessarily interbank rates. Chart 12 shows that the change in average lending rates lags the change in Chinese government bond yields. Therefore, the upcoming cuts in the LPR are a result of lowered interbank rates and bond yields, not a cause for changes in government bond yields going forward. Bottom Line: Monetary policy will remain relatively loose this year, but we think the PBoC’s recent aggressive easing will be a temporary event. Any additional easing by the PBoC this year will likely be through providing short-term cash relief and temporarily lowered funding costs to non-financial corporations. There are also near-term risks that interbank rates may be pushed up due to a liquidity crunch.  Hence, yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Investment Conclusions While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. Barring a lasting economic slowdown from the Covid-19 outbreak, the long-end of the curve has the potential to move moderately higher in the second half of the year, as China’s economy recovers from the outbreak-induced shock. Bond yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Given this, we continue to expect Chinese domestic and investable equities to outperform government bonds in the next 6-12 months, and we would advise Chinese fixed-income investors against an aggressively long duration stance. Onshore corporate bonds, while risking a higher default rate in the near term, shares a similar outlook on a cyclical basis: onshore spreads are pricing in (massively) higher default losses than we believe are warranted. This means that onshore corporate bonds will still outperform duration-matched government bonds without any changes in yield, underpinning another year of Chinese corporate bond market outperformance versus government bonds.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Special Report "How To Analyze And Position Towards Chinese Government Bonds," dated January 29, 2020, available at cis.bcaresearch.com 2   Please see China Investment Strategy Weekly Report "The Evolving Crisis," dated February 13, 2020, available at cis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Recovery, Temporarily Interrupted," dated February 5, 2020, available at cis.bcaresearch.com 4   ChinaBond, as of 2019 Cyclical Investment Stance Equity Sector Recommendations