Equities

Highlights Please note that we published a Special Report early this week titled Brazilian Banks: Falling Angels, and an analysis on India. Please also note that we are publishing an analysis on Indonesia below. Given uncertainty over the depth and duration of the unfolding global recession, a sustainable equity bull run is now unlikely. It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. EM currencies and EM fixed-income markets will remain under selling pressure. Feature The question investors now face is whether the recent rebound will endure for a few months or it will just be a bear market rebound that is already fading. BCA’s Emerging Market Strategy service believes it is the latter. EM and DM share prices will likely make new lows.  A Tale Of Two Charts Chart I-1and I-2 overlay the current S&P 500 selloff with the market crashes of 1987 and 1929, respectively. The speed and ferocity of the current selloff is on a par with both. In 1987, following the 33% crash, share prices rebounded 14% but then relapsed without breaking below previous lows (Chart I-1). That was a hint that US share prices were entering a major bull market that indeed ensued. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In 1929, US share prices collapsed by 36% over several weeks. Then, the overall index staged an 18% rebound within a couple of weeks, rolled over and plunged to new lows. The magnitude of the second downleg was 27% (Chart I-2). Chart I-1S&P 500: Now Versus 1987 Chart I-2S&P 500: Now Versus 1929   Fast forward to today, the S&P 500 plummeted 34% in a matter of only four weeks and then staged a 17.5% rebound in only a few days. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In fact, we are assigning a higher probability to share prices in EM and DM breaking down to new lows than for the recent lows to hold. Chart I-3S&P 500: Now Versus 1929-32 Readers may question why we are comparing the current episode with the 1929 bear market. The argument against this comparison stresses that policymakers made numerous mistakes between 1929 and 1932, refusing to ease policy even after the crisis commenced. That led to debt deflation and a banking crisis, which in turn produced a vicious equity bear market of 85% lasting 3 years. At present, authorities around the world have reacted swiftly, providing enormous fiscal and monetary stimulus. We agree with this reasoning, but our point is as follows: Due to the US’s ongoing aggressive and timely policy response, stocks will avoid the protracted second phase of the 1930-‘32 bear market when share prices plummeted by another 80% (Chart I-3). Nonetheless, the US equity market could still repeat what occurred in the initial part of the 1929 bear market, as illustrated in Chart I-2 and Chart I-3. The Fundamentals The basis for our expectations of continued weakness in share prices is as follows: The selloff in the S&P 500 began from overbought and expensive levels (Chart I-4). The duration of the selloff so far has been only four weeks. We doubt that such a short, albeit vicious, selloff was enough to clear out valuation and positioning excesses. For example, even though by March 24 net long positions in US equity futures had dropped significantly, they were still above their 2011 and 2015/16 lows (Chart I-5). Chart I-4S&P 500: Correcting From Expensive Levels Chart I-5Net Long Positions In US Equity Indexes Futures   Besides, US equity valuations are still elevated. The cyclically adjusted P/E ratio for the S&P 500 – based on operating profits – is 25 compared with its historical mean of 16.5, as demonstrated in the top panel of Chart I-4. While this valuation model does not take into account interest rates, our hunch is as follows: facing such high uncertainty over the profit outlook, investors will require higher than usual risk premiums to invest in equities. In short, the ongoing profit collapse and the extreme uncertainty over the cyclical outlook heralds a higher risk premium. The discount rate – which is the sum of the risk-free rate and risk premium – presently should not be lower than its average over the past 20 years. We are experiencing a sort of natural disaster, and there is little policymakers can do amid lockdowns. Natural disasters require time to play out, and financial markets are attempting to price in this downturn.  Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. At the moment, global output and demand remain in freefall. The recovery will be hesitant and is unlikely to be V-shaped for two reasons: (1) social distancing measures will be eased only gradually; and (2) the lost household income and corporate profits from weeks and months of shutdowns will continue to weigh on consumer and business sentiment and their spending patterns for several months. China’s economy is a case in point. Both manufacturing and services PMIs for March posted readings in the 50-52 range. These are rather underwhelming numbers. Following stringent lockdowns in February when the level of economic output literally collapsed, only 52% of companies surveyed reported an improvement in their business activity/new orders in March relative to February. Chart I-6Our Reflation Confirming Indicator Is Downbeat If true, these PMI readings imply a level of output and demand in China that is still well below March 2019 levels. It seems China has not been able to engineer a V-shaped recovery in demand and output. Therefore, the odds are that, outside China, economic activity will come back only slowly. This entails that some businesses will not reach their breakeven points anytime soon, and that their profits will be contracting for some time to come. We do not think this is reflected in today’s asset prices.       Finally, our Reflation Confirming Indicator – which is composed of equally-weighted prices of industrial metals, platinum and US lumber – is pointing down (Chart I-6). Bottom Line: This bear market has been ferocious, but too short in duration. It is unlikely that share prices have already bottomed, given uncertainty over the depth and duration of the unfolding global recession. EM Versus DM: Stay Underweight Chart I-7EM Versus DM: Relative Equity Prices EM stocks have failed to outperform DM equities in the recent rebound. As a result, EM versus DM relative share prices are testing new lows (Chart I-7). Odds are that EM will underperform DM in the coming weeks or months. Outside North Asian economies (China, Korea and Taiwan), EM countries have less capacity to deal with the COVID-19 pandemic than advanced countries. First, health care systems in developing countries are far less equipped to deal with the pandemic than DM ones. Chart I-8 shows the number of hospital beds per 1,000 people in India, Indonesia, Brazil and Mexico are significantly lower than in Europe and the US. Chart I-8Many EMs Have Poor Health Infrastructure Second, EM ex-North Asian economies lack both the social safety net of Europe and the US’s capacity to inject large amounts of fiscal and monetary stimulus into the system. With the US dollar being the world reserve currency, the US has no problem monetizing its public debt and fiscal deficits. The same is true for the European Central Bank (ECB). If current account-deficit EM countries following in the footsteps of the US and monetize fiscal deficits/public debt, their currencies will likely depreciate. Last week, the South African central bank announced that it will buy local currency government bonds to cap their yields and inject liquidity into the system. This is of little help to foreign investors in domestic bonds because the rand has continued to sell off, eroding the US dollar value of their government bond holdings. Hence, the foreign investor exodus from the local currency bond market will likely continue. The same would be true for many other EM countries if they contemplate QE-type policies. Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. Third, unlike the Fed and the ECB, EM ex-North Asia central banks have limited capacity to alleviate funding stress for their companies. The Fed is also purchasing investment-grade corporate bonds and is setting up structures to channel credit to companies. All of this will marginally help ease financial and credit stress in the US. In contrast, central banks in EM ex-North Asia are unlikely to adopt similar policies on a comparable scale as the US. While DM countries do not mind seeing their currencies depreciate, authorities in many developing countries are fearful of further depreciation. The latter will inflict more stress on EM companies and banks that have large foreign currency debt. We will publish a report on EM foreign currency debt next week. Further, corporate bonds in DM are issued in local currency, allowing their central banks to purchase corporate bonds in unlimited quantities by creating money “out of thin air.” Chart I-9EM Performance Correlates With Commodities In contrast, outside of China and Korea, the majority of EM corporate bonds are issued in US dollars. This means that to bring down their corporate US borrowing costs, central banks in developing countries need to spend their finite US dollar reserves. Finally, commodities prices are critical to EM financial markets’ absolute and relative performance (Chart I-9). The outlook for commodities prices remains dismal. As the global economy has experienced a sudden stop, demand for raw materials and energy has literally evaporated. Liquidity provisions by the Fed and other key central banks may at a certain point help financial assets but will not help commodities. The basis is that demand for equities and bonds is entirely driven by investors, but in the case of commodities a large share of demand comes from the real economy. In bad times like these, central banks’ liquidity provisions can at a certain point persuade investors to look through the recession and begin buying financial assets before the real economy bottoms. In the case of commodities, when real demand is collapsing, financial demand will not be able to revive commodities prices. Bottom Line: It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. Technicals: Old Support = New Resistance? Calling tops and bottoms in financial markets is never easy. When formulating investment strategy it is helpful to examine both market price actions and other subtle clues that financial markets often provide. The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs. We have detected the following patterns that suggest the recent rebound is facing major resistance, and new lower lows are likely: The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs (Chart I-10). Unless these equity indexes decisively break above these lines, the odds favor retesting their recent lows or even falling to new lows. Many other equity indexes and individual stocks are also displaying similar technical patterns. The Korean won versus the US dollar as well as silver prices exhibit a similar technical profile (Chart I-11). Chart I-10Ominous Technical Signals Chart I-11New Lows Ahead   Global materials have decisively broken below their long-term moving average that served as a major support in 2002, 2008 and 2015 (Chart I-12). The same multi-year moving average is now likely to act as a resistance. Hence, any rebound in global materials stocks – that extremely closely correlate with EM share prices – is very unlikely to prove durable until this support-turned-resistance level is decisively breached. US FAANGM (FB, AMZN, APPL, NFLX, GOOG, MSFT) equally-weighted stock prices have dropped below their 200-day moving average that served as a major support in recent years (Chart I-13). They did rebound but have not yet broken above the same line. Odds are that this line will become a resistance. If true, this will entail new lows in FAANGM stocks. Chart I-12Global Materials Broke Below Their Long-Term Defense Line Chart I-13FAANGM: Previous Support Has Become New Resistance   Bottom Line: Various financial markets are exhibiting technical patterns consistent with retesting recent lows or making lower lows. Stay put. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Indonesia: A Fallen Angel Chart II-1Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian stock prices are in freefall - both in absolute terms and relative to EM - with no visible support (Chart II-1). We recommend that investors maintain an underweight position in both Indonesian equities and fixed-income and continue to short the rupiah versus the US dollar. We explain the reasoning behind this recommendation below. First, the key vulnerability of Indonesian financial markets is that they had been supported by massive foreign inflows stirred by falling US interest rates, despite deteriorating domestic fundamentals and falling commodities prices. We discussed this at length in our previous reports. However, the COVID-19 pandemic has brought these weak fundamentals to light. The latter have overshadowed falling US interest rates (Chart II-2) triggering an exodus of foreign portfolio capital and a plunge in the exchange rate. Currency depreciation has in turn mounted foreign investors losses resulting in a vicious feedback loop. As of the end of February, foreigners held about 37% of local currency bonds. Meanwhile, they held 56% of equities as of last week. Ongoing currency weakness and continued jitters in global financial markets will likely generate more foreign capital outflows.                    Second, the Indonesian economy - both domestic demand and exports - were already weak even before the breakout of COVID-19 occurred (Chart II-3).  Chart II-2Indonesia: Falling US Rates Stopped Mattering Chart II-3Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak   Chart II-4Indonesia: Struggling Under High Lending Rates With imposition of social distancing measures, output and nominal incomes will contract (Chart II-4). Third, the nation’s very underdeveloped health care system makes it more vulnerable to a pandemic compared to other mainstream EM countries. For example, the number of hospital beds per 1000 people - at 1.2 - is among the lowest within the mainstream EM universe. We discuss this issue for EM in greater detail in our most recent weekly report. In brief, it will take a longer time for this nation to overcome the pandemic and get its economy back on track. Fourth, Indonesia - as with many EM countries - is short on both social safety programs and fiscal stabilizers that are available in North Asian countries, Europe and the US. Moreover, the country lacks the administrative system needed to promptly execute fiscal stimulus. Besides, the economic stimulus announced by the Indonesian authorities is so far insufficient to meaningfully moderate the economic blow. The government announced a fiscal stimulus that barely amounts to 1% of GDP. This will do little to counter the recession that the nation’s economy is now entering. On the monetary policy front, though the central bank has been cutting policy rates and injecting local currency liquidity into the system, this will only help reduce liquidity stress. It will not directly aid ailing households and small businesses suffering from an income shock. Critically, prime lending rates have not dropped despite dramatic cuts in policy rates (Chart II-4). Chart II-5Bank Stocks - Last Shoe To Drop - Are Unraveling Now Meanwhile, the government’s decision to grant a debt servicing holiday to borrowers will only help temporarily. These borrowers will still need to repay their debts at some point down the line. Given the magnitude and uncertain duration of their income loss, there is no guarantee they will be in a position to service their debt after the pandemic is over. Eventually, Indonesian commercial banks will experience a large increase in non-performing loans (NPLs). Overall, the plunge in domestic demand combined with the fall in global trade and commodities prices entails that Indonesia is heading into its first recession since 1998. Given Indonesia has for many years been one of the darlings of EM investors, a recession in Indonesia and global flight to safety herald continued liquidation in its financial markets. Both local government bond yields and corporate US dollar bonds yields are breaking out. Rising borrowing costs amidst the recession will escalate the selloff in equities. Remarkably, non-financial stocks and small-caps have already fallen by 40% and 55% in US dollar terms, respectively (Chart II-5, top two panels). It was banks stocks – which comprise 35% of total market cap – that were holding up the overall index (Chart II-5, bottom panel). Given banks will likely experience rising defaults as discussed above, their share prices have more risk to the downside. Bottom Line: Absolute return investors should stay put on Indonesian risk assets for now. We maintain our short position on the rupiah versus the US dollar. EM-dedicated equity investors should keep underweighting Indonesian equities within an EM equity portfolio. Meanwhile, EM-dedicated fixed income investors should continue to underweight Indonesian local currency bonds as well as sovereign and corporate credit. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

In our latest Weekly Report we boosted the S&P data processing index to overweight from previously underweight. Data processing stocks are a services-based defensive tech index that typically thrive in deflationary and recessionary environments, according to empirical evidence (see chart). We are currently in recession, thus a deflationary impulse will grip the economy and investors will flock to defensive tech stocks when growth is scarce. Tack on the spike in the greenback, and the disinflationary backdrop further boosts the allure of these tech services stocks (third panel). Beyond the recessionary related tailwinds, data processing stocks should also enjoy firming relative demand. While the two bellwether stocks, V and MA, will suffer from the decrease in consumption that requires physical visits and from select services outlays that are severely affected by the coronavirus, online spending by households and corporations should at least serve as a partial offset. Bottom Line: We recently lifted the S&P data processing index to overweight from previously underweight. The ticker symbols for the stocks in this index are: BLBG: S5DPOS – ADP, V, MA, PYPL, FIS, FISV, GPN, PAYX, FLT, BR, JKHY, WU, ADS.  

Highlights The economic shutdown needed to exhaust the coronavirus pandemic must last much longer than is anticipated. For example, in Italy it must last 24 weeks. If the economy is reopened too soon, the pandemic will reignite in a second wave later this year, just as in 1918. Take the 12 percent profit in the tactical overweight to equities versus bonds and go neutral. Stay underweight European equities and euro area banks given their high sensitivity to the economy. Stay overweight US T-bonds versus German bunds and Swiss bonds. All high-quality bond yields will eventually reach the lower bound of -1 percent, making US T-bonds the most attractive in class. The euro is a structural overweight but a tactical neutral – because in equity market corrections the repatriation of foreign investments into domestic cash boosts the demand for dollars relative to the euro. Fractal trades: Go long Australia versus New Zealand. Short palladium versus nickel was closed at 32 percent profit. Feature “You’ve got to understand that you don’t make the timeline, the virus makes the timeline” – Dr. Anthony Fauci, Director of the National Institute of Allergy and Infectious Diseases It’s A Biological Crisis The coronavirus crisis is first and foremost a biological crisis. This makes it fundamentally different to the 2008 global financial crisis, the 2000 dot com bust, the 1990 Japanese crash, and the 1930s Great Depression – all of which were financial crises needing financial and economic cures. As such, the current crisis needs to be analysed very differently. Crucially, the financial and economic policy responses to the coronavirus crisis are only a palliative, not a cure. The cure is to exhaust the coronavirus pandemic. But to exhaust the pandemic without overburdening stretched healthcare systems will require shutting the economy for months. If the economy is reopened too soon, then the pandemic will reignite in a second and a possible third wave just as in 1918-19 (Chart of the Week). Chart I-1If The Economy Is Reopened Too Soon The Pandemic Will Reignite, Just As In 1918-19 The US fiscal stimulus package amounts to 10 percent of annual GDP. But if exhausting the pandemic requires a third of the economy to be shut for a third of the year, then the economy would lose one ninth, or 11 percent, of its annual output. Hence, despite the biggest fiscal boost of all time, the economy would end up shrinking (Chart I-2). Chart I-2Fiscal Stimulus Is Massive, But Might Not Be Enough Meanwhile, Germany’s willingness to remove the ‘debt brake’ that limits its structural federal deficit to 0.35 percent of GDP, the willingness to issue euro ‘corona-bonds’, and the ECB’s willingness to increase the size and breath of its asset-purchase program are minor details in a much bigger story. Rather like rearranging the deckchairs on the Titanic. Ignore the minor details and concentrate on the bigger story. How long must the economy stay shut to exhaust the pandemic? The Crucial Metric Is Not Mortality, It Is Morbidity Some people counter that in shutting the economy, “the cure is worse than the disease”. They argue that most coronavirus victims suffer mild or no illness. Moreover, the mortality rate is low and might not be much higher than that of the flu. Even if this turns out to be true, the argument misses the point. Death requires very little medical intervention and resource, whereas severe illness requires massive medical intervention and resource. Moreover, when the severe illness is a respiratory illness, it leaves the sufferer struggling to breathe and needing ventilation in an intensive care unit (ICU). No civilized society can deny an ICU to somebody who is struggling to breathe. Therefore, the most important metric for the coronavirus crisis is not its mortality rate, but rather its morbidity (severe illness) rate. Or more specifically, the morbidity rate versus the economy’s ICU capacity. How long must the economy stay shut to exhaust the pandemic? Enter the Diamond Princess. The cruise ship turned into a laboratory for the coronavirus because all 3700 passengers and crew were quarantined and tested for the infection. Of the 700 people who tested positive, 11 have subsequently died. But the more important point is that 45 people needed ICU treatment, meaning the coronavirus morbidity rate was four times its mortality rate (Table I-1). Table I-1On The Diamond Princess, The COVID-19 Morbidity Rate Was Four Times Its Mortality Rate A separate study by the Intensive Care National Audit & Research Centre in the UK corroborates this, suggesting that the coronavirus morbidity rate is around three times the mortality rate and that the average time in an ICU for a coronavirus patient is half a week.1 Let’s be optimistic and assume that the coronavirus mortality rate is around 0.3 percent and that its morbidity rate is around three times higher at 1 percent. This means that if a hundred thousand people get infected, one thousand will need ICU treatment. But even advanced economies have only a dozen or so ICU beds per hundred thousand people. For example, Italy has 12.5 (Chart I-3). Chart I-3Advanced Economies Have Only A Dozen Or So ICU Beds Per Hundred Thousand People If each severely ill coronavirus patient averages half a week in an ICU, this means that only 2500 Italians out of hundred thousand, or 2.5 percent of the population, can get infected every week before the ICU capacity is breached. Northern Italy, specifically Lombardy, went into crisis because it allowed its coronavirus infection rate to breach its ICU capacity. Yet ‘flattening the curve’ of infections comes at a cost. Keeping the weekly infection rate below ICU capacity means that the infection rate must be suppressed for longer to achieve the holy grail of ‘herd immunity’. This is the point when around 60 percent of the population have caught the disease. To achieve herd immunity without breaching its ICU capacity, Italy would have to shut its economy for 24 weeks. Other economies might need less or more time depending on their own morbidity rates versus ICU capacity, but it would still be a minimum of many months. Meaning that the draconian measures that flatten the infection curve – quarantining, social distancing, and essentially shutting the economy – must also stay in place for many months after infection rates have stopped rising. Therein lies the big problem.2 If The Economy Reopens Too Soon The Pandemic Will Reignite A pandemic is a classic complex adaptive system. Its evolution depends on the sum of many millions of individual actions which themselves depend on the evolving pandemic data.  When mortality, morbidity and infection rates are surging the public will sense an emergency, and so accept the loss of liberty and livelihood that comes from quarantining and shutting the economy. The result is that ‘R-nought’ – the number of people that each infected person infects – drops, which suppresses the pandemic. If the economy reopens too soon, the pandemic will reignite in a second wave. But once infection rates level off or reverse, the public’s sense of emergency dissipates. People push back against the continued loss of liberty and livelihood. As do policymakers, especially those seeking imminent re-election. The result is that R-nought reaccelerates. In fact, the emergency has not dissipated. Once R-nought reaccelerates, the large proportion of the population who have not been infected are sitting ducks for the virus. Therefore, if the economy reopens too soon, the pandemic will reignite in a second wave (Chart I-4). Chart I-4When A Large Proportion Of The Population Is Uninfected, ‘R-Nought’ Must Stay Low History provides a salutary warning. During the 1918-19 pandemic, no US city experienced a second wave while its main battery of social distancing policies remained in place. Second waves only occurred after the city economies were reopened too soon.3 Implications For The Financial Markets The key message is that the economic shutdown must last longer than is anticipated. And that if the economy is reopened too soon, the pandemic will reignite in a second wave later this year. Therefore: 1. Move to neutral equities tactically: Our March 12 tactical recommendation to overweight equities versus bonds (long S&P500 versus German 30-year bund) achieved its 12 percent profit target and is now closed (Chart I-5). Chart I-5The Technical Rebound Has Happened As Predicted 2. Overweight equities on a long-term horizon: Investors with a 2 year or longer horizon beyond the pandemic should overweight equities versus bonds – because the prospective annualised return from equities, 6 percent, is much more attractive than that from bonds, 1 percent (Chart I-6 and Chart I-7). Chart I-6The Prospective Annual Return From Equities At 6 Percent… Chart I-7...Is Much More Attractive Than 1 Percent From Bonds 3. Underweight European equities: Our 2020 recommendation to underweight the euro area relative to the US and Japan is providing rich rewards as the S&P 500 has outperformed by 8 percent, and the Nikkei 225 has outperformed by 10 percent. Given the economic sensitivity of the Eurostoxx 50, stay underweight. 4. Underweight euro area banks: Likewise, euro area banks have underperformed the market by almost 25 percent this year. But it is too soon to remove this underweight. 5. Overweight US T-bonds versus German bunds and Swiss bonds: The US 30-year T-bond has outperformed the German 30-year bund by 18 percent this year. Stick with this position. Ultimately, all high-quality bond yields are going to hit the lower bound of -1 percent, making US T-bonds the most attractive in class. 6. The euro is a structural overweight but a tactical neutral: The structural pecking order for currencies is the reverse of bonds. However, during equity market corrections the repatriation of foreign investments into domestic cash boosts the demand for dollars relative to other currencies. This warrants a tactically neutral stance to the euro. Fractal Trading System* The fractal trading system has performed very well during the recent crisis. Long S&P 500 versus the German 30-year bund delivered its 12 percent profit target. And short palladium versus nickel delivered its 32 percent profit target. This week’s recommended trade is to go long Australia versus New Zealand expressed through their MSCI (US$) indexes. The profit target is 12 percent with a symmetrical stop-loss. The rolling 12-month win ratio now stands at 64 percent. Chart I-8Australia Vs. New Zealand When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: ICNARC report on COVID-19 in critical care, 27 March 2020 2 If 60 percent are infected, then 0.6 percent would require an ICU. This equates to 600 people out of a hundred thousand for whom there are 12.5 ICUs. If the average stay in the ICU is half a week, this would require 600/12.5 half weeks, or 0.5*600/12.5 full weeks = 24 weeks. 3 Source: Public health interventions and epidemic intensity during the 1918 influenza pandemic; Hatchett, Mecher, and Lipsitch Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 31, 2020.  The model upgraded Canada and Australia to overweight, financed by a reduction in the overweights of the US, Italy, Sweden and Spain, largely due to improvement in these two countries’ liquidity indicators. Now the US, Australia and Spain are the top three overweight countries, while Japan, the UK and France remain the three large underweight countries, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed the MSCI World benchmark in March by 78 bps. The Level 1 model outperformed 14 bps because of the overweight in the US, however, the non-US Level 2 model suffered 357 bps of underperformance driven largely by the underweight in Japan and overweight in Spain. Since going live, the overall model has underperformed by 8 bps, with 125 bps of underperformance by the Level 2 model, and 13 bps of underperformance from the Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1)     Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of March 31, 2020. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The coronavirus (COVID-19) outbreak caused tremendous market volatility and huge declines in equities throughout March with the MSCI ACWI broad index down -24% overall, and various sectors hit even harder. Last month, the sector model’s defensive tilt helped mitigate this shortfall, and the model outperformed its benchmark by 85 basis points. The global growth proxy used in our model remains negative. This will continue to make the model's positioning focused on less cyclical sectors. Additionally, last month’s sector moves led the momentum component to favour Consumer Staples rather than Discretionary. The coordinated accommodative policy stance implemented by global central banks should keep the liquidity component favouring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, we highlight that Info Tech’s valuation component has broken into overvalued territory (yet the model awaits a downwards confirming momentum signal to recommend an underweight). The model is now overweight four sectors in total, one cyclical sector versus three defensive sectors. These are Information Technology, Utilities, Consumer Staples, and Health Care. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Overall Model Performance Table 4Current Model Allocations ​​​​​​​Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com ​​​​​​​Amr Hanafy Senior Analyst amrh@bcaresearch.com  

Highlights Recommended Allocation The outlook for markets over the next few months is highly uncertain. On the optimistic side, new COVID-19 cases are probably close to peaking (for now), and so equities could continue to rally. But there are many risks too. Growth numbers will be horrendous for some months. Second-round effects (corporate defaults, problems in EM and with euro zone banks, for example) will emerge. We recommend a balanced portfolio, robust both for risk-on rallies and a further sell-off. We stay overweight equities versus bonds. Government bonds will not provide significantly positive returns even in a severe recession. Thus, over the next 12-months, equities are likely to outperform them. But we leaven the equity overweight with a “minimum volatility” strategy, overweight the low-beta US market, and more stable sectors such as Healthcare and Technology. Within bonds, we stay underweight government bonds, and raise Investment Grade credit to overweight, given the Fed’s backstop. Even in a risk-on rally, government yields will not rise quickly so we recommend a neutral stance on duration. The massive stimulus will eventually be inflationary, so we recommend TIPS, which are very cheaply valued. We are overweight cash and gold as hedges against further market turbulence. Among alternatives, macro hedge funds and farmland look attractively defensive now. We would start to look for opportunities in private debt (especially distressed debt) as the recession advances. Commodity futures are attractive as an inflation hedge. Overview Playing The Optionality From the start of the crisis, we argued that markets would bottom around the time when new cases of COVID-19 peaked. At the end of March, there were clear signs that this would happen in April, with Italy and Spain having probably already peaked and the US, if it follows the same trajectory, being only two or three weeks away (Chart 1). Chart 1Close To A Peak In New Cases? But what happens next? A relief rally is likely, as often happens in bear markets – and indeed one probably started with the three-day 18% rise in US equities in the last week of March. Note, for example, the strong rallies in spring 2008 and summer 2000 before the second leg down in those bear markets (Chart 2). Chart 2Mid Bear Market Rallies Are Common However, there is still a lot of potential bad news for markets to digest. Global growth has collapsed, as a result of people in many countries being forced to stay at home. US GDP growth in Q2 could fall by as much as 10% quarter-on-quarter (unannualized). Horrendously bad data will come as a shock to investors over the coming months. Despite the unprecedented stimulus measures from central banks and governments worldwide (Chart 3), nasty second-round effects are inevitable. Given the high level of corporate debt in the US, defaults will rise, to perhaps above the level of 2008-9 (Chart 4). EM borrowers have almost $4 trillion of foreign-currency debt outstanding, and will struggle to service this after the rise in the dollar and wider credit spreads. Euro area banks are poorly capitalized and have high non-performing debt levels left over from the last recession; they will be hit by a new wave of bankruptcies. Undoubtedly, there are some banks and hedge funds sitting on big trading losses after the drastic sell-off and stomach-churning volatility. Mid-East sovereign wealth funds will unload more assets to fill fiscal holes left by the collapsed oil price. Chart 3Massive Stimulus Everywhere Chart 4Possible Second-Round Effects     There is also the question of when the pandemic will end. We are not epidemiologists, so find this hard to judge (but please refer to the answers from an authority in our recent Special Report1). The coronavirus will disappear only when either enough people in a community have had the disease to produce “herd immunity,” or there is a vaccine – which is probably 18 months away.  Some epidemiologists argue that in the UK and Italy 40%-60% of the population may have already had COVID-19 and are therefore immune.2 But an influential paper from researchers at Imperial College suggested that repeated periods of lockdown will be necessary each time a new wave of cases emerges3 (Chart 5). Chart 5More Waves Of The Pandemic To Come? At the end of March, global equities were only 23% off their mid-February record high – and were down only 34% even at their low point. That doesn’t seem like enough to fully discount all the potential pitfalls over coming months. This sort of highly uncertain environment is where portfolio construction comes in. We recommend that clients position their portfolios with optionality to remain robust in any likely outcome. There are likely to be rallies in risk assets over coming months, particularly when the coronavirus shows signs of petering out. There is significant asymmetric career risk for portfolio managers here. No portfolio manager will be fired for missing the pandemic and underperforming year-to-date (though some may because their firms go out of business or retrench). But a PM who misses a V-shaped rebound in risk assets over the rest of the year could lose their job.  This will provide a strong incentive to try to pick the bottom. Chart 6Bond Yields Can't Go Much Lower Government bond yields are close to their theoretical lows. The 10-year US Treasury yield is 0.6% and it unlikely to fall below 0% even in a severe recession (since the Fed has stated that it will not cut short-term rates below 0%). In other countries, the low for yields has turned out to be around -0.3% to -0.9% (Chart 6). The total return from risk-free bonds, therefore, will be close to zero even in a dire economic environment (Table 1). This means that the call between bonds and equities comes down to whether equity prices will be higher or lower in 12-months. Quite likely, they will be higher. Given this, and the optionality of participating in rebounds, we maintain our overweight on equities versus bonds. We would, however, be inclined to lower our equity weighting in the event of a big rally in stocks over the next few months.   Table 1Not Much Room For Upside From Bonds Table 2Bear Markets Are Often Much Worse But there are also many downside risks. In the past two recessions, global equities fell by 50%-60% (Table 2). Despite the much worse economic environment this time, the peak-to-trough decline is so far much more limited. Moreover, valuations are not particularly compelling yet (Chart 7). To leaven our overall overweight on equities, we recommend a “minimum volatility” strategy, with tilts towards the low-beta US market, and some more defensive sectors such as Healthcare and Technology. China and China-related stocks also look somewhat attractive, since that country got over the coronavirus first, and is responding with a big increase in infrastructure spending (Chart 8). To hedge against downside risk, we also leave in place our overweights in cash and gold. Chart 7Equities Are Not Yet Super Cheap Chart 8China Infra Spending To Rise Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking – About The Coronavirus Have We Seen The Bottom In Equity Markets?  Chart 9Watch Closely COVID-19 After hitting a low on March 23, global equities have recovered more than one-third of their loss during this particularly rapid bear market, in response to the massive monetary and fiscal stimulus around the globe. It’s very hard to pinpoint the exact bottom of any equity bear market.  The current one is particularly difficult in two ways: First, it was largely due to the exogenous shock from the COVID-19 pandemic. If history is any guide, we will first need to see a peak in infected cases globally before we can call a true bottom in equities (Chart 9). Second, the massive and coordinated response from central banks and governments around the world is unprecedented, as the global “lockdown” freezes the global economy. It’s encouraging to see the Chinese PMI bouncing back to 52 in March after a sharp drop to deep contraction level in February. However, the bounce back was mostly from production. Both export orders and imports remain weak. US initial jobless claims have skyrocketed to 3.3 million. If the peak of infection in the US follows similar patterns in China and Italy, then it would be another encouraging sign even if the US economic data continued to get worse. BCA Research’s base-case is for this recession to have a U-shaped recovery. This means that equity markets are likely to be range bound until we have a better handle on the future course of the pandemic. As such, we suggest investors actively manage risk by adding to positions when the S&P 500 gets close to 2250 and reducing risk when it gets close to 2750 during the bottoming process. What Will Be The Long-Term Consequences? Maybe it seems too early to think about this, but the coronavirus pandemic will change the world at least as profoundly as did the 1970s inflation, 9/11, and the Global Financial Crisis (GFC). Here are some things that might change: Chart 10Government Debt Will Rise Significantly Government debt levels will rise dramatically, as a result of the huge fiscal packages being (rightly) implemented by many countries. In the US, after the $2 trillion spending increase and a fall in tax revenues, the annual fiscal deficit will rise from 6% of GDP to 15%-20%. Government debt/GDP could exceed the 122% reached at the end of WW2 (Chart 10). Ultimately, central banks will have to monetize this debt, perhaps by capping long-term rates or by buying a substantial part of issuance. This could prove to be inflationary. Households and companies may want to build in greater cushions and no longer live “on the edge”. US households have repaired their balance-sheets since 2009, raising the savings rate to 8% (Chart 11). But surveys suggest that almost one-third of US households have less than $1,000 in savings. They may, therefore, now save more. This could depress consumption further in coming years. Companies have maximized profitability over the past decades, under pressure from shareholders, by keeping inventories, spare cash, and excess workers to a minimum. Given the sudden stop caused by the pandemic (and who is to say that there will not be more pandemics in future), companies may want to protect themselves from future shocks. The inventory/sales ratio, which had been falling for decades, has picked up a little since the GFC (Chart 12). Inventory levels are likely to be raised further. Companies may also run less leveraged balance-sheets, rather than hold the maximum amount of debt their targeted credit rating can bear. This is all likely to reduce long-term profit growth. Chart 11Households May Become Even More Cautious Chart 12Companies Will Run With Higher Inventories The pandemic has highlighted the vulnerability of healthcare systems. China still spends only 5% of GDP on health, compared to 9% in Brazil and 8% in South Africa (Chart 13). The lack of intensive care beds and woefully inadequate epidemic plans in the US and other developed countries will also need to be tackled. Healthcare stocks should benefit. Chart 13Healthcare Spending Will Need To Rise How Risky Are Euro Area Banks? Chart 14Euro Area Banks Are Quite Fragile Banks in the euro area have underperformed their developed market peers by over 65% since the Global Financial Crisis (GFC) (Chart 14, panel 1). Their structural issues – many of which we highlighted in a previous Special Report – remain unsolved.  Euro area banks remain highly leveraged compared to their US counterparts (panel 2). Their exposure to emerging economies is high (panel 3), and they continue to be a major provider of European corporate funding. US corporates, by contrast, are mainly funded through capital markets. The sector is also highly fragmented with both outward and inward M&A activity declining post the GFC. Profitability continues to be a key long-term concern, despite having recently stabilized (panel 4). The ECB’s ultra-dovish monetary stance and negative policy rates do not help banks’ performance either.  Banks’ relative return has been correlated to the ECB policy rate since the GFC (panel 5). Following the coronavirus outbreak, the ECB is likely to remain dovish for a prolonged period. The ECB’s recently announced measures should, however, provide banks with ample liquidity to hold and spur economic activity through increased lending to households and corporates. Absent consolidation in the European banking sector, competition is likely to dampen banks’ profits. Additionally, the severity of the economic downturn caused by the coronavirus outbreak will determine if their significant exposure to emerging economies, the energy sector, and domestic corporates will hurt them further. For now, we would recommend investors underweight euro area banks. Where Can I Get Income In This Low-Yield World? Chart 15The Bear Market Has Unveiled Attractive Income Opportunities For long-term investors who can tolerate price volatility, there is currently an opportunity to invest in high-income securities at relatively cheap prices. Below we list three of our favorite assets to obtain income returns: Dividend Aristocrats: The S&P 500 Dividend Aristocrats Index is composed of S&P 500 companies which have increased dividend payouts for 25 consecutive years or more. In order to provide such a steady stream of income through a such long timeframe, and even provide dividend increases in recessions, the companies in this index need to have a track record of running cashflow-rich businesses. Thus, the risk of dividend cuts is relatively low in these companies. Currently, the Dividend Aristocrat Index has a trailing dividend yield of 3.2% (Chart 15 – top panel). Fallen Angels: As we discussed in our November Special Report, fallen angels have attractive characteristics that separate them from the rest of the junk market. They tend to have longer maturities as well as a higher credit quality than the overall index. Crucially, fallen angels often enter the high-yield index at a discount, since certain institutional investors are forced to sell them when they are no longer IG-rated (middle panel). Thus, selected fallen angels which are not at a substantial risk of default could be a tremendous income opportunity. Currently fallen angels have a yield to worst of 10.65%. Sovereign US dollar EM debt: Our Emerging Markets Strategy service has argued that most EM sovereigns are unlikely to default on their debts, and instead will use their currencies as a release valve to ease financial conditions in their economies. Thus, hard-currency sovereign issues could prove to be attractive income investments if held to maturity. The bottom panel of Chart 15 (panel 3) shows the current yield-to-worst of the EM sovereign hard currency debt that has an overweight rating by our Emerging Markets service. Global Economy Chart 16The Collapse Begins Overview: The global economy in early January looked on the cusp of a strong manufacturing pickup, driven by the natural cycle and by moderate fiscal stimulus out of China. The coronavirus changed all that. We now face a recession of a severity unseen since the 1930s. The fiscal and monetary response has been similarly rapid and radical. This will tackle immediate liquidity and even solvency risks. But, with consumers in many countries confined to their homes, a recovery is entirely dependent on when the number of new cases of COVID-19 peaks. In an optimistic scenario, this might be in late April or May. On a pessimistic one, the pandemic will continue in waves for several quarters.  US: It is highly likely that the NBER will eventually declare that the US entered recession in March 2020. With many states in lockdown, consumption (which comprises 70% of GDP) will slump: only half of consumption is non-discretionary (rent, food, utility bills etc.); the other half is likely to shrink significantly while lockdowns continue. Judged by the 3.3 million initial claims in the week of March 16-21, unemployment will jump from its February level of 3.5% very rapidly towards 10%. Fiscal and monetary stimulus measures will cushion the downside (enabling households to pay rent and companies to service debt). But whether the recession is V-shaped or prolonged will be dependent on the length of the pandemic. Euro Area: European manufacturing growth was showing clear signs of picking up before the coronavirus pandemic hit (Chart 16 panel 1). But lockdowns in Italy, Spain and other countries will clearly push growth way into negative territory. The severity is clear from the first datapoints to reflect March activity, such as the ZEW survey. The ECB, after an initially disappointing response, has promised EUR750 billion (and more if needed) in bond purchases. The fiscal response so far has been more lukewarm, although Germany has now scrapped its requirement to run a budget surplus. One key question: will the stronger nothern European economies agree to “euro bonds”, joint and severally guaranteed, to finance fiscal spending in the weaker periphery?   Chart 17...With Chinese Data Leading The Way Japan: Japan’s economy was performing poorly even before the coronavirus pandemic, mainly because of the side-effects of last October’s consumption tax hike, and the slowdown in China (Chart 17, panel 2). So far, Japan has seen fewer cases of COIVD-19 than other large countries, but this may just reflect a lack of testing. Japan also has less room for policy response. Government debt is already 250% of GDP. The Bank of Japan has moderately increased purchases of equity ETFs and remains committed to maintaining government bonds yields around 0%. But Japan seems culturally and institutionally unable to roll out the sort of ultra-radical measures taken in other developed economies. Emerging Markets: China’s economy was severely disrupted in January and February, as reflected in an unprecedented collapse of the Caixin Services PMI to 26.5 (Chart 17, panel 3). However, big data (such as traffic congestion) suggest that in March people were gradually returning to work and companies restarting manufacturing operations. Q1 GDP growth will clearly be negative, and growth for the year may be barely above 0%. The authorities are ramping up infrastructure spending, which BCA expects to grow by 6-8% this year.4 Interest rates have also fallen below their 2015 levels, but not yet to their 2009 lows. Both fiscal and monetary policy are likely to be eased further. Elsewhere in Emerging Markets, the key question is whether central banks will cut rates to support rapidly weakening economies, or keep rates steady to prop up collapsing currencies. This is not an easy choice. Interest Rates: Central banks in developed markets have cut rates to their lowest possible levels with the Fed, for example, slashing from 1.25%-1.5% to 0%-0.25% within just 10 days in March. The Fed has signalled that it will not go below zero. Short-term policy rates globally, therefore, have essentially hit their lower bounds. Long-term rates have been volatile, with the 10-year US Treasury yield swinging down to 0.6% before jumping to 1.2%. While uncertainty continues, long-term risk-free rates are unlikely to rise substantially and, in the event of a prolonged severe recession, we would see the US 10-year yield falling to zero – but no lower. Global Equities Chart 18Is The V-Shaped Recovery Sustainable? What’s Next?  Global equities lost 32.8% year-to-date as of March 23, 2020. All countries and sectors in our coverage were in the red. Even the best performing country (Japan) and the best performing global sector (Consumer Staples) lost 26.7% and 23.2% respectively.  From March 24 to March 26, however, equities made the best three-day gains since the Great Depression, recouping about one-third of the loss,  even though US initial jobless claims came in at 3.3 million and also the US reported a higher number of cumulative infected people than China, with a much higher number of deaths per million people (Chart 18). So have we reached the bottom of the bear market? Is this “V-shaped” recovery sustainable? How should an investor construct a multi-asset global portfolio that’s sound for the next 9-12 months given the uncertainty associated with COVID-19 and the massive monetary and fiscal stimulus around the world? Based on our long-held philosophy of taking risks where risks will most likely be rewarded, we are most comfortable taking risk at the asset class level, by overweighting equities versus bonds, together with overweights in cash and gold as hedges. Within the equity portfolio, we are reducing risk by making the following adjustments: Upgrade US to overweight from underweight financed by downgrading the euro zone to underweight from overweight. Upgrade Tech to overweight, while closing two overweight bets on Financials and Energy and one underweight on consumer staples to benchmark weighting.   Country Allocation: Becoming More Defensive Chart 19US And Euro Area: Trading Places In December 2019 we added risk by upgrading the euro area to overweight and Emerging Markets to neutral based on our macro view that the global economy was on its way to recovery.  Data releases in January did show signs of recovery in the global economy. However, the COVID-19 outbreak has changed the global landscape, and we are clearly in a recession now.  When conditions change, we change our recommendations. We must make a judgment call because the economic data will not give us any timely, useful readings for some time to come. Back in December, the key reason to upgrade the euro area was the recovery of China which flows into the exports of the euro area. We think China will continue to stimulate its economy. However, given the global growth collapse, the “flow through” effect to the euro area will be delayed for some time. We prefer to play the China effect directly rather than indirectly. That’s why we maintain the neutral weighting of EM versus DM, but downgrade the euro area to underweight, and upgrade US to overweight. We also note the two following factors: First, as shown in Chart 19, panel 1, the relative performance between the euro area and the US is highly correlated with the relative performance between global Financials and Technology. This is not surprising given the sector composition of the two region’s equity indices. As such, this country adjustment is in line with our sector adjustment of upgrading Technology and downgrading Financials. Second, with a lower beta, US equities provide a better defense when economic uncertainty and financial market volatility are high. The risk to this adjustment, however, is valuation. As shown in panel 4, euro area valuation is extremely cheap compared to the US. However, PMI releases as well as forward earnings estimates are likely to get worse again before they get better, given the region’s reliance on exports to China and the structural issues in its banking system. Global Sector Allocation: Getting Closer To Benchmark Chart 20Reducing Sector Bets We make four changes in the global sector portfolio to reduce sector bets, since we do not have a high conviction given market volatility and our house view that recovery out of this recession will be U-shaped. These are downgrading Financials to neutral, while upgrading Technology to overweight. We also close the overweight in Energy and underweight in Consumer Staples, leaving them both at benchmark weighting. Financials: We upgraded Financials in October last year as an upside hedge. This move did not pan out as bond yields plummeted. BCA Research’s US Bond Strategy service upgraded duration to neutral from underweight on March 10 as they do not see a high likelihood for yields to move significantly higher over the next 9-12 months. This does not bode well for Financials’ performance (Chart 20, panel 1). Even though the Fed and other central banks have come in as the lenders of last resort, loan growth could be weak going forward and non-performing loans could increase, especially in the euro area. Valuation, however, is very attractive. Technology: DRAM prices started to improve even before the COVID-19 outbreak. The global lockdown to fight against the pandemic is further spurring demand for both software and hardware, which should support better earnings growth (panel 2). The risk is that relative valuation is still not cheap, even though absolute valuation has come down after the recent selloff. Energy:  The outlook for oil prices is too uncertain. The fight between Saudi Arabia and Russia is weighing on the supply side, while the global lockdown is denting demand prospect. The earnings outlook for energy companies is dire, while valuations are very attractive (panel 3). Consumer Staples: This is a classic defensive sector that does well in recessions. In addition, its relative valuation has improved to neutral from very expensive (panel 4).   Government Bonds Chart 21Stay Aside On Duration Upgrade Duration To Neutral. Global bond yields had a wild ride in Q1 as equities plummeted into bear market territory. The 10-year US Treasury yield made an historical low of 0.32% overnight on March 9, then quickly reversed back up to 1.27% on March 18, closing the quarter at 0.67%, compared to 1.88% at the beginning of the quarter (Chart 21). We are already in a recession and BCA’s house view is for a U-shaped recovery. This implies that global bond yields will likely follow a bottoming process similar to global equities, as new infections peak and high-frequency economic data start to recover. As such, we upgrade our duration call to neutral, to be in line with the position of BCA Research’s US Bond Strategy (USBS) service. Favor Linkers Vs. Nominal Bonds.  The combined effect of the plummet in oil prices and the coronavirus outbreak has crushed inflation expectation to an extremely low level. As shown in Chart 22, the 10-year breakeven inflation rate is currently at 0.95%, 88 bps lower than its fair value. The fair value is estimated based on USBS’s Adaptive Expectations Model.  Investors with a 12-month investment horizon should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position. Chart 22TIPS Offer A Ton Of Long-Run Value Extremely Cheap Inflation Protection   Corporate Bonds Chart 23High Quality Junk It is undeniable that the dearth of cashflow caused by the lockdowns will spur a ferocious wave of defaults, particularly in the high-yield sector. It also is not clear that this risk is adequately compensated for. Currently, our US bond strategist believes that spreads are pricing an 11% default rate – in line with the default rate of the 2000/2001 recession. While it is not our base case, a default cycle like 2008, where 14% of companies in the index defaulted is a very clear possibility, as revenues have ground to a halt. However, several positive factors in the junk space must also be considered. Roughly 1% of the high-yield index matures in less than one year, which means that refinancing risk for junk credits should remain relatively subdued (Chart 23, top panel). Moreover, the quality of junk bonds is relatively high compared to previous periods of stress: when the market peaked in 2000 and 2007, Ba-rated credit (the highest quality of high yield) stood at 30% and 37% of the overall index respectively (middle panel). Today this credit quality stands at 49% of the high yield market, indicating a relatively healthier credit profile for junk. Additionally, the high-risk energy sector, which is likely to experience a substantial amount of defaults given the collapse in oil prices, now represents less than 8% of the market capitalization of the whole index (bottom panel). Taking these positive factors into consideration, we believe that a downgrade to underweight is not warranted, and instead we are downgrading high-yield credit from overweight to neutral. What about the investment-grade space? the massive stimulus package announced by the Fed, which effectively allows IG issuers to roll over their entire stock of debt, should provide a backstop to this market. One valid concern is that credit agencies can still downgrade a large number of issuers, making them ineligible to receive support. However, it seems that the credit agencies are aware of how much hinges on their ratings, and are communicating that they will factor the measures taken by various government programs into their credit analysis.5 Thus, considering that spreads are already extended, the Fed is providing unprecedent support and credit agencies are unlikely to knock out many companies out of investment-grade ratings, we are upgrading investment-grade credit from neutral to overweight.   Commodities Chart 24Oil Prices & Politics Do Not Mix Energy (Overweight): Oil markets were driven by supply/demand dynamics until a third factor, politics, shifted the market equilibrium. The recent clash between Saudi Arabia and Russia led to the breakdown of the OPEC 2.0 coalition and to Brent prices tanking by over 60% to $26 in March. The length of this breakdown is unknown. However, we believe the parties are likely to return to the negotiation table within the next months as the damage to countries which are dependent on oil begins to appear. The fiscal budget breakeven point remains much higher than the current oil price – it is around $83 for Saudi Arabia and $47 for Russia. Weakness in global crude demand will continue to put further downward pressure on prices, until economic activity recovers from the COVID-19 slowdown. Our Commodity & Energy Strategists expect the Brent crude oil price to average $36/bbl, with WTI trading some $3-$4 below that, in 2020 (Chart 24, panels 1 & 2). Industrial Metals (Neutral): Industrial metals prices were on track to pick up until the coronavirus hit global activity at the beginning of the year. Prices face further short-term headwinds as global manufacturing remains suppressed. Once the global social distancing ends and activity resumes, industrial metal prices should pick up as fiscal stimulus and infrastructure spending, especially in China, is implemented (panel 3). Precious Metals (Neutral):  As the coronavirus spread, global risk assets have tumbled. Over the past 12 months, we have recommended investors increase their allocation to gold as both an inflation hedge and a beneficiary of accommodative monetary policy globally. However, we also recently highlighted that gold was reaching overbought territory and that a pullback was possible in the short-term. Nevertheless, investors should continue to maintain gold exposure to hedge against the eventuality that the pandemic is not contained within the coming weeks (panels 4 & 5).   Currencies Chart 25Competing Forces Pushing The US Dollar In Different Directions The USD has gone through a rollercoaster during the coronavirus crisis. Initially, the DXY fell by 4.8%, as rate differentials moved violently against the dollar when the Fed cut rates to zero. But this fall didn’t last long: as liquidity dried up, the cost for dollar funding surged, causing the dollar to skyrocket by almost 8.3%. Since then, the liquidity measures taken by monetary authorities have made the dollar reverse course once more. At this point there are multiple forces pulling the greenback in opposing directions. On the one hand, the collapse in global growth caused by the shutdowns should push the dollar higher. Moreover, momentum – one of the most reliable directional indicators for the dollar – continues to point to further upside (Chart 25, panels 1 and 2). However, the Fed’s generous USD swap lines with other major central banks as well as the massive pool of liquidity deployed have already stabilized funding costs in European and British currency markets, and look poised to do the same in others (Chart 25, panel 3). Thus, since there is no clarity on which force will prevail in this tug of war, we are remaining neutral on the US dollar. That being said, long-term investors can begin to buy some of the most depressed currencies, such as AUD/USD. This cross is currently trading at a 12% discount to PPP according to the OECD – the steepest discount that this currency has had in 17 years. Additionally, our China Investment Strategy projects that China will accelerate infrastructure investment this year to counteract the negative economic effects of the lockdown. This pick up in investment should increase base-metal demand, proving a boost to the Australian dollar in the process.   Alternatives Chart 26Favor Macro Hedge Funds Over Private Equity During Recessions Intro: The coronavirus outbreak caused tremendous market volatility and huge declines in liquid assets. Many clients have asked over the past few weeks which illiquid assets make sense in the current environment. To answer that, we stick to our usual recommendation framework, dividing illiquid assets into three buckets: Return Enhancers: Over the past year, we have been recommending clients to pare back private-equity exposure and increase allocation to hedge funds – particularly macro hedge funds, which often outperform other risky alternative assets during economic slowdowns and recessions (Chart 26, panel 1). Private debt – particularly distressed debt – could become a beneficiary of the current environment. The market turmoil will leave some assets heavily discounted, which can provide an opportunity for nimble funds to make investments at attractive valuations. In a previous Special Report, we highlighted Business Development Companies (BDCs) as a liquid alternative to direct private lending.6 They have taken a hit over the past month, even compared to equities and junk bonds. However, their recovery as markets bottom is usually significant (panels 2 & 3). Inflation Hedges: The coordinated “whatever-it-takes” stance implemented by global governments and central banks to mitigate the coronavirus crisis is likely to have inflationary consequences in the long-term. In that environment, investors should favor commodity futures over real estate (panel 4). As global growth reaccelerates in response to stimulus and resumed manufacturing activity over the next 12 months, the USD should weaken, and commodity prices should rise. Volatility Dampeners: Timberland and farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets (panel 5). Farmland particularly should fare well in this environment, being more insulated from the economy, given food’s inelastic demand Risks To Our View Chart 27Dollar Would Fall In A Strong Recovery Since our recommendations are based on a middle course, hedging both upside and downside risks, we need to consider how extreme these two eventualities could be. On the upside, the most optimistic scenario would be one in which the coronavirus largely disappears after April or May. The massive amount of fiscal and monetary stimulus would produce a jet-fuelled rally in risk assets. The dollar has soared over the past few weeks, as a risk-off currency (Chart 27), and would likely fall sharply. This would be very positive for commodities and Emerging Markets assets. The strong cyclical recovery would also help euro zone and Japanese equities relative to the more defensive US. Value stocks and small caps would outperform. Chart 28Could It Get Worse Than 2008 - Or Even 1932? Downside risks are less easy to forecast. As Warren Buffet wrote in 2002: “you only find out who is swimming naked when the tide goes out.” The shock to the system caused by the coronavirus is certainly larger than the Global Financial Crisis of 2007-9 and could approach that caused by the Great Depression (Chart 28), though hopefully without the egregious policy errors of the latter. It is hard, therefore, to know where problems will emerge: US corporate debt, EM borrowers, and euro zone banks would be our most likely candidates. But there could be others. The oil price is another key uncertainty. Demand could collapse by at least 10% as a result of the severe recession. The breakdown of the production agreement between Saudi Arabia and Russia could produce a supply increase of 4-5%.  Given this, Brent crude would fall to $20 a barrel. That would represent a strong tailwind to global recovery (Chart 29). On the other hand, a rapprochement between Saudi and Russia (and even with regulators in Texas) could push oil prices back up again – a positive for markets such as Canada and Mexico. Chart 29Cheap Oil Boosts Growth   Footnotes 1   Please see BCA Special Report, "Questions On The Coronavirus: An Expert Answers," dated 31 March 2020, available at bcaresearch.com 2   https://www.medrxiv.org/content/10.1101/2020.03.24.20042291v1 3    https://www.imperial.ac.uk/media/imperial-college/medicine/sph/ide/gida-fellowships/Imperial-College-COVID19-NPI-modelling-16-03-2020.pdf 4    Please see China Investment Strategy Weekly Report, “Chinese Economic Stimulus: How Much For Infrastructure And The Property Market,” dated 25th March 2020, available at cis.bcaresarch.com 5    A release by Moody’s on March 25 stated that their actions “will be more tempered for higher-rated companies that are likely to benefit from policy intervention or extraordinary government support.” 6    Please see Global Asset Allocation Special Report, “Private Debt: An Investment Primer,” dated June 6, 2018, available at gaa.bcaresearch.com GAA Asset Allocation  

Late last year we started closely monitoring the Value Line Geometric Index (gauging the median stock, VLGI) and nominated it as a “Chart Of The Year” candidate. This Index’s track record was, and remains, 100% accurate in leading the SPX peaks. As a reminder, it petered out in advance of the SPX in all three previous recessions. It also topped out in advance of the February 19, 2020 SPX peak (see chart on the next page). Now this index has collapsed, falling intraday to a level of 293.6 from a peak of 594.35 in the summer of 2018, a greater than 50% drawdown. In fact, the VLGI recently returned to a level first hit in 1994! Our point here is that the median stock has collapsed in the broad US equity space and already reflects an economic and profit contraction similar to the Great Recession. While the VLGI’s track record at troughs is more coincident than leading, there is a high chance that stocks may have already put in a bottom. Bottom Line: Our view remains that investors with a cyclical 9-12 month time horizon and higher risk tolerance should be layering into this market.

Highlights Chinese stocks have outperformed global benchmarks by a wide margin. We are taking profits on our overweight position, and downgrading our tactical call on Chinese stocks to neutral. In absolute terms, Chinese stocks have failed to buck the trend in a global selloff of risk assets. This suggests Chinese stocks are not immune to worldwide panics. Investors should wait for a peak in the global pandemic before going long on Chinese equities. Chinese stocks have become less cheap relative to global benchmarks. The size of Chinese stimulus is also less impressive compared with other major economies such as the US. Therefore, in order to maintain an overweight stance on Chinese risk assets in a global portfolio, Chinese stocks need to either offer a better price entry point, or a more upside potential in earnings outlook relative to their global peers. Feature Chart I-1Chinese Stocks Have Significantly Outperformed Global Benchmarks... In the current pandemic environment, economic fundamentals mean little to panicked investors who have mostly ignored the unprecedented degree of monetary and fiscal stimulus pouring into the global economy. Investors are looking for clear signs that the COVID-19 crisis can be brought under control, but medical experts have been unable to predict the timing of a peak in the pandemic. Policymakers around the world are beginning to address investors’ concerns that substantial and timely fiscal policy supports are needed to offset the knock-on effects on businesses and individuals.1 However, until the number of new infections in major economies peaks, the erratic trading behavior among global investors will persist. Given the lack of near-term certainty, we are downgrading our tactical stance on Chinese stocks from overweight to neutral. Chart 1 highlights since we upgraded our tactical call to overweight in end-2019, Chinese stocks have significantly outperformed global stocks. This outperformance has been passive in nature; Chinese stocks are down about 10% year-to-date in US$ terms, versus a 23% decline in global stocks. We are also closing 7 of our 10 high-conviction investment calls from our trade book, for reasons cited here and then detailed in the next sections. Of the 10 active trades in our book, 7 have generated a positive return since their inceptions, including 3 that have recorded double-digit gains.2 Investors should wait for clarity on the peak of the global pandemic before going long on risk assets. Investors should wait for more signs of an upside potential in earnings and/or a better price entry point to go long on Chinese stocks. China Is Not Immune To A Global Pandemic Chart I-2...But Their Prices Have Also Plunged In Absolute Terms Chinese equities have not been immune from the gyrations in the global financial markets, which have not responded to monetary and fiscal stimulus measures in either a customary or predictive manner. Unlike the 2008 global recession triggered by a financial crisis, public health crises damage the economy by reducing human activity and, therefore, erode both supply and demand. A return to normalcy depends almost entirely on whether the pandemic can be contained. Even though Chinese business activities are gradually resuming, Chinese stocks failed to buck the worldwide trend of a liquidation in risk assets. While Chinese stocks have outperformed global benchmarks by a wide margin, the relative gains have mostly been passive since early March. In absolute terms, Chinese domestic stocks have lost all their gains from February and investable stock prices have fallen back to their November 2018 level (Chart 2). Chart I-3Number Of Imported Cases Now On The Rise China is not immune to a second COVID-19 wave. China has been reporting zero-to-low single-digit numbers of locally transmitted cases since mid-March, but it is now experiencing an increase in imported cases from overseas travelers (Chart 3). The mounting numbers have led the Chinese government to shut its borders to non-Chinese citizens.3 This indicates that it is still too early to claim a victory in China’s virus containment efforts.  Given that China’s domestic businesses are open, the trajectory of new cases also remains unknown. These lingering doubts will slow the pace in the resumption of Chinese production (Chart 4).   Chart I-4Chinese Companies Operating At 80% Capacity Moreover, China is not immune to qualms about the depth and duration of a global recession. China has the political will and policy room to stimulate its economy, and the country’s dominant domestic demand makes the economy relatively insulated from a global recession. However, when more than 40% of China’s trading partners (including Europe and the US) remain under lockdown, a collapse of external demand will weigh on China’s economic and corporate profit recovery in the next quarter or two. Therefore, short-term risks on Chinese stocks are tilted to the downside. Bottom Line: Chinese stocks have failed to buck the trend in the global pandemic and the tsunami selloff in risk assets. Investors should wait for a peak in the outbreak before going long on Chinese equities. Chinese Stocks Have Become Less Cheap Relative To Global Benchmarks Chart I-5Outperformance In Chinese Stocks Seems Quite Extended Chinese stocks, particularly in the domestic market, are no longer priced at deep discounts compared with global equities (Chart 5). The recent outperformance of Chinese stocks has brought the relative performance trend in both investable and domestic stocks back close to late-2017/early-2018 levels. That was before the US-China trade war began, and at a point where China’s economy was close to peak strength for the cycle. Although a passive outperformance does not automatically warrant an underweight stance on Chinese stocks, investors will demand a higher upside potential in Chinese corporate earnings to justify an overweight position in Chinese equities. Therefore, we will watch for the following signs before buying Chinese stocks: a strengthening in China’s economy and corporate profits outpacing recoveries in other major economies, and/or a near-term drop in Chinese stock prices outsizing the decline in global stock prices. Given the exceedingly strong policy responses from G20 economies (particularly the US), China’s stimulus will need to be amplified so that investors are confident that the rate of Chinese corporate profit recovery will surpass their global counterparts.4 In a recent Politburo meeting, Chinese policymakers signaled their willingness to expand stimulus, including much larger fiscal deficits and local-government special bond issuance quotas in 2020, along with further interest rate cuts.5 An escalation in policy support will probably bring China’s stimulus in line with that extended in the 2008-2009 global financial crisis. However, the size of the stimulus package will be determined at the National People’s Congress (NPC) meeting, which is delayed to end-April or early May. In the near term, the selloff in Chinese stocks will likely persist as financial markets continue to price in bad news in the global economy. Chinese investable stock prices continue to be priced at a discount relative to global benchmarks, although the discount is much smaller than it was three months ago. In absolute terms, Chinese investable stock prices have not reached their technical support levels.  The offshore market historically rebounds when prices approach a major defense line, measured by a 12-year moving average. This technical support for the MSCI China Index is currently 65, still about 13% below the March 30 close (Chart 6). Chart I-6Investable Stock Prices Not Yet At Their Long-Term Support The prices in Chinese domestic stocks have reached their 12-year moving average, although A-share prices are not decisively in a structural “cheap” territory yet (Chart 7).  Investors should wait on the sidelines for now, since the full effects of any enhanced stimulus in China will be felt in the real economy with a time lag. China’s production supply side is only operating at about 80% of normal capacity, and demand has yet to catch up (Chart 4 and Chart 8).  This suggests the rebound in economic activities in Q2 will likely be gradual, and corporate profits are likely to remain depressed. Chart I-7Domestic Stock Prices Approaching A Structural "Cheap" Territory Chart I-8Demand In Manufacturing Remains Sluggish Bottom Line: Chinese stocks have become less cheap against the backdrop of a massive liquidation of global equities. Chinese existing stimulus also appears moderate compared with other major economies. Therefore, in order for investors to overweight Chinese risk assets in a global portfolio, Chinese stocks either will have to offer a better entry price point or more upside corporate earnings potential. Both are currently missing. Investment Conclusions Investors should stay neutral on Chinese stocks in the next 3 months, and we are closing 7 out of the 10 active positions in our trade book. These trades are especially vulnerable to a protracted global recession and more selloffs in the domestic stock market. We will look for opportunities to incrementally add new trades to our book in the coming months. Here are our reasons for retaining or closing some of our positions: Long China Onshore Corporate Bonds (Maintain): The trade has yielded a handsome return of 16% since its inception in June 2017, (Chart 9). Although the spread in Chinese onshore corporate bond yields has widened sharply in the past few weeks, it has been the result of an indiscriminate global selloff of financial assets rather than the market pricing in any China-centric credit risks (Chart 10). In the next 6 to 12 months, corporate credit spreads should normalize as we expect monetary policies in major economies to remain ultra-loose, the global economy to recover and investors’ risk sentiment to improve. Chinese onshore corporate bonds will likely continue to offer a better risk-reward profile relative to other economies, with a higher risk premium and relatively stable default rate. Chart I-9Chinese Onshore Corporate Bonds Remain Attractive Chart I-10Corporate Credit Spreads Should Narrow Over A 12-Month Horizon     Long MSCI China Energy Stocks (Close): This trade has had the worst performance among our positions due to consistently falling oil prices since October 2018 (Chart 11). Although BCA’s commodity strategists expect Brent prices to average $36/barrel in 2020, $3 higher than the average oil prices in March, it is still at a 50% discount from the $70 price tag just 3 months ago. Such a minor improvement in the price outlook does not offer enough upside potentials to offset downside risks in earnings in the next 9 months. Therefore, we would rather cut the losses. Long China Domestic Consumer Discretionary Equities Versus Benchmark and Long China Domestic Consumer Discretionary Equities/Short China Domestic Consumer Staples Equities (Close): As explained in the previous sections, we think there will be better entry price points for Chinese stocks as well as cyclical stocks. Besides, discretionary consumption in China has yet to show signs of a meaningful rebound. In the near term, we will also look for opportunities to go long position in domestic consumer staple stocks because we think that food and beverage price inflation will persist well into the second half of this year (Chart 12).  Chart I-11Depressed Oil Prices Lead To Significant Underperformance In Energy Stocks Chart I-12Consumer Staple Stocks Should Benefit From Stubbornly High Food Prices   Long MSCI China Index, Long MSCI China Onshore Index, Long MSCI China Growth Index/ Short MSCI All Country World (Close): We will need to see more stable sentiment in the global financial markets, a better entry price point for Chinese stocks and a sure sign of outsized Chinese stimulus before reinitiating a long position on Chinese stocks. Jing Sima China Strategist jings@bcaresearch.com   Appendix Table 1Massive Stimulus In Response To Pandemic Footnotes 1  Please see Table 1 in the Appendix. 2  Please see the trade table at the end of the report. 3  https://www.bloomberg.com/news/articles/2020-03-26/china-to-suspend-foreigners-entry-starting-saturday?mc_cid=1bdcd29ddd&mc_eid=9da16a4859 4  The stimulus package announced in the US amounts to 9% of the country’s 2019 GDP, whereas China’s stimulus would be about 3% of its 2019 GDP. 5  http://www.xinhuanet.com/politics/leaders/2020-03/27/c_1125778940.htm Cyclical Investment Stance Equity Sector Recommendations

S&P 500 futures (ES) have fallen over 36% from peak to trough. This is similar to the median fall during recession bear markets dating back to the Great Depression. Most importantly, comparing the two most recent iterations is instructive in attempting to figure out what is baked in the cake. Namely, in the 9/11 catalyzed recession and subprime mortgage collapse catalyzed recession, EPS got halved. Similarly, equities fell 50% from their respective peaks. If we use that assumption – i.e. a recessionary equity bear market fall predicts the eventual profit drubbing – then what the ES futures clocking in at 2174 discounted is that trailing EPS will fall from $162 to $104 and forward EPS from $177 to $113 (see chart). While we have no real visibility on EPS, our sense is that we will not fall further than what was already discounted in the broad market. If we are offside and a GFC or Great Depression ensues, then profits will get halved to $81 and the SPX will fall to 1700. Another simple way of looking at the EPS drawdown is by considering $162 as trend EPS. Then for every month that the economy is shut down roughly $13.5 get shaved off EPS. Thus, triangulating both approaches, a $104 EPS level has discounted a shutdown lasting 4 months and 10 days. This is a tall order and we would lean against such extreme pessimism. Bottom Line: Investors with higher risk tolerance and a cyclical 9-12 month time horizon will be handsomely rewarded. Please see yesterday’s Weekly Report for more details.