Financial Markets

Analyses on Chinese autos and Brazil are available below. Highlights The Fed’s aggressive monetization of public and some private debt has inspired investors to allocate cash to risk assets However, a number of cyclical indicators continue to flash red or amber, suggesting this rally is not about a cyclical economic recovery.  Continue underweighting EM equities and credit markets versus their DM counterparts. We will wait for a correction to assess whether to maintain or close our shorts on EM currencies. Feature Neither the ongoing plunge in corporate profits nor a great deal of uncertainty about the economic outlook justify this rally. It seems the sole driver of the rally from March’s lows has been the Federal Reserve’s enormous purchases of various securities. These unprecedented actions are crowding out investors into riskier parts of fixed-income markets and persuading them to purchase equities. Neither the ongoing plunge in corporate profits nor a great deal of uncertainty about the economic outlook justify this rally. It Has Not Been About Profits And Valuations In the past two months, the S&P 500 index has experienced not only the fastest and steepest crash on record, but also the speediest rebound (Chart I-1). Investors have had to make swift investment decisions amid extremely low economic visibility. Chart I-1The S&P 500: The Fastest Crash And Speediest Recovery Indeed, it is fair to say that during the mayhem and carnage many investors operated on a “sell now, think later” principle, and on the subsequent rebound with a “buy now, ask questions later” framework. Remarkably, the plunge and subsequent recovery in global share prices has been so rapid that even equity analysts’ forward earnings estimates cannot keep up. The top panel of Chart I-2 illustrates that the global forward EPS usually tracks the world equity index. When share prices rally, analysts upgrade their earning expectations; when equities sell off, analysts’ downgrade their earnings outlooks. In the past month, analysts have continued to slash forward EPS estimates despite the strong equity rebound. As a result, the 12-month forward P/E ratio for global stocks is back to its post-2008 highs (Chart I-2, bottom panel). Chart I-2Rising Share Prices Amid Collapsing Forward Earnings Chart I-3China: A Decoupling Between Economy And Equities Elsewhere, Chart I-3 illustrates China’s domestic orders for 5000 industrial enterprises historically correlated with the Shanghai Composite equity index. Since early this year, domestic orders have plummeted due to the country-wide lockdown. Yet equity prices in China have not fallen enough to reflect the downfall in economic activity and corporate profits. This underscores that investors’ purchases of global and Chinese stocks in the past month have been driven by factors other than the corporate profit outlook.   This leaves two rationales for justifying roaring equity purchases in recent weeks: (1) liquidity overflows due to central banks’ balance sheet expansion, and (2) valuations. We examine the first argument in this report and will revisit the topic of equity valuations in forthcoming publications. In a nutshell, although equity valuations may be cheap in EM, Europe and Japan, they are expensive in the US. Nevertheless, the US stock market has been substantially outperforming EM and DM ex-US equities. Further, the most expensive stocks in the US – FAANGM – have by far outperformed the rest. Chart I-4China: A Decoupling Between New And Old Economy Stocks In China, the ChiNext index – a Nasdaq proxy of the onshore market – has massively outperformed the Shanghai Composite index, which is dominated by “old” economy stocks (Chart I-4). The trailing P/E ratios on the ChiNext and Shanghai Composite indexes are 62 and 14, respectively. In short, the fact that most expensive equity segments/sectors have outperformed suggests that cheap valuation have not been the key driver of this rally. Bottom Line: Neither profits nor considerations of equity valuations have been the driving factor behind the recent equity rally.  The Sole Driver Of This Rally The Fed’s aggressive monetization of public and some private debt has inspired investors to allocate cash to risk assets. The US broad money supply is surging at a record pace, both in nominal and real terms (Chart I-5). Is there too much money relative to the size of financial assets? Chart I-5US Broad Money Supply Is Booming Today we explore how the level of US broad money supply (M2) relates to the market cap of all bonds and stocks denominated in US dollars. US broad money (M2) supply encompasses all deposits and cash of residents and non-residents in and outside the US. Chart I-6 exhibits the ratio of US broad money supply (M2) relative to the sum of: Chart I-6The US: Broad Money Supply Relative To Equity And Bond Market Capitalization the US equity market capitalisation (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. The higher this ratio is, the more US dollar deposits (liquidity) is available per one dollar of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, the US M2-to-market value of securities ratio is somewhat elevated. This means liquidity is relatively abundant. However, this may not preclude the ratio from drifting higher like it did in 2008. This scenario would be consistent with a renewed selloff in equity and credit markets. Interestingly, back in January, the ratio was almost at a 20-year low – i.e., money supply (liquidity) was tight relative to the market value of outstanding US dollar-denominated securities. This was contrary to the prevalent perception in the global investment community that in 2019 the advances in share prices and credit markets were liquidity-driven. We discussed what constitutes pertinent liquidity for financial assets in our January 16 report titled, A Primer On Liquidity. The key takeaways of the report were: Money supply – not central bank assets – is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Changes in the velocity of money are as important as those in money supply. Yet forecasting changes in the velocity of money is a near-impossible task, as it entails foreseeing the behavior of economic agents. A large and expanding stock of money in and of itself does not guarantee greater liquidity for asset markets. Gauging liquidity flows to asset markets boils down to predicting investor behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Bottom Line: Even though the US money supply is expanding at a record pace, the key to financial asset price fluctuations is willingness among investors to purchase those assets. In turn, willingness to allocate cash to securities is generally driven by (1) the potential income and cash flow generation by securities issuers; (2) uncertainty related to future income (the risk premium); and (3) the opportunity cost of holding cash. Presently, the opportunity cost of holding cash is the sole reason to buy risky securities. Cash flow/income generation is currently impaired for the majority of equities and credit instruments. Further, there is a great deal of uncertainty about issuers’ ability to generate cash/income for investors – i.e., the required risk premium should be very high. All of these circumstances make the risk-reward profile of this rally poor. Reasons To Fade This Rally There are several market-based indicators that do not corroborate a further run-up in EM and DM equity prices. Our Risk-On / Safe-Haven Currency Ratio has struggled to gain traction (Chart I-7, top panel). It is not confirming the rebound in EM share prices. It is essential to emphasize that this indicator is agnostic to the direction of the US dollar, as it is calculated as the ratio of cyclical commodities currencies (AUD, NZD, CAD, ZAR, BRL, MXN, CLP, RUB, and IDR) versus safe-haven currencies such as the Swiss franc and Japanese yen on a total-return basis – i.e., all exchange rates include the cost of carry. Chart I-7Various Reflation Indicators Have Been Slugish Our Reflation Confirming Indicator has not been sending a strong bullish reflation signal either (Chart I-7, bottom panel). This indicator is composed of an equally-weighted average of industrial metals, platinum and US lumber prices. The Global Cyclical-to-Defensive Equity Sectors Ratio has formed a classic head-and-shoulders pattern, and has broken down (Chart I-8, top panel). The latest rebound has not altered this pattern. Therefore, the path of least resistance for this ratio is still down, which entails underperformance of the global cyclical equity sector versus global defensives. The latter often occurs in selloffs. Similarly, the relative performance of Swedish versus Swiss non-financial stocks has failed to rebound, having experienced a major breakdown in March (Chart I-8, bottom panel). Swedish non-financial stocks are much more cyclical than Swiss ones. Finally, the global business cycle is experiencing its deepest recession in the post-World War II period, with the pace and nature of the recovery remaining highly uncertain. Chart I-9 portends global EPS in SDR, which is the proper measure given the greenback’s weight in SDR is 58%, the euro’s 39%, the yen’s 11%, and the yuan’s 1%. Chart I-8Global Cyclical Stocks Have Not Outperformed Chart I-9Global Corporate EPS In Perspective Global EPS shrank by 28% in 2001-2002 and by 40% in the 2008 recession. Given the current recession will be deeper, global EPS will likely shrink by about 50%. We do not think equity markets are discounting such a dire outcome after the recent rally. Bottom Line: A number of cyclical indicators continue to flash red or amber, suggesting this rally is not about a cyclical economic recovery.     Investment Strategy We closed our short position in EM equities on March 19, and on the March 26 report we argued that it was too late to sell but still too early to buy. Given the rally in global equities is overstretched from a short-term perspective, we will wait for a correction to assess whether to maintain or close our shorts on EM currencies. Chart I-10EM Currencies And S&P 500 That said, we maintained our underweights in both EM stocks and credit versus their DM peers. Also, we have continued to short EM currencies versus the US dollar. Chart I-10 demonstrates that EM currencies have failed to rally despite the strong rebound in the S&P 500.   Given the rally in global equities is overstretched from a short-term perspective, we will wait for a correction to assess whether to maintain or close our shorts on EM currencies. For dedicated EM equity managers, our recommended overweights are Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Brazil, South Africa, Turkey, Indonesia, India and the Philippines. We are neutral on other bourses. Last week we published two reports for fixed-income investors: EM: Foreign Currency Debt Strains and EM Domestic Bonds And Currencies. In the first report we assessed individual EM countries' vulnerabilities to foreign debt and discussed strategies for EM sovereign and corporate credits. In the second report, we upgraded our stance on EM local markets from underweight to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Chinese Auto Sales: Disappointments Ahead Chinese automobile sales plunged 42% year-on-year over the first quarter of this year, due to the Covid-19 lockdowns (Chart II-1). We still expect auto sales in China to be flat or very mildly negative year-on-year over the period of April-December of this year. First, official data shows the growth rate for nominal disposable income was falling toward zero, but realistically it was probably negative in the first quarter (Chart II-2, top panel). Very sluggish household income growth – in combination with the still-elevated uncertainty of the job market (Chart II-2, bottom panel) – will restrain Chinese auto demand. Chart II-1Auto Sales In China: A Rate Of Change Recovery Ahead Chart II-2Sluggish Household Income Growth Will Constrain Chinese Auto Demand While household income growth will recover from current level later this year, it will likely remain much lower than the previous years’ 8-9% growth. Second, Chinese households are already quite leveraged. Their debt levels reached over 94% of annual disposable income, almost as high as in the US (Chart II-3). Third, peer-to-peer lending – an important source of auto loans in recent years – has shrunk considerably and is unlikely to pick up this year (Chart II-4). Chart II-3Chinese Household Debt Burden Is High Chart II-4Auto Financing Has Become More Scarce Bank lending rates for household consumption loans and peer-to-peer lending rates are currently about 5% and 10%, respectively. Such borrowing costs are restrictive given the tame growth of household income. Finally, the stimulus packages intended to boost automobile demand this year are no greater than they were last year. This entails that the net stimulus is close to zero. The focus of this year’s stimulus remains on the demand for new energy vehicles (NEV), which is in line with the central government’s strategic goal. Given that NEVs account for only 5% of auto sales, any boost to NEV demand is unlikely to make a huge difference in aggregate auto sales.  Another boost to auto sales is the relaxation of license controls in the first-tier cities. The extent of these measures is so far considerably smaller than it was last year. About 60,0001 additional new license plates have so far been added, accounting for only 0.2% of Chinese auto sales. This number was 180,000 last year.2  This year local governments in 16 cities announced cash subsidies for auto buyers.3 Despite larger geographic coverage, the amount of cash subsidies is similar to what it was last year – at about 3% of the retail price. This is too small to make any meaningful impact on auto sales. Investment Implications The lack of considerable new stimulus for auto purchases and lower household income growth will make the recovery in passenger car sales halting and hesitant. The lack of considerable new stimulus for auto purchases and lower household income growth will make the recovery in passenger car sales halting and hesitant. Chinese auto stock prices in the domestic A-share market are breaking down (Chart II-5). Lingering demand contraction as well as possible price cuts will further curtail auto producers’ profits. Disappointing Chinese auto sales will lead to sluggish auto production and, consequently, to weak demand for metals like steel, aluminum and zinc. Chinese auto exports will outpace its imports (Chart II-6). As China accounts for about 30% of global auto sales and production, rising net exports of automobiles from China may diminish other global producers’ margins. Chart II-5Avoid Chinese Auto Stocks For Now Chart II-6Rising Chinese Auto Net Exports Are Negative To Other Global Auto Producers   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Brazil: Not Out Of The Woods Yet We believe risks to Brazilian assets remain to the downside. Political infighting among various branches of power and state institutions will depress consumer and business confidence, lengthening the recession. Chart III-1Brazil: Recurring Crises Political infighting among various branches of power and state institutions will depress consumer and business confidence, lengthening the recession (Chart III-1). Political turmoil also reduces the probability of structural reforms. This combined with a delayed economic recovery will further strain the already precarious public debt dynamics.  First, the country is in a full-blown political crisis. The Supreme Court's decision to reject Bolsonaro's nomination for Director of the Federal Police manifests broad-based political infighting among Brazilian institutions. Further, the Supreme Court has started an investigation into the President as calls for impeachment intensify among both the public and the Congress. The rift between President Bolsonaro and Congressional President Maia is especially worrisome. Given Maia’s future political ambitions, we do not expect a truce between the two. On the contrary, they will continue to stand off in order to assert control over the fragmented Congress. As a result, structural reforms such as the national tax program and privatizations will be delayed. Second, Bolsonaro’s popularity is also plunging due to his slow and controversial response to the COVID-19 outbreak. This week, Bolsonaro’s disapproval ratings jumped above those of former president Lula da Silva, and public support for impeachment is now over 54%. Third, Congress has allowed the government to go over the limit of fiscal spending this year, which has resulted in almost 1.2 trillion reais in emergency fiscal spending, or about 16% of GDP. This will push the gross public debt-to-GDP ratio to well above 100% by the end of 2020. Chart III-2This Large Gap Makes Public Debt Dynamics Untenable In order to stabilize its public debt-to-GDP ratio, a government’s borrowing costs should be below nominal GDP growth. Brazil fails to meet this condition. Local currency interest rates at 5.5% are well above nominal GDP growth, which will likely be negative in 2020 (Chart III-2). This assures unsustainable debt dynamics. Finally, in terms of monetary policy, the central bank’s policy rate cuts have not been efficiently transmitted to the real economy, as discussed in our March 31st Special Report. Borrowing costs for companies and households remain elevated relative to their nominal income growth. Overall, the sole feasible way for Brazil to stabilize its public debt-to-GDP ratio is to push nominal GDP growth above interest rates. Further, this is only possible with falling interest rates and further material currency depreciation. The continued currency devaluation represents a risk to foreign investors holding local assets. Investment Recommendations Continue to underweight Brazil within EM equity and credit portfolios. We reiterate our trade to short the BRL versus the US dollar. Even though the BRL is moderately cheap (Chart III-3), there is still considerable downward pressure on the currency. The BRL is tightly correlated with commodities prices (Chart III-4). Until these do not bottom out, the real will continue depreciating. Critically, the real needs to depreciate to lift nominal GDP growth above borrowing costs. The latter is essential to stabilize public debt dynamics. Chart III-3The BRL Is Only Modestly Cheap Chart III-4The BRL Correlates With Commodities Prices Finally, we are underweight both local currency and US$ denominated bonds in Brazil due to worrisome public debt dynamics and high foreign currency stress.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1    Shanghai announced to add 40,000 new license plates this year while Hangzhou increased 20,000 new license plates. 2   There were 100,000 additional license plates approved by Guangzhou province and an additional 80,000 by Shenzhen in 2019. 3   The cash subsidies are about RMB1000-3000 for buying regular cars, RMB3000-5000 for car replacement (e.g., scrapping their autos with Emission Standard 3 and buying autos with new Emission Standard 6), and RMB5000-10,000 for NEV purchases. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The six-month increase in European bank credit flows amounts to an underwhelming $70 billion, compared to a record high $660 billion in the US and $550 billion in China. Underweight European domestic cyclicals versus their peers in the US and China. Specifically, underweight euro area banks versus US banks. Overweight equities on a long-term (2 years plus) horizon. The mid-single digit return that equities are offering makes them attractive versus ultra-low yielding bonds. But remain neutral equities on a 1-year horizon, until it becomes clear that we can prevent a second wave of the pandemic. Fractal trade: long bitcoin cash, short ethereum. Feature Chart I-1Bank Credit 6-Month Flow Up $70 Bn ##br##In The Euro Area… Chart I-2…But Up $700 Bn ##br##In The US Governments and central banks are dishing out an alphabet soup of stimulus. The question is: how much is reaching those that need it? Our preferred approach to assessing monetary stimulus is to focus on the evolution of bank credit flows and bond yields over a six-month period. Bank Credit Flows Have Surged In The US And China, Not In Europe On our preferred assessment, Europe’s monetary stimulus is underwhelming compared with that in the US and China. The six-month increase in US bank credit flows, at $660 billion, is the highest in a decade and not far from the highest ever. In China, the equivalent six-month increase is $550 billion. But in the euro area, the six-month increase in bank credit flows amounts to an underwhelming $70 billion (Charts I-1 - Chart I-4). Chart I-3Bank Credit 6-Month Flow Up $550 Bn In China… Chart I-4...And Up ##br##Globally Admittedly, US firms are drawing on pre-arranged bank credit lines rather than taking out new loans. Furthermore, the link between bank credit flows and final demand might be compromised during the current economic shutdown. For example, if firms are borrowing to pay workers who are not producing any output, then the transmission of a credit flow acceleration to a GDP acceleration would be weakened. Europe’s monetary stimulus is underwhelming compared with that in the US and China. Nevertheless, some bank credit flows will still reach the real economy. And the US and China are creating more bank credit flows than Europe. Focus On The Deceleration Of The Bond Yield Turning to the bond yield, it is important to focus not on its level, and not on its decline. Instead, it is important to focus on its deceleration. The focus on the deceleration of the bond yield sounds counterintuitive, but it results from a fundamental accounting identity. The next two paragraphs may seem somewhat technical but read them carefully, as they are important for understanding the transmission of stimulus. GDP is a flow. It measures the flow of goods and services produced in a quarter. Hence, GDP receives a contribution from the flow of credit. The flow of credit, in turn, is established by the level of bond yields. When we talk about stimulating the economy, we mean boosting the GDP growth rate from, say, -1 percent to +1 percent, which is an acceleration of GDP. This acceleration in the GDP flow must come from an acceleration in the flow of credit. This acceleration in the flow of credit, in turn, must come from a deceleration of bond yields. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Banks tend to perform better after bond yields have decelerated. The good news is that in the US and China, bond yields have decelerated; the bad news is that in Europe, they have not. Over the past six months, the 10-year bond yield has decelerated by 40 bps in the US and by 65 bps in China. Yet in France, despite the coronavirus crisis, the 10-year bond yield has accelerated by 60 bps (Charts I-5 - Chart I-8).1 Chart I-5The Bond Yield Has Accelerated ##br##In The Euro Area... Chart I-6...Decelerated ##br##In The US... Chart I-7...Decelerated In China... Chart I-8...And Decelerated Globally European bond yields are struggling to decelerate because of their proximity to the lower bound to bond yields, at around -1 percent. The inability to decelerate the bond yield constrains the monetary stimulus that Europe can apply compared to the US and China, whose bond yields are much further from the lower bound constraint. Compared to Europe, the US and China have much stronger decelerations in their bond yields and much stronger accelerations in their bank credit flows. This suggests underweighting European domestic cyclicals versus their peers in the US and China. Specifically, banks tend to perform better after bond yields have decelerated; and they tend to perform worse after bond yields have accelerated. On this basis, underweight euro area banks versus US banks (Chart I-9). Chart I-9Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Long-Term Asset Allocation Is Straightforward, Shorter-Term Is Not The level of the bond yield, or of so-called ‘financial conditions’, does not drive the short-term oscillations in credit flows. To repeat, it is the acceleration and deceleration of the bond yield that matters. Yet when it comes to the long-term valuation of assets, the level of the bond yield does matter, and when the bond yield is ultra-low it matters enormously. An ultra-low bond yield justifies a much lower prospective return on competing long-duration assets, like equities. The reason is that when bond yields approach their lower bound, bond prices can no longer rise, they can only fall. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on equities. In this world of ultra-low numbers – for both bond yields and equity risk premiums – the low to mid-single digit long-term return that equities are offering makes them attractive versus bonds (Chart I-10). Chart I-10Equities Are Offering Mid-Single Digit Long-Term Returns But this long-term valuation argument only works for those with long-term investment horizons. What does long-term mean? There is no clear dividing line, but we would define long-term as two years at the very minimum. For a one-year investment horizon, the much more important question is: what will happen to 12-month forward earnings (profits)?  In the stock market recessions of 2008-09 and 2015-16, the stock market reached its low just before forward earnings reached their low. Assuming the same holds true in 2020-21, we must establish whether forward earnings are close to their low or not. In 2008-09, world forward earnings collapsed by 45 percent. In the current recession, which is putatively worse, world forward earnings are down by less than 20 percent to date. To have already reached the cycle low in forward earnings with only half the decline of 2008, the current recession needs to be much shorter than the 2008-09 episode (Chart I-11 and Chart I-12). Chart I-11In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent Chart I-12In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? Whether this turns out to be the case or not hinges on the pandemic and our response to it. A controlled easing of lockdowns will boost growth as more of the economy comes back to life. But too rapid an easing of lockdowns will unleash a second wave of the pandemic, requiring a second wave of economic shutdowns, a double dip recession and a new low in the stock market. Hence, if you have a long-term (2-year plus) investment horizon, the choice between equities and bonds is very straightforward: overweight equities. On this long-term horizon, German and Swedish equities are especially attractive versus negative-yielding bonds. On a 1-year investment horizon, the key question is: can we avoid a second wave of the pandemic? But if you have a 1-year investment horizon, the choice is less straightforward, because it hinges on whether we can avoid a second wave of the pandemic or not. Until it becomes clear that governments will not reopen economies too quickly, remain neutral equities on the 1-year horizon. Fractal Trading System* This week’s recommended trade is a pair-trade within the cryptocurrency asset-class. Long bitcoin cash / short ethereum. Set the profit target at 21 percent with a symmetrical stop-loss. The 12-month rolling win ratio now stands at 61 percent. Chart I-13Bitcoin Cash Vs. Ethereum 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 In the US, the 10-year bond yield has declined by 120 bps in the past six months compared with 80 bps in the preceding six months, which equals a deceleration of 40 bps; in China, the 10-year bond yield has declined by 73 bps in the past six months compared with 18 bps in the preceding six months, which equals a deceleration of 65 bps; but in France, the 10-year bond yield has increased by 12 bps in the past six months compared with a 48 bps decline in the preceding six months, which equals an acceleration of 60 bps. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Real Yield Curve: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). High-Yield: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Bank Bonds: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. Feature Oil was the big mover in financial markets last week, with the WTI price dropping briefly into negative territory on the day before expiry of the May futures contract.1  Bond markets didn’t react much to the negative oil price (Chart 1), but this doesn’t mean that the energy market is unimportant for yields. On the contrary, the oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Chart 1Negative Oil Didn't Shock The Bond Market A Bond Market Trade Inspired By Negative Oil The Fisher Equation is the formula that relates nominal yields, real yields and inflation expectations. In its simplest form the Fisher equation is: Nominal Yield = Real Yield + Inflation Expectations When applying this equation to the act of bond yield forecasting we find it helpful to note that both the nominal yield and inflation expectations have specific valuation anchors. The Federal Reserve sets the valuation anchor for nominal yields because it controls the overnight nominal interest rate. If you enter a long position in a nominal Treasury security and hold to maturity you will make money versus a position in cash if the average overnight nominal interest rate turns out to be lower than the nominal bond yield at the time of purchase. The oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Similarly, inflation expectations are anchored by the actual inflation rate. If you enter a long position in inflation protection and hold to maturity you will make money if actual inflation turns out to be higher than the rate that was embedded in bond prices at the time of purchase.2 Turning to real yields, we see why the Fisher Equation is important. Real yields have no obvious valuation anchor. This means that the best forecasting technique is often to: (1)   Use our known valuation anchors (the fed funds rate and inflation) to forecast the nominal yield and inflation expectations. (2)  Use the Fisher Equation to back-out a fair value for real yields. With all that said, let’s apply this framework to today’s bond market in light of last week’s dramatic oil price moves. Inflation Compensation The cost of inflation protection tracks the oil price, more so at the front end of the curve than at the long end. This makes sense given that recent oil price trends tell us a fair amount about the outlook for inflation over the next year but very little about the outlook for inflation over the next 10 or 30 years. The inflation market didn’t react much to oil’s dip into negative territory last week, but this year’s broader drop in the WTI price from above $50 to below $20 had a big impact on TIPS breakeven inflation rates and CPI swap rates, particularly at short maturities (Chart 2). In fact, consistent with expectations for a very low oil price, the bond market is now pricing-in deflation over the next two years. Chart 2Bond Market Priced For Deflation Nominal Yields The Fed’s zero interest rate policy is having a profound effect on nominal bond yield volatility. Because the consensus investor expectation is that the Fed will keep rates pinned near zero for a long time, almost irrespective of economic outcomes, even a significant market event like a plunge in the oil price will do very little to move nominal bond yields. During the last zero-lower-bound period, nominal bond yield volatility fell across the entire yield curve but fell much more at the short end of the curve than at the long end (Chart 3). The same phenomenon will re-occur during the current zero-lower-bound episode. Chart 3The Zero Lower Bound Crushes Nominal Bond Yield Volatility Real Yields Using the Fisher Equation, we can deduce how real yields must move given changes in inflation expectations and nominal bond yields. With the Fed ensuring that short-maturity nominal yields remain stable, the recent decline in oil and inflation expectations caused short-dated real yields to jump (Chart 4). Long-maturity real yields remain low because (a) the shock to inflation expectations was smaller at the long-end of the curve and (b) the Fed’s forward rate guidance doesn’t suppress nominal bond yield volatility as much for long maturities. Chart 4There's Value In Short-Maturity Real Yields Investment Implications If we assume that last week’s -$37.60 WTI print will mark the cyclical trough in oil prices, US bond investors can profit by implementing real yield curve steepeners.3  Short-dated real yields will fall as oil and short-dated inflation expectations recover and nominal yields remain stable. In this scenario, real yields are more likely to rise at the long-end of the curve, given the greater volatility in long-dated nominal yields and the fact that long-maturity inflation expectations are not as depressed. Looking at the 2008 episode as a comparable, we see that the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI (Chart 5). After that trough, with the Fed keeping short-dated nominal rates pinned near zero, the inflation compensation curve flattened and the real yield curve steepened. Chart 5Initiate Real Yield Curve Steepeners Bottom Line: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). Poor Junk Bond Valuations Illustrated In recent reports we have been advising investors to own spread products that offer attractive spreads and that benefit from Fed support.4 This includes investment grade corporate bonds and Ba-rated high-yield bonds, but not junk bonds rated B or below. In past reports we also showed that B-rated and below junk spreads don’t adequately compensate investors for likely default losses. But this week, we want to quickly illustrate that junk spreads are trading too tight even compared to other common coincident indicators. Specifically, we zero in on the VIX and ratings migration. In 2008, the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI. Charts 6A, 7A and 8A show the historical relationship between the VIX and Ba, B and Caa junk spreads. In all three cases, spreads are well below levels that have been historically consistent with the current reading from the VIX. Charts 6B, 7B and 8B show the historical relationship between the monthly Moody’s rating downgrade/upgrade ratio and Ba, B and Caa spreads. These charts tell a similar story. In fact, March saw nearly 12 times as many ratings downgrades as upgrades, the third highest monthly ratio since 1986. With more downgrades coming in the months ahead, it is apparent that junk spreads are stretched. Chart 6ABa Spreads & VIX Chart 6BBa Spreads & Ratings Chart 7AB Spreads & VIX Chart 7BB Spreads & Ratings Chart 8ACaa Spreads & VIX Chart 8BCaa Spreads & Ratings Relatively tight spreads are probably justified in the Ba space where firms will benefit from the Federal Reserve’s Main Street Lending facilities.5 However, B-rated and below securities have mostly been left out in the cold. We see high odds of spread widening for those credit tiers.  Bottom Line: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Subordinate Bank Debt Is A Good Bet The Fed’s decision to exclude bank bonds from its primary and secondary market corporate bond purchases complicates our investment strategy. We want to focus on sectors that offer attractive spreads and that benefit from Fed support, but should we carve out an exception for bank bonds? Bank Bonds Are A Defensive Sector First, we note that banks are a defensive corporate bond sector. This is due to bank debt’s relatively high credit rating and low duration. Notice that banks outperformed the rest of the corporate index when spreads widened in March, but have lagged the index by 131 bps since spreads peaked on March 23 (Chart 9). Bank equities don’t exhibit the same behavior and have in fact steadily underperformed the S&P 500 since the start of the year (Chart 9, bottom 2 panels). Chart 9Bank Bonds Are Defensive... However, if we consider senior and subordinate bank debt separately, a different picture emerges (Chart 10). Senior bank bonds behave defensively, as described above, but the lower-rated/higher duration subordinate bank bond index is more cyclical. It has outperformed the corporate benchmark by 316 bps since March 23 (Chart 10, bottom panel). Chart 10...Except Subordinate Debt The Value In Bank Bonds Despite being a defensive sector, senior bank bonds offer attractive risk-adjusted value. The average spread of the senior bank index is 18 bps above the spread offered by the equivalently-rated (A) corporate bond benchmark. Further, the senior bank index has lower average duration than the A-rated benchmark, making the sector very attractive on a per-unit-of-duration basis (Chart 11A). Chart 11ASenior Bank Bond Valuation Chart 11BSubordinate Bank Bond Valuation ​​​​​​​Turning to subordinate bank bonds, risk-adjusted value looks only fair compared to other equivalently-rated (Baa) corporate bonds (Chart 11B). However, in absolute terms the subordinate bank index offers a spread of 246 bps, compared to a spread of 178 bps on the senior bank index. Downgrade Risk Is Minimal We think investors should overweight subordinate bank bonds for two reasons. First, we think the Fed’s aggressive policy response means that investment grade corporate bond spreads, in general, have already peaked. We would expect defensive senior bank bonds to underperform in this environment of spread tightening, even though they offer attractive risk-adjusted value. Subordinate bank bonds should outperform the index in this environment, even if other Baa-rated sectors offer better value. Second, other Baa-rated corporate bond sectors offer elevated spreads because downgrade risk remains high. The Fed’s facilities will prevent default for investment grade firms, but many Baa-rated issuers will end up taking on a lot of debt to avoid bankruptcy and will get downgraded. We think banks are insulated from this downgrade risk. Even in the Fed's "Severely Adverse Scenario", three of banks' four main capital ratios remain above pre-GFC levels. Chart 12 shows the four main capital ratios calculated for US banks, and the dashed line shows the minimum value the Fed estimates that those ratios will hit under the “Severely Adverse Scenario” from the 2019 Stress Test. Three of the four ratios would remain above pre-crisis levels, and the Tier 1 Leverage Ratio would be only a touch lower. Chart 12Banks Have Huge Capital Buffers Further, our US Investment Strategy service observes that the large banks had sufficient earnings in the first quarter to significantly ramp up loan loss provisions without taking any capital hit at all.6 Our US Investment Strategy team believes that, as long as the shutdown doesn’t last more than six months, the big banks will have sufficient earnings power to absorb loan losses this year, without having to mark down their capital ratios, which in any case are extremely high. Bottom Line: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. In short, subordinate bank debt looks like a reasonably safe way to capture high-beta exposure to the investment grade corporate bond market.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed explanation of the WTI price’s shocking move please see Commodity & Energy Strategy Special Alert, “WTI In Free Fall”, dated April 20, 2020, available at ces.bcaresearch.com 2 An example of a long position in inflation protection would be buying the 5-year TIPS and shorting the equivalent-maturity nominal Treasury security. 3 Our Commodity & Energy Strategy service’s view is that the WTI oil price will average ~$60 to $65 in 2021. For further details please see Commodity & Energy Strategy Weekly Report, “US Storage Tightens, Pushing WTI Lower”, dated April 16, 2020, available at ces.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 For more details on the Fed’s different emergency facilities please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, April 2020”, dated April 20, 2020, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Inflation-Linked Bonds: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy awakens from the COVID-19 slumber, depressed market-derived inflation expectations can move higher across the developed markets – most notably in the US, the UK, Australia and Canada. Favor inflation-linked government bonds versus nominals in those countries on a strategic (6-12 months) basis. UK Corporates: The Bank of England (BoE) is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases, with credit spreads at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from BoE buying. Feature Chart of the WeekThe Link Between Oil & Bond Yields Remains Strong The shocking, albeit brief, journey of the West Texas Intermediate (WTI) oil price benchmark below zero last week was another in a long line of stunning market moves seen during the COVID-19 pandemic. Those negative oil prices were technical in nature and lasted all of one day, but the ramifications for global bond markets of the falling cost of oil in 2020 have been more enduring. Government bond yields have largely followed the ebbs and flows in energy markets for most of the past decade, and this year has been no exception (Chart of the Week). That link from oil has been through the inflation expectations component of yields, which have been (and remain) highly correlated to oil prices in virtually every developed market country. This is likely due to the persistent low global inflation backdrop since the 2008 financial crisis, which has made cyclical swings in energy prices the marginal driver of both realized and expected inflation. Chart 2BCA's Commodity Strategists Expect Oil Prices To Recover Our colleagues at BCA Research Commodity & Energy Strategy now anticipate higher oil prices over the next 12-18 months.1 Global growth is expected to recover from the COVID-19 recession sooner (and faster) than global oil production, helping to improve the demand/supply balance in energy markets and boost oil prices (Chart 2). Our energy strategists expect the benchmark Brent oil price to rise to $42/bbl by the end of 2020 and $78/bbl by the end of 2021. Those are big moves compared to the current spot price around $20/bbl, and would impart significant upward pressure on inflation expectations if the history of the past decade is any guide. That kind of move in oil prices should also help lift overall nominal government bond yields. Although the real (inflation-adjusted) component of yields is likely to remain low as major central banks like the Fed and ECB will remain highly accommodative, even when growth and inflation begin to recover, given the severity of the COVID-19 global recession. With market-based inflation expectations now at such beaten-up levels, and with the disinflationary effect of falling energy prices set to fade, we see an opportunity to play for a cyclical rebound in inflation breakevens across the developed markets by favoring inflation-linked government bonds versus nominal yielding equivalents. A Simple Framework For Finding Value In Inflation Breakevens Given the remarkably tight correlation between oil prices and market-determined inflation expectations in so many countries, it should be fairly straightforward to model the latter using the former as the main input. We have developed a series of fair value regressions for breakevens in the major developed countries which do exactly that. In this simple approach, we attempt to model the 10-year breakeven from inflation-linked bonds for eight countries – the US, the UK, Germany, Japan, France, Italy, Canada and Australia - as a function of a short-run variable (oil prices) and a long-run variable (the trend in realized inflation). Specifically, we are using the annual percentage change in the Brent oil price benchmark in local currency terms (i.e. converted from US dollars at spot exchange rates) as the short-run variable and a five-year moving average of realized headline CPI inflation as the long-run variable. The latter is included to provide an “anchor” for breakevens based on the actual performance of inflation in each country. In other words, expectations about what inflation will look like in the future are informed by what it has done in the past – what economists refer to as “adaptive” expectations. The generic regression equation used for each country is: 10-year inflation breakeven = α + β1 * (annual % change of Brent oil price in local currency terms) + β2 * (60-month moving average of headline CPI inflation) In Table 1, we present the results of the regressions of each of the eight countries, which use weekly data dating back to the start of 2012 to capture the period when oil prices have most heavily influenced inflation expectations. The coefficients, R-squareds and standard errors of the regressions are all shown, as well as the most recent model residual (i.e. the deviation of 10-year inflation expectations from model-determined fair value). All the coefficients for each model are significant. The R-squareds of the models vary, with the models for France and Australia doing the best job of explaining changes in inflation expectations in those two countries. Table 1Details Of Our New 10-Year Inflation Breakeven Models For the UK and Japan, we added an additional “dummy” variable to control for the unique situations that we believe have influenced inflation breakevens in those countries. For the UK, the period since the June 2016 Brexit vote has seen the path of inflation expectations stay nearly 50bps higher than implied by moves in GBP-denominated oil prices and the trend in actual UK inflation. For Japan, the period since the Bank of Japan initiated its Yield Curve Control policy in September 2016 has seen breakevens stay nearly 60bps below fair value as derived from JPY-denominated oil prices and the trend in actual Japanese inflation. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. In Charts 3 to10 over the next four pages, we show the models for each country. 10-year inflation breakevens versus the independent variables in the models are shown in the top two panels, the model fair value is presented in the 3rd panel, and the deviation from fair value is in the bottom panel. In all cases, breakevens are below fair value, suggesting that inflation-linked bonds look relatively attractive versus nominal government bonds. Chart 3Our US 10-Year TIPS Breakevens Model Chart 4Our UK 10-Year Breakeven Inflation Model Chart 5Our France 10-Year Breakeven Inflation Model Chart 6Our Italy 10-Year Breakeven Inflation Model Chart 7Our Japan 10-Year Breakeven Inflation Model Chart 8Our Germany 10-Year Breakeven Inflation Model Chart 9Our Canada 10-Year Breakeven Inflation Model Chart 10Our Australia 10-Year Breakeven Inflation Model Chart 11Real Inflation-Linked Bond Yields Will Remain Subdued For Longer The largest deviations from fair value can be found in Canada (-70bps), Australia (-48bps), the UK (-29bps), and the US (-26bps). 10-year breakevens are also below fair value in the euro zone countries and Japan, but not by more than one standard deviation as is the case for the other four countries. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. Focus on the four markets with breakevens furthest from fair value, although from a market liquidity perspective it is easier to implement those positions in the US and UK, which represent a combined 69% of the Bloomberg Barclays Global Inflation-Linked bond index. A rise in inflation expectations should also, eventually, put some sustained upward pressure on nominal bond yields. We would rather play that initially by positioning for higher inflation breakevens, rather than having outright below-benchmark duration exposure, as developed market central banks will stay accommodative for longer given the severity of the COVID-19 recession - that will keep real bond yields lower for longer (Chart 11). Breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Bottom Line: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy starts to awaken from the coronavirus induced slumber, breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Favor linkers over nominals in those countries. Where Is The Value In UK Corporate Bonds? Chart 12Upgrade UK IG Corporates To Overweight On BoE Buying The Bank of England (BoE) initiated its Corporate Bond Purchase Scheme (CBPS) in August 2016 as part of a package of stimulus measures to cushion the economic blow from the UK’s vote to exit the European Union. As we noted in recent joint report with our sister service, BCA Research US Bond Strategy,2 the CBPS helped tighten spreads by lowering downgrade and default risk premiums and also helped spur corporate bond issuance (Chart 12). Shortly after that report was published, the BoE announced that it would be purchasing a further £10 billion in investment grade nonfinancial corporate bonds in the coming months, doubling the scheme’s aggregate holdings to £20 billion. In addition, the bank would make these purchases at a significantly faster pace than in 2016, which implies a faster transmission towards tightening of spreads. Compared to other central bank peers, however, the BoE’s program still has room to expand, which makes UK investment grade credit attractive over tactical and strategic investment horizons. Using the market value of the Bloomberg Barclays UK corporate bond index (excluding financials) as a proxy for the total value of eligible bonds, the CBPS is on track to own roughly 9% of all eligible bonds by the time the £20 billion target is reached. The neighboring European Central Bank, on the other hand, already owns 23% of the stock of eligible euro area corporate bonds in its market, and that figure is only set to increase with policymakers set to do “whatever it takes” to backstop the investment grade market. Year-to-date, UK corporate bonds appear to have recovered somewhat from the panicked selloff earlier this quarter (Table 2), with the Bloomberg Barclays UK investment grade corporate bond index down only -0.3% in total return terms. In excess return terms relative to duration-matched UK corporate bonds, however, the index is down -5.2%, indicating that weakness has persisted in the pure credit component. Table 2UK Investment Grade Corporate Bond Returns At the broad sector level, Other Industrials appear to be the outlier, having delivered positive excess returns (+0.6%) and significant total returns (+16%). These returns are not nearly as attractive, however, on a risk-adjusted basis once you consider that this sector has an index duration more than three times that of the overall index.3 Outside of that sector, the best performers, in excess return terms, are predominantly the more “defensive” sectors—Utilities (-3.4%), Technology (-3.7%), Communications (-4.2%) and Consumer Non-Cyclical (-4.6%). Meanwhile, the sectors most exposed to vanishing consumer demand and weak global growth have performed the worst—Transportation (-9.5%), Capital Goods (-7%), Energy (-6.8%), and Basic Industry (-6.2%). Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases. Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases (Chart 13). The overall index spread, although still elevated at 228bps, has already tightened by 57bps from the peak in late March. The gap between the index spreads of Baa-rated and Aa-rated UK debt remained relatively stable through the wave of sell-offs, peaking at +53bps, below the 2019 high of +55bps, and settling now to +36bps. Outside the purview of the CBPS, however, the situation is a bit rockier, with the overall high-yield index spread +590bps above that of the investment grade index. Broadly speaking, there is a clear disparity between those credit tiers that have the support of the monetary authorities and those that do not. Investment grade spreads will continue to tighten as the BoE rapidly increases its holdings of investment grade corporate bonds. However, high-yield bonds remain exposed to downgrade/default risk and ongoing uncertainty stemming from the COVID-19 economic shock. To drill down into which credit tier spreads offer the most value within the UK investment grade space, we use the 12-month breakeven spread percentile rankings. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. Chart 14 shows the 12-month breakeven spread percentile rankings for all the credit tiers in the UK investment grade space. Aaa-rated debt appears most unattractive, with the spreads currently ranking below the historical median. Between the other three tiers, Aa-rated debt offers the most value, although all three are at historically attractive levels. Chart 13UK IG Has Held Up Well During The COVID-19 Shock Chart 14UK IG Breakeven Spreads Look Most Attractive For Aa-Rated Bonds On the sector-level, the disparity in spreads is most clearly visible in the sectors most exposed to the pandemic. In Charts 15 & 16, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays UK investment grade corporate index. Spreads look widest relative to history for sectors such as Energy and Transportation, while spread widening has been contained in more insulated sectors such as Financials. Chart 15A Mixed Performance For UK IG By Sector In 2020 … Chart 16… But Spreads, In General, Remain Below Previous Cyclical Peaks Another way to assess value across UK investment grade corporates is our sector relative value framework. Borrowing from the methodology used for US corporate credit by our colleagues at BCA Research US Bond Strategy, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall UK investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The dependent variables in the model are each sector's duration, 12-month trailing spread volatility and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. We see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. The latest output from the UK relative value spread model can be found in Table 3. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 17 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 17UK Investment Grade Corporate Sectors: Valuation Versus Risk We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. Amid a backdrop of global uncertainty, we reiterate one of our major themes this quarter—buy what the central banks are buying. Given that UK corporate spreads are attractive on a breakeven basis, and with the BoE purchasing corporate debt at an even faster pace than during the volatile period following the shock Brexit vote in 2016, we see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. This is both on a tactical (0-6 months) and strategic basis (6-12 months). In our model bond portfolio, we have added two percentage points to our recommended UK corporate bond allocation, funded by reducing further our existing underweight on Japanese government bonds. At the sector level, given this positive backdrop for credit performance, we do not see a need to favor lower risk sectors with a DTS score below that of the overall UK investment grade index. On that basis, we are looking to go overweight sectors with higher relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 17. Based on the latest output from the relative value model, the strongest overweight candidates are the following UK investment grade sectors: selected Financials (Insurance, Subordinated Bank Debt, and Other Financials), Media Entertainment, Cable Satellite, Tobacco, Diversified Manufacturing, and Communications. The least attractive sectors within this framework are: Packaging, Lodging, REITs, Other Industrials, Metals, Natural Gas, Restaurants, Transportation Services, Financial Institutions, and Midstream Energy. Bottom Line: The BoE is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases. Spreads have already begun to tighten in response but are still at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across credit tiers, favor Aa-rated debt. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from the CBPS.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, "US Storage Tightens, Pushing WTI Lower", dated April 16, 2020, available at ces.bcaresearch.com. 2 Please see BCA US Bond Strategy Special Report, "Trading The US Corporate Bond Market In A Time Of Crisis", dated March 31 2020, available at usbs.bcaresearch.com. 3 Other Industrials has an index duration of 28.6 years, compared to 8.5 years for the overall UK investment grade corporate bond index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy We remain comfortable with a 3,000 SPX fair value estimate backed up by our DDM, forward ERP and sensitivity analyses. The path of least resistance remains higher for the SPX on a 9-12 month cyclical time horizon. The oil price collapse is eliciting a massive supply response that should help rebalance the oil markets, and coupled with glimmers of hope on reopening the economy, it should put a floor under oil prices. CB are injecting unprecedented amounts of liquidity in the markets and at some point this will lead to a growth revival which is negative for gold prices. Taken together, and given all-time lows in relative valuations and technicals, we are compelled to go long US oil & gas exploration & production stocks at the expense of global gold miners. We are putting the S&P managed health care index on downgrade alert to reflect the risk that rising unemployment poses to health care enrollment. Falling interest rates also weigh on industry profitability at a time when relative valuations are perky and technicals are overbought. Recent Changes Initiate a long S&P oil & gas exploration & production/short global gold miners pair trade, today. Table 1 Feature Equities marked time last week, despite the passage of a fresh mini fiscal 2.0 package and efforts to restart the economy in parts of the globe. In contrast, news that President Trump may delay reopening the economy along with negative crude oil prices weighed heavily on the S&P 500. Nevertheless, energy equities fared very well, defying the oil market carnage and impressively relative energy share prices have led the SPX trough (Chart 1). We remain constructive on the broad equity market on a cyclical 9-12 month time horizon. Following up from last week’s SPX dividend discount model (DDM) update, we complement our research with two additional ways of approximating the SPX fair value: EPS and multiple sensitivity analysis and a forward equity risk premium (ERP) analysis. While at the nadir the stock market priced in a collapse in EPS close to $104 for the current year (please refer to our analysis here1), in 2021 EPS can return to their long-term trend line near $162. At first sight this spike in EPS seems unrealistic. However, here are two salient points: Chart 1Energy As A Leading Indicator First, hard-hit COVID-19 subsectors are a small fraction of SPX profits and market capitalization. In other words, the S&P 500 is a market cap weighted index and has already filtered out hotels, cruises, restaurants, homebuilders, autos, auto parts, airlines, and even energy as they comprise a small part of the SPX. Second, historical precedents show an explosive year-over-year growth increase in EPS from recessionary troughs. In fact, the steeper the collapse the more violent the rebound. Hence, our recovery EPS estimate is more or less in line with empirical evidence (Chart 2). Chart 2Violently Oscillating EPS For comparison purposes, the Street is still penciling in EPS near $135 and $170 for 2020 and 2021, respectively. Table 2 shows our sensitivity analysis and an SPX ending value of just above 2,900 using $162 EPS and an 18x forward multiple as our base case. This multiple is slightly below the historical time trend using IBES data dating back to 1979, and represents our fair value PE estimate (please see page 17 of our April 6, 2020 webcast2 available here). Table 2SPX EPS & Multiple Sensitivity With regard to the forward ERP analysis, our starting point is an equilibrium ERP of 440 basis points (bps). The way we derived this number was using the last decade’s average observed forward ERP (middle panel, Chart 3). We used to think equilibrium ERP was closer to 200bps. However, if the Fed’s extraordinary – and unorthodox – measures since the onset of the GFC did not manage to bring down the ERP (middle panel, Chart 3), then in the current recession with uncertainty on the rise, it only makes sense to model a higher than previously thought equilibrium ERP (middle panel, Chart 4). Chart 3The Forward Equity Risk Premium… Chart 4…Will Recede And, just to put the forward ERP in perspective, keep in mind that it jumped from 350bps to just below 600bps year-to-date (Chart 4)! A doubling in the 10-year US treasury yield to 120bps is another assumption we are making along with using our trend EPS estimate of $162 for calendar 2021. Backing out price results in a roughly 2,900 SPX fair value estimate (Table 3). Table 3Forward Equity Risk Premium Analysis We remain comfortable with a 3,000 SPX fair value estimate backed up by our DDM, forward ERP and sensitivity analyses. Despite the much needed current consolidation phase, the path of least resistance is higher for the SPX on a 9-12 month cyclical time horizon. This week we are putting a health care subgroup on downgrade alert and initiating a high-octane intra-commodity market-neutral pair trade to benefit from the looming handoff of liquidity to growth. Time To Buy “Black Gold” At The Expense Of Gold Bullion We have been long and wrong on the S&P energy sector and its subcomponents, as neither we nor our Commodity & Energy Strategists anticipated -$40/bbl WTI crude oil futures prices. Nevertheless, as the energy sector is drifting into oblivion within the SPX – it is now the second smallest GICS1 sector with a 2.77% market cap weight slightly higher than materials – we think that WTI May contract reaching -$40/bbl marked the recessionary trough. Similar to the early-2018 “volmageddon” incident when a volatility exchanged trade product blew up and got dismantled and marked that cyclical peak in the VIX, the recent near collapse of USO and shuttering of another oil related levered exchange traded product serve as the anecdotes that likely mark the low in oil prices. True, negative WTI futures prices are no longer taboo and the CME prepared for them by reprograming its systems to handle negative futures prices, thus they can happen again. With regard to the significance of anecdotes in market tops and bottoms, another interesting one that comes to mind is from our early days at BCA in May of 2008 where we worked for the Global Investment Strategy team as a senior analyst. Back then, we vividly remember a Goldman Sachs analyst slapping a $150/bbl target on crude oil,3 and only days later in unprecedented hubris Gazprom’s CEO upped the ante with an apocalyptic $250/bbl prediction.4 This prompted us to create our first mania chart at BCA with crude oil prices on June 20, 2008 (please see chart 16 from that report available here5), which proved timely as oil prices peaked less than a month later at $147/bbl. Today, we are compelled to perform the opposite exercise and run a regression of previous equity sector market crashes on the S&P oil & gas exploration & production index (E&P, that most closely resembles WTI crude oil prices) in order to gauge a recovery profile. Chart 5 suggests that if the anecdotes are accurate in calling the trough in oil prices, then E&P stocks should enjoy a steep price appreciation trajectory in the coming two years. Beyond the overweights we continue to hold in the S&P energy sector and all the subgroups we cover, we believe that there is an exploitable trading opportunity to go long S&P E&P/short global gold miners (Chart 6). Chart 5Heed The US Equity Strategy’s Crash Index Message This high-octane trade is extremely volatile, but the recent carnage in the oil markets offers a great entry point for investors that can stomach heightened volatility, with an enticing risk/reward tradeoff. The gold/oil ratio (GOR) is trading at 112 as we went to press and we think that it will have to settle down. The Fed is doing its utmost to dampen volatility, and historically, suppressed volatility has been synonymous with a falling GOR (Chart 7). As a result, our pair trade will have to at least climb back to its recent breakdown point, representing a near 34% return (top panel, Chart 6). Chart 6Buy E&P Stocks At The Expense Of Gold Miners From a macro perspective the time to buy oil equities at the expense of gold miners is when there is a handoff from liquidity to growth (bottom panel, Chart 6). While we are still in the liquidity injection phase we deem the Fed and other Central Banks (CB) are committed to do “whatever it takes” to sustain the proper functioning of the markets. Therefore, at some point likely in the back half of the year when the economy slowly reopens, all these CB programs will bear fruit and growth will recover violently (middle panel, Chart 6), especially given our long-held view that the US will avoid a Great Depression. Chart 7VIX Says Sell The GOR With regard to balancing the oil market, nothing like price to change behavior. In more detail, the recent collapse in oil prices will work like magic to bring some semblance of normality back to the crude oil market, as it will naturally cause a shut in of production; there is no doubt about it. Not only has the supply response commenced, but it is also accelerating to the downside as the plunging rig count depicts (Chart 8). This will lead to some longer-term bullish oil price ramifications. As a reminder, while demand drives prices in the short-term, supply dictates the oil price direction in the long-term. Chart 8Oil Price Collapse Induced Supply Response Turning over to gold and gold miners, all this liquidity is forcing investors to chase bullion and related equities higher. Tack on that every CB the world over is trying to debase their currency, and factors are falling into place for sustainable flows into gold and gold mining equities. However, there are high odds that all this money sloshing around will eventually generate growth especially in the western hemisphere that is slowly contemplating of restarting its economic engines. As a result, real yields will rise which in turn is negative for gold and gold miners (Chart 9). Finally, relative valuations and technicals could not be more depressed, which is contrarily positive (Chart 10). Chart 9Liquidity To Growth Handoff Beneficiary Netting it all out, the oil price collapse is eliciting a massive supply response that should help rebalance the oil markets, and coupled with glimmers of hope on reopening the economy, it should put a floor under oil prices. CB are injecting unprecedented amounts of liquidity in the markets and at some point this will lead to a growth revival which is negative for gold prices. Taken together, and given all-time lows in relative valuations and technicals, we are compelled to go long US oil & gas exploration & production equities at the expense of global gold miners. Chart 10As Bad As It Gets Bottom Line: Initiate a long US oil & gas exploration & production/short global gold miners pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: BLBG: S5OILP – COP, EOG, HES, COG, MRO, NBL, CXO, APA, PXD, DVN, FANG, (or XOP:US exchange traded fund) and GDX:US exchange traded fund, respectively. Put HMOs On Downgrade Alert We upgraded the S&P managed health care index last April, the Monday after Bernie Sanders re-introduced his “Medicare For All” bill.6 Our thesis was that the drubbing in this sector was a massive overreaction and we, along with our Geopolitical Strategists, thought that he would have low chances of clinching the Democratic Presidential candidacy and threatening to render HMOs obsolete. A year later, this thesis has panned out and the S&P managed care index is up 30% versus the S&P 500. Nevertheless we do not want to overstay our welcome and are putting it on our downgrade watch list and instituting a 5% rolling stop in order to protect gains in our portfolio (top panel, Chart 11). Relative share prices have broken out to fresh all-time highs, not only courtesy of a more moderate Democratic Presidential candidate, but also because a significant boost to margins and profits is looming. The delayed effect of fewer elective procedures (i.e. hip and knee replacements and even non-life threatening bypass surgeries) owing to the coronavirus pandemic will result in a sizable, yet temporary, margin expansion phase (second panel, Chart 11). Tack on, still roughly 20% health care insurance CPI and the outlook for HMO margins and profits further improves (bottom panel, Chart 11). Nevertheless, there are some negative offsets. Over the past 5 weeks unemployment insurance claims have soared to 26.5mn, erasing all the employment gains of the past decade, thus private insurance enrollment will take a sizable hit (top panel, Chart 12). Chart 11The Good… Chart 12…And The Bad Moreover on the income side, the premia that HMOs take in are typically invested in the risk free asset and given the two month fall from 1.5% to around 0.6% in the 10-year Treasury yield, managed health care earnings will also, at the margin, suffer a setback (bottom panel, Chart 12). True, the HMOs earnings juggernaut has been one of a kind over the past decade underpinning relative share prices (top panel, Chart 13). However, we reckon a lot of the good news and very little if any of the bad news is priced in extremely optimistic relative profit expectation going out five years (middle panel, Chart 13). Keep in mind that the bulk of the M&A activity is behind this industry as the dust has now settled from the previous two year frenzied pace of inter and intra industry combinations (top panel, Chart 14). Chart 13Lots Of Good News Is Already Priced In Chart 14Preparing Not To Overstay Our Welcome Finally, relative technicals are in overbought territory close to one standard deviation above the historical mean and relative valuations are also becoming a tad too lofty for our liking (middle & bottom panel, Chart 14). Adding it all up, we are putting the S&P managed health care index on downgrade alert to reflect the risk that rising unemployment poses to health care enrollment. Falling interest rates also weigh on industry profitability at a time when relative valuations are perky and technicals are overbought. Bottom Line: Stay overweight the S&P managed health care index, but it is now on our downgrade watch list. We are also instituting a rolling 5% stop as a portfolio management tool in order to protect profits. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5MANH-UNH, ANTM, HUM, CNC.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “What Is Priced In?” dated March 30, 2020, available at uses.bcaresearch.com. 2     https://www.icastpro.ca/events/bca/2020/04/06/us-equity-market-what-the-future-holds/play/16925 3    https://www.nytimes.com/2008/05/21/business/21oil.html 4    https://www.reuters.com/article/gazprom-ceo/russias-gazprom-sees-higher-gas-prices-ceo-idUSL1148506420080611 5    Please see BCA Global Investment Strategy Weekly Report, “Strategy Outlook - PART 1 - Third Quarter 2008” dated June 20, 2008, available at gis.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Show Me The Profits” dated April 15, 2019, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Why is the gap between the stock market and the economy so wide?: It is well established that stocks can diverge considerably from fundamentals in the near term, but lately it is as if the stock tables and the front-page headlines are from entirely different newspapers. It may be because the virus poses much less of a threat to the owners of equities than the general populace: More affluent households are more readily able to work from home and to practice social distancing. They also have access to better medical care. With the S&P 500 having hit technical resistance, however, the gap may be nearing its upper limit: Large-caps have run in place since retracing half of their peak-to-trough losses, and the next Fibonacci resistance level is only another 5% higher. Where are the shoddy loans?: During the expansion, corporations were able to borrow on prodigally easy terms. If banks aren't holding the loans, who is? Feature That’s New York’s future, not mine – “Hold On” (Reed) For someone who entered the business as a sell-side trader, it is a matter of course that prices can diverge from fundamentals. The trading desk had a one-day horizon, and the traders necessarily made their way on price signals while barely considering fundamentals. Though the junior traders had been exposed to dividend discount models at their fancy colleges, the ones who lasted recognized they weren’t relevant to the desk’s mission. Trading the daily flow required accepting that new news can have a dramatically larger effect on stocks in the here and now than it would on the lifetime stream of earnings available to common shareholders. Long-run fair value might solely turn on the fundamentals, but animal spirits hold sway over any given tick. The sudden stop imposed by stay-at-home orders has made backward-looking economic data nearly irrelevant, but the sizable upward surprises in unemployment claims should not be ignored. Our Global Investment Strategy colleagues showed last week just how difficult it is for even severe near-term shocks to materially alter the present value of aggregate future earnings.1 Furthermore, the market effects of negative earnings shocks are inherently self-limiting at the margin because they tend to be accompanied by lower interest rates, driving up the equity risk premium and making stocks more attractive relative to “safe” fixed income alternatives. Bear markets coincide with recessions, though, as near-term earnings expectations are revised lower and animal spirits droop (Chart 1). Given that the recession just begun is expected to be the worst since the Great Depression, one would expect that equities would be stumbling in search of a bottom as investors remained fearful of taking on risk. Chart 1Joined At The Hip They have instead been acting like the S&P 500 found that bottom on March 23rd, when the index completed a 35% peak-to-trough decline in just 23 sessions. It then proceeded to gain 28.5% over the next eighteen sessions. Some retracement is to be expected after a sudden, sharp move, and the S&P 500 has only recovered half of the ground that it lost. It certainly priced in a great deal of bad news on the way down, but the data have been worsening, and investors have been forced to give up on the notion of a swift economic recovery. Why are stocks rising when economic projections are being downwardly revised and good virus news has been few and far between? We ourselves have been barely glancing at backward-looking economic data releases that merely confirm the well-understood fact that draconian social distancing measures have wrung much of the life out of the economy. The degree to which job losses have outrun consensus forecasts stands out nonetheless. Aggregate initial unemployment claims over the last five weeks have exceeded consensus expectations by 5.5 million (Table 1). Even though the forecasts have caught up to the situation on the ground, the claims data suggest that unemployment is now pushing 20%, a worst-case-scenario level that is far above the first forecasts that incorporated the effects of stay-at-home orders. Claims may well have peaked, but they’re still an order of magnitude higher than normal, and they are not finished exerting upward pressure on the unemployment rate. Table 1Job Losses Have Been Worse Than Expected Meanwhile, COVID-19 data have yet to provoke much optimism. The rate of US infections has yet to come down to Italy’s level (Chart 2), and hopes that remdesivir might prove to be a wonder drug were dashed late last week. Clients are increasingly asking us why the stock market is traveling such a dramatically different path than the economy and the virus. How could stocks have plunged at a record rate as the coronavirus drew a bead on the United States, but surged after crippling social distancing measures were put in place? Chart 2The US Has Fallen Behind Italy's Pace A Tale Of Two Boroughs The simplest answer is that the Fed’s response was swifter and more far-reaching than expected. Ditto Congressional actions, and we expect that DC will continue to deploy its fiscal firepower to try to shield households and businesses from the worst of the effects of the anti-virus measures. We believe the monetary and fiscal efforts will make a difference, and do not think it’s a coincidence that equities turned around the week of March 23rd, which began with the Fed’s rollout of a formidable new arsenal and ended with the passage of the CARES Act. But the market action has not accounted for the shift from expectations of a V-bottom to talk of Us, Ls and Ws. Two articles published a week apart in The New Yorker vividly illustrated a demographic virus gap. The first looked at COVID-19 from the perspective of financial professionals at hedge funds and other sophisticated investment aeries.2 Although the views of the investors in the profile shifted with the tide of the incoming data, they were generally of the mind that the health threat was being dramatically overhyped. One retired hedge fund manager boasted about his and his family’s non-stop early March air travel between New York, London and a Wyoming ski resort. The second article followed an emergency room resident at Elmhurst, a publicly funded hospital in a working-class Queens neighborhood, which has been described as the epicenter of the outbreak in several local media reports.3 “‘It’s become very clear to me what a socioeconomic disease this is,’” he said. “‘Short-order cooks, doormen, cleaners, deli workers – that is the patient population here. Other people were at home, but my patients were still working. A few weeks ago, when they were told to socially isolate, they still had to go back to an apartment with ten other people. Now they are in our cardiac room dying.’” Stock ownership is largely reserved to the affluent, with the top percentile of households owning 53% of equities as of the end of 2019, and the rest of the top decile owning another 35% (Chart 3). For households in the top decile, maintaining a healthy distance from the virus isn’t that difficult. Knowledge workers equipped with a laptop and a reliable internet connection can work from anywhere, unlike the Elmhurst patients in low-skilled service positions who have to work onsite. The tonier precincts of Manhattan feel nearly deserted, with their residents having decamped for second homes in lower-density areas. Perhaps it's because the Fed's attempts to shore up the economy have far more personal relevance for investors than the spread of the virus. There are no comprehensive data series on virus infections and outcomes by zip code, which would facilitate analysis of the link between household wealth and COVID-19, but New York state reports age-adjusted fatality rates in four racial/ethnic categories. In New York state ex-New York city, which has lesser extremes of wealth than the city itself, the cross-category disparities are striking (Chart 4). Race/ethnicity is far from an ideal proxy for inequality, but it is fair to conclude that financial market participants have a sound basis for being more sanguine about the virus than the overall population. Assuming that more affluent households will be able to remain out of the virus’ reach, the dichotomy can persist for as long as the economic impacts do not become so bad that investors cannot reasonably look through them. Chart 3Demographics Drive Stock Ownership ... Chart 4... And COVID-19 Fatalities Technical Resistance Back on the trading desk, technical analysis was the go-to tool for traders pricing large blocks of stock in real time. Following sizable moves, the Fibonacci sequence provided a popular method for assessing how far a stock might retrace its steps before resuming its course. The most widely used Fibonacci retracement levels are 38% and 62%, and 50%, a round number exactly between the two, has also become an anticipated stopping point. From the February 19 closing high of 3,386.15 to the March 23 closing low of 2,237.40, the S&P 500 lost 1,148.75 points. The 38%, 50% and 62% retracement levels are 2,673.93, 2,811.78 and 2,949.63, respectively. The S&P paused at the 38% level for just two days before breaking through it decisively, but it’s had more trouble making its way through 2,812, failing to hold above it for more than a day or two at a time (Chart 5). Should it escape 2,812, the 2,950 level waits just 5% higher. Chart 5Fibonacci Retracement Levels For The S&P 500 We are fundamental investors who do not get hung up on technical levels, though they can become self-fulfilling prophecies if enough participants are following them. Given the popularity of Fibonacci retracement, it is possible that a critical mass of short-term investors may view 2,812 and 2,950 as preferred levels for exiting long positions in the S&P. Our bigger near-term concern is that it is hard to see US equities making much more headway while the virus and ongoing distancing measures have the potential to cause investors to revise their fundamental expectations lower and/or lose a little bit of their policy-fueled nerve. Who's Left Holding The Bag? Multiple commentators have expressed alarm at the post-2008 increase in corporate debt, especially given anecdotal reports that lending covenants had been loosened dramatically. If the banks don’t hold the debt, as we’ve argued, who does, and could a wave of virus-inspired defaults cause larger problems in the financial system? The Fed’s fourth quarter Flow of Funds report, published last month, provides some clues, but does not answer the question definitively. As we saw in higher frequency data on aggregate banking system exposures, bank loans to nonfinancial corporations grew modestly (3.2% annualized) since December 31, 2008. Nonfinancial corporations borrowed in the bond market at double that rate (6.2% annualized). Foreign loans, powered by near doubling in 2017 and 2018, grew at an annualized 13.4% pace, and are four times as large as they were at the end of 2008. Finance company loans have shrunk, and trade payables grew at a modest 2% rate. (Chart 6). Chart 6Debt Risks Are Pretty Well Diffused Publicly available data from Preqin on the capital raised by direct lending funds suggests that their impact has been modest, accounting for only about a quarter of outstanding bank loans if every dollar they’ve raised is currently deployed. Demand for leveraged loans, senior floating-rate debt issued to high-yield borrowers, was occasionally intense as investors sought protection from rising rates. The desire for duration protection has faded as rates have plunged to new lows, but ETFs and CLOs were eager buyers at points during the last expansion. In a Special Report published last summer, our US Bond Strategy and Global Fixed Income Strategy services concluded that the ownership of leveraged loans is diffuse enough that credit strains are unlikely to pose a systemic threat. They were also encouraged that leveraged loans and high yield corporate bonds act as substitutes, keeping one another in check as investor preferences for fixed and floating instruments wax and wane. They also noted that leveraged loan lending standards had tightened last year, with a reduced share of covenant-lite loans being issued, though standards have eased again since they published their report (Chart 7). Chart 7Covenant Protections Have Eroded Chart 8Diverse Corporate Bond Ownership Will Help Mitigate The Effect Of Defaults There is no way around the fact that high yield corporate bondholders (Chart 8), owners of CLO tranches rated below AAA and leveraged loan holders face elevated credit losses as the broad economic shutdown provokes a wave of defaults in instruments without Fed support. We expect that the default losses will be spread out across enough constituents that they will not become worryingly concentrated, but they may contribute to a further erosion of risk appetites.       Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 23, 2020 Global Investment Strategy Weekly Report, "Could The Pandemic Actually Raise Stock Prices?" available at gis.bcaresearch.com. 2 Paumgarten, Nick. "The Price of a Pandemic." The New Yorker, April 20, 2020, pp. 20-24. The article, relaying traders’ conversations, contains some profanity. 3 Galchen, Rivka. "The Longest Shift." The New Yorker, April 27, 2020, pp. 20-26. The article, relaying ER conversations, contains some profanity.

Special Report

Highlights A simple three-factor model has outperformed the DXY index since 1980. The main variables have been relative changes in interest rates, valuation and sentiment. The dominant factor varies from one currency to the next. The model recommends a barbell strategy over the next month – long SEK along with some safe havens. Commodity currencies remain a short. Feature Over the past few months, we have been trying to see if a rules-based approach in trading foreign exchange would have provided some sort of anchor amid the market chaos. In our February 7 report, we suggested that a currency investor could construct a long-term portfolio based on three criteria:1  A macroeconomic variable that captures the most important relative price between any two currencies: the real interest rate. A valuation measure that captures dislocation in a currency pair relative to its own history. A key assumption is stationarity, meaning the currency cross should mean-revert back to fair value over time. For this exercise, we use our adjusted purchasing power parity (PPP) models. More on this later. A sentiment indicator. We use a combination of the bullish consensus indicator published by martketvane.net and momentum measures that worked best. Other measures such as net speculative positioning from the Commodity Futures Trading Commission (CFTC) also provide relatively reliable results. This is a very simplistic approach, since foreign exchange markets discount a lot more macroeconomic information, and valuation measures span the spectrum of PPP, effective exchange rates, and behavioral and fundamental models. We intend to build upon the work laid out in this paper, but the goal is to see whether a simple trading rule has provided alpha for G10 currencies versus the US dollar. The good news is that it has. Since the 1980s, our three-factor model has outperformed the DXY index by 280%.  Since the 1980s, our three-factor model has outperformed the DXY index by 280% (Chart 1). There are three important considerations. First, the trading rules are generated monthly, which might be too frequent for hedging managers but make sense in the foreign exchange-trading world. This also made carry less important for excess returns. Second, the model has experienced some significant drawdowns. For example, the model started shorting the US dollar in 2014 (Chart 2) as it was making fresh highs. Since 2015, however, the DXY index has been broadly flat (EUR/USD is still above its 2015 lows). Otherwise, the USD has sold off massively against commodity FX and petrocurrencies. Finally, the model does now account for size in positioning. Chart 1Model Relative Return Chart 2DXY Trading Signal: > 0 = Buy; < 0 = Sell Part of the reason for the model’s volatility is its inherent design. The model is very aggressive in establishing long and short positions. This has paid off handsomely over time but can be quite painful in the short to medium term. In a nutshell, it provides a mechanical tool to anchor our ever-shifting fundamental biases towards currencies.  The Macro Factor Chart 3The Dollar And Interest Rates Diverge If a currency exchange rate is simply a measure of relative prices between two countries, then the most important price is the cost of money, or the interest rate. Over time, rising interest rates have usually been associated with an appreciating currency, and vice versa (Chart 3). Our trading rule for the macro model is as follows: First, only currencies with a positive real rate are eligible for long positions (negative real rate currencies are shorted). And second, this positive real rate should be rising relative to the US. We do not account for trading or hedging costs in this exercise, which are important considerations. The model has worked well most of the time, but less so for the commodity currencies and safe-haven currencies. The lack of terms-of-trade considerations is an important factor for commodity currencies. A buy-and-hold strategy for safe-haven currencies has also performed in line with the model, due to the significant upside safe-haven currencies command during market selloffs. A review of the results for each currency is available starting on page 7. The Value Factor Chart 4The USD Is Expensive According To PPP Valuation has proved to be a powerful catalyst for buying currencies over the longer term. In our previous work, we showed that value strategies in FX, especially based on PPP, needed an adjustment to be effective due to shortfalls in the measure.2 But once an adjustment was made, it was profitable to buy cheap currencies while selling expensive ones over the long term. While we look at a wide swath of currency valuation models, we only tested our adjusted PPP model for the purposes of this paper. Our in-house PPP models have undergone two crucial adjustments. In order to get closer to an “apples-to-apples” comparison across countries, we divide the consumer price index (CPI) baskets into five major groups: food, restaurants and hotels, shelter, health care, culture and recreation, and energy and transportation. We then take a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% of the US CPI basket but 19% of the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. In most cases, this breakdown captures 90% of the national CPI basket. Buy currencies that are 5% or more cheaper than their PPP-implied fair value, and short currencies that are 5% or more overvalued.  The trading rule is simple. Buy currencies that are 5% or more cheaper than their PPP-implied fair value, and short currencies that are 5% or more overvalued. The outperformance versus a buy-and-hold strategy for the dollar was significant, but came with much volatility. The results also show that the cheapest currencies today are the Swedish krona and the Norwegian krone (Chart 4). The results for individual currencies are available on page 7. The Sentiment Factor We use a combination of the bullish consensus data published by martketvane.net and momentum measures for the sentiment component of the model. Speculative positioning tends to be our favorite contrarian indicator, but it has data limitations and is less effective as a monthly timing tool. The rules for the sentiment indicator encompass both the momentum and mean-reversion factor to exchange rates: If bullish sentiment (range is 0 – 100) is > 70, buy the currency. If it is < 30, sell the currency. If the one-month change in bullish sentiment is positive, buy. If it is negative, sell. If the 2-month return on a currency is > 10-month return, buy. If it is less, sell. The overarching theme from this exercise is that the US dollar is a momentum currency.3 Meanwhile, sentiment has proven to be quite agile in catching shifts in the FX market over the shorter term. We intend to explore this part of the paper in forthcoming iterations for more tactical trade ideas. Portfolio Calibration A composite model aggregates the signal from the three main factors. A buy signal is generated for values > =1 and a sell signal is generated for values < =1. The results are presented in Charts 5A and 5B. The model currently suggests a barbell strategy consisting off being long SEK, as well as the safe-haven currencies (CHF and JPY). The model is neutral on EUR, GBP, CAD, and NOK, while bearish on AUD and NZD. This fits with our near-term view that there could still be short-term upside to the US dollar, warranting holding a basket of the cheapest currencies as well as some safe havens. Chart 5ATrading Signal: >0 = Buy, <0 = Sell Chart 5BTrading Signal: >0 = Buy, <0 = Sell Kelly Zhong Research Analyst kellyz@bcaresearch.com   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Appendix Chart 6US Dollar Chart 7FX Model: The Euro Chart 8FX Model: British Pound Chart 9FX Model: Japanese Yen Chart 10FX Model: Australian Dollar Chart 11FX Model: New Zealand Dollar Chart 12FX Model: Canadian Dollar Chart 13FX Model: Swiss Franc Chart 14FX Model: Norwegian Krone Chart 15FX Model: Swedish Krona   Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Building A Protector Currency Portfolio”, dated February 7, 2020, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, titled “Value Strategies In FX Markets, Putting PPP To The Test”, dated May 11, 2018, available at fes.bcaresearch.com. 3 Please see Foreign Exchange Strategy Special Report, titled, “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The collapse in oil prices supercharges the geopolitical risks stemming from the global pandemic and recession. Low oil prices should discourage petro-states from waging war, but Iran may be an important exception. Russian instability is one of the most important secular geopolitical consequences of this year’s crisis. President Trump’s precarious status this election year raises the possibility of provocations or reactions on his part. Europe faces instability on its eastern and southern borders in coming years, but integration rather than breakup is the response. Over a strategic time frame, go long AAA-rated municipal bonds, cyber security stocks, infrastructure stocks, and China reflation plays. Feature Chart 1Someone Took Physical Delivery! Oil markets melted this week. Oil volatility measured by the Crude Oil ETF Volatility Index surpassed 300% as WTI futures for May 2020 delivery fell into a black hole, bottoming at -$40.40 per barrel (Chart 1). Our own long Brent trade, initiated on 27 March 2020 at $24.92 per barrel, is down 17.9% as we go to press. Strategically we are putting cash to work acquiring risk assets and we remain long Brent. The forward curve implies that prices will rise to $35 and $31 per barrel for Brent and WTI by April 2021. We initiated this trade because we assessed that: The US and EU would gradually reopen their economies (they are doing so). Oil production would be destroyed (more on this below). Russia and Saudi Arabia would agree to production cuts (they did). Monetary and fiscal stimulus would take effect (the tsunami of stimulus is still growing). Global demand would start the long process of recovery (no turn yet, unknown timing). On a shorter time horizon, we are defensively positioned but things are starting to look up on COVID-19 – New York Governor Andrew Cuomo has released results of a study showing that 15% of New Yorkers have antibodies, implying a death rate of only 0.5%. The US dollar and global policy uncertainty may be peaking as we go to press (Chart 2). However, second-order effects still pose risks that keep us wary. Chart 2Dollar And Policy Uncertainty Roaring Geopolitics is the “next shoe to drop” – and it is already dropping. A host of risks are flying under the radar as the world focuses on the virus. Taken alone, not every risk warrants a risk-off positioning. But combined, these risks reveal extreme global uncertainty which does warrant a risk-off position in the near term. This week’s threats between the US and Iran, in particular, show that the political and geopolitical fallout from COVID-19 begins now, it will not “wait” until the pandemic crisis subsides. In this report we focus on the risks from oil-producing economies, but we first we update our fiscal stimulus tally. Stimulus Tsunami Chart 3Stimulus Tsunami Still Building Policymakers responded to COVID-19 by doing “whatever it takes” to prop up demand (Chart 3). Please see the Appendix for our latest update of our global fiscal stimulus table. The latest fiscal and monetary measures show that countries are still adding stimulus – i.e. there is not yet a substantial shift away from providing stimulus: China has increased its measures to a total of 10% of GDP for the year so far, according to BCA Research China Investment Strategy. This includes a general increase in credit growth, a big increase in government spending (2% of GDP), a bank re-lending scheme (1.5% of GDP), an increase in general purpose local government bonds (2% of GDP), plus special purpose bonds (4% of GDP) and other measures. On the political front, the government has rolled out a new slogan, “the Six Stabilities and the Six Guarantees,” and President Xi Jinping said on an inspection tour to Shaanxi that the state will increase investments to ensure that employment is stabilized. This is the maximum reflationary signal from China that we have long expected. The US agreed to a $484 billion “fourth phase” stimulus package, bringing its total to 13% of GDP. President Trump is already pushing for a fifth phase involving bailouts of state and local governments and infrastructure, which we fully expect to take place even if it takes a bit longer than packages that have been passed so far this year. German Chancellor Angela Merkel has opened the way for the EU to issue Eurobonds, in keeping with our expectations. Germany is spending 12% of GDP in total – which can go much higher depending on how many corporate loans are tapped – while Italy is increasing its stimulus to 3% of GDP. As deficits rise to astronomical sums, and economies gradually reopen, will legislatures balk at passing new stimulus? Yes, eventually. Financial markets will have to put more pressure on policymakers to get them to pass more stimulus. This can lead to volatility. In the US the pandemic is coinciding with “peak polarization” over the 2020 election. Lack of coordination between federal and state governments is increasing uncertainty. Currently disputes center on the timing of economic reopening and the provisioning bailout funds for state and local governments. Senate Majority Leader Mitch McConnell is threatening to deny bailouts for American states with large, unfunded public pension benefits (Chart 4A). He is insisting that the Senate “push the pause button” on coronavirus relief measures; specifically that nothing new be passed until the Senate convenes in Washington on May 4. He may then lead a charge in the Republican Senate to try to require structural reforms from states in exchange for bailouts. Estimates of the total state budget shortfall due to the crisis stand at $500 billion over the next three years, which is almost certainly an understatement (Chart 4B). Chart 4AUS States Have Unfunded Liabilities Chart 4BUS States Face Funding Shortfalls Could a local government or state declare bankruptcy? Not anytime soon. Technically there is no provision for states to declare bankruptcy. A constitutional challenge to such a declaration would go to the Supreme Court. One commonly cited precedent, Arkansas in 1933, ended up with a federal bailout.1 A unilateral declaration could conceivably become a kind of “Lehman moment” in the public sector, but state governors will ask their legislatures to provide more fiscal flexibility and will seek bailouts from the federal government first. The Federal Reserve is already committed to buying state and local bonds and can expand these purchases to keep interest rates low. Washington would be forced to provide at least short-term funding if state workers started getting fired in the midst of the crisis because of straightened state finances – another $500 billion for the states is entirely feasible in today’s climate. Constraints will prevail on the GOP Senate to provide state bailout funds. This conflict over state finances could have a negative impact on US equities in the near term, but it is largely a bluff – McConnell will lose this battle. The fundamental dynamic in Washington is that of populism combined with a pandemic that neutralizes arguments about moral hazard. Big-spending Democrats in the House of Representatives control the purse strings while big-spending President Trump faces an election. Senate Republicans are cornered on all sides – and their fate is tied to the President’s – so they will eventually capitulate. Bottom Line: The global fiscal and monetary policy tsunami is still building. But there are plenty of chances for near-term debacles. Over the long run the gargantuan stimulus is the signal while the rest is noise. Over the long run we expect the reflationary efforts to prevail and therefore we are long Treasury inflation-protected securities and US investment grade corporate bonds. We recommend going strategically long AAA-rated US municipal bonds relative to 10-year Treasuries. Petro-State Meltdown Since March we have highlighted that the collapse in oil prices will destabilize oil producers above and beyond the pandemic and recession. This leaves Iran in danger, but even threatens the stability of great powers like Russia. Normally there is something of a correlation between the global oil price and the willingness of petro-states to engage in war (Chart 5). Chart 5Petro-States Cease Fire When Oil Drops When prices fall, revenues dry up and governments have to prioritize domestic stability. This tends to defer inter-state conflict. We can loosely corroborate this evidence by showing that global defense stocks tend to be correlated with oil prices (Chart 6). Global growth is the obvious driver of both of these indicators. But states whose budgets are closely tied to the commodity cycle are the most likely to cut defense spending. Chart 6Global Growth Drives Oil And Guns Russia is case in point. Revenues from Rostec, one of Russia’s largest arms firms, rise and fall with the Urals crude oil price (Chart 7). The Russians launch into foreign adventures during oil bull markets, when state coffers are flush with cash. They have an uncanny way of calling the top of the cycle by invading countries (Chart 8). Chart 7Oil Correlates With Russian Arms Sales Chart 8Russian Invasions Call Peak In Oil Bull Markets Chart 9Turkish Political Risk On The Rise In the current oil rout, there is already some evidence of hostilities dying down in this way. For instance, after years of dogged fighting in Yemen, Saudi Arabia is finally declaring a ceasefire there. Turkey, which benefits from low oil prices, has temporarily gotten the upper hand in Libya vis-à-vis Khalifa Haftar and the Libyan National Army, which depends on oil revenues and backing from petro-states like Russia and the GCC. Of course, Turkey’s deepening involvement in foreign conflicts is evidence of populism at home so it does not bode well for the lira or Turkish assets (Chart 9). But it does highlight the impact of weak oil on petro-players such as Haftar. However, the tendency of petro-states to cease fire amid low prices is merely a rule of thumb, not a law of physics. Past performance is no guarantee of future results. Already we are seeing that Iran is defying this dynamic by engaging in provocative saber-rattling with the United States. Iran And Iraq The US and Iran are rattling sabers again. One would think that Iran, deep in the throes of recession and COVID-19, would eschew a conflict with the US at a time when a vulnerable and anti-Iranian US president is only seven months away from an election. Chart 10US Maximum Pressure On Iran Iran has survived nearly two years of “maximum pressure” from President Trump (Chart 10), and previous US sanction regimes, and has a fair chance of seeing the Democrats retake Washington. The Democrats would restart negotiations to restore the 2015 nuclear deal, which was favorable to Iran. Therefore risking air strikes from President Trump is counterproductive and potentially disastrous. Yet this logic only holds if the Iranian regime is capable of sustaining the pain of a pandemic and global recession on top of its already collapsing economy. Iran’s ability to circumvent sanctions to acquire funds depended on the economy outside of Iran doing fine. Now Iran’s illicit funds are drying up. This could lead to a pullback in funding for militant proxies across the region as Iran cuts costs. But it also removes the constraint on Iran taking bolder actions. If the economy is collapsing anyway then Iran can take bigger risks. Furthermore if Iran is teetering, there may be an incentive to initiate foreign conflicts to refocus domestic angst. This could be done without crossing Trump’s red lines by attacking Iraq or Saudi Arabia. With weak oil demand, Iran’s leverage declines. But a major attack would reduce oil production and accelerate the global supply-demand rebalance. Iran’s attack on the Saudi Abqaiq refinery last September took six million barrels per day offline briefly, but it was clearly not intended to shut down that production permanently. Threats against shipping in the Persian Gulf bring about 14 million barrels per day into jeopardy (Chart 11). Chart 11Closing Hormuz Would Be The Biggest Oil Shock Ever Iran-backed militias in Iraq have continued to attack American assets and have provoked American air strikes over the past month, despite the near-war scenario that erupted just before COVID. Iranian ships have harassed US naval ships in recent days. President Trump has ordered the navy to destroy ships that threaten it; Iranian commander has warned that Iran will sink US warships that threaten its ships in the Gulf. There is a 20% chance of armed hostilities between the US and Iran. Why would Iran be willing to confront the United States? First, Iran rightly believes that the US is war-weary and that Trump is committed to withdrawing from the Middle East. But this could prompt a fateful mistake. The equation changes if the US public is incensed and Trump’s election campaign could benefit from conflict. Chart 12Youth Pose Stability Risk To Iran Second, the US is never going to engage in a ground invasion of Iran. Airstrikes would not easily dislodge the regime. They could have the opposite effect and convert an entire generation of young, modernizing Iranians into battle-hardened supporters of the Islamic revolution (Chart 12). This is a dire calculation that the Iranian leaders would only make if they believed their regime was about to collapse. But they are quite possibly the closest to collapse that they have been since the 1980s and nobody knows where their pain threshold lies. They are especially vulnerable as the regime approaches the uncharted succession of Supreme Leader Ali Khamanei. Since early 2018 we have argued that there is a 20% chance of armed hostilities between the US and Iran. We upgraded this to 40% in June 2019 and downgraded it back to 20% after the Iranians shied from direct conflict this January. Our position remains the same 20%. This is still a major understated risk at a time when the global focus is entirely elsewhere. It will persist into 2021 if Trump is reelected. If the Democrats win the US election, this war risk will abate. The Iranians will play hard to get but they are politically prohibited from pursuing confrontation with the US when a 2015-type deal is available. This would open up the possibility for greater oil supply to be unlocked in the future, but sanctions are not likely to be lifted till 2022 at earliest. Russia Russia may not be on the verge of invading anyone, but it is internally vulnerable and fully capable of striking out against foreign opponents. Cyberattacks, election interference, or disinformation campaigns would sow confusion or heighten tensions among the great powers. The Russian state is suffering a triple whammy of pandemic, recession, and oil collapse. President Vladimir Putin’s approval rating has fallen this year so far, whereas other leaders in the western world have all seen polling bounces (even President Trump, slightly) (Chart 13). Putin postponed a referendum designed to keep him in office through 2036 due to the COVID crisis. In other words, the pandemic has already disrupted his carefully laid succession plans. While Putin can bypass a referendum, he would have been better off in the long run with the public mandate. Generally it is Putin’s administration, not his personal popularity, that is at risk, but the looming impact on Russian health and livelihoods puts both in jeopardy (Chart 14) and requires larger fiscal outlays to try to stabilize approval (Chart 15). Chart 13Putin Saw No COVID Popularity Bump Chart 14Russian Regime Faces Political Discontent Moreover, regardless of popular opinion, Putin is likely to settle scores with the oligarchs. The fateful decision to clash with the Saudis in March, which led to the oil collapse, will fall on Igor Sechin, Chief Executive of Rosneft, and his faction. An extensive political purge may well ensue that would jeopardize domestic stability (Chart 16). Chart 15Russia To Focus On Domestic Stability Chart 16Russian Political Risk Will Rise Russian tensions with the US will rise over the US election in November. The Democrats would seek to make Russia pay for interfering in US politics to help President Trump win in 2016. But even President Trump may no longer be a reliable “ally” of Putin given that Putin’s oil tactics have bankrupted the US shale industry during Trump’s reelection campaign. The American and Russian air forces are currently sparring in the air space over Syria and the Mediterranean. The US has also warned against a malign actor threatening to hack the health care system of the Czech Republic, which could be Russia or another actor like North Korea or Iran. These issues have taken place off the radar due to the coronavirus but they are no less real for that. Venezuela We have predicted Venezuela’s regime change for several years but the oil meltdown, pandemic, and insufficient Russian and Chinese support should put the final nail in the regime’s coffin. Hugo Chavez’s rise to power, the last “regime change,” occurred as oil prices bottomed in 1998. Historically the Venezuelan armed forces have frequently overthrown civilian authorities, but in several cases not until oil prices recovered (Chart 17). Chart 17Venezuelan Coups Follow Oil Rebounds The US decision to designate Nicolas Maduro as a “narco-terrorist,” to deploy greater naval and coast guard assets around Venezuela, to reassert the Monroe Doctrine and Roosevelt Corollary, and to pull Chevron from the country all suggest that Washington is preparing for regime change. Such a change may or may not involve any American orchestration. Venezuela is an easy punching-bag for President Trump if he seeks to “wag the dog” ahead of the election. Venezuela would be a strategic prize and yet it cannot hurt the US economy or financial markets substantially, giving limited downside to President Trump if he pursues such a strategy. Obviously any conflict with Venezuela this year is far less relevant to global investors than one with Iran, North Korea, China, or Russia. Regime change would be positive for oil supply and negative for prices over the long run. But that is a story for the next cycle of energy development, as it would take years for government and oil industry change in Venezuela to increase production. The US election cycle is a critical aggravating factor for all of these petro-state risks. Shale producers are going bankrupt, putting pressure on the economy and some swing states. The risk of a conflict arises not only from Trump playing “wag the dog” after the crisis abates, but also from other states provoking the president, causing him to react or overreact. The “Other Guys” Oil producers outside the US, Canada, gulf OPEC, and Russia – the “other guys” – are extremely vulnerable to this year’s global crisis and price collapse. Comprising half of global production, they were already seeing production declines and a falling global market share over the past decade when they should have benefited from a global economic expansion. They never recovered from the 2014-15 oil plunge and market share war (Chart 18). Angola (1.4 million barrels per day), Algeria (one million barrels per day), and Nigeria (1.8 million barrels per day) are relatively sizable producers whose domestic stability is in question in the coming years as they cut budgets and deplete limited forex reserves to adjust to the lower oil price. This means fewer fiscal resources to keep political and regional factions cooperating and provide basic services. Algeria is particularly vulnerable. President Abdelaziz Bouteflika, who ruled as a strongman from 1999, was forced out last year, leaving a power vacuum that persists under Prime Minister Abdelaziz Djerad, in the wake of the low-participation elections in December. An active popular protest movement, Hirak, already exists and is under police suppression. Unemployment is high, especially among the youth. Neighboring Libya is in the midst of a war and extremist militants within Libya and North Africa would like to expand their range of operations in a destabilized Algeria. Instability would send immigrants north to Europe. Oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Brazil is not facing the risk of state failure like Algeria, but it is facing a deteriorating domestic political outlook (Chart 19). President Jair Bolsonaro’s popularity was already low relative to most previous presidents before COVID. His narrow base in the Chamber of Deputies got narrower when he abandoned his political party. He has defied the pandemic, refused to endorse social distancing or lockdown orders by local governments, and fired his Health Minister Luiz Henrique Mandetta. Chart 18Petro-States: 'Other Guys' Face Instability Chart 19Brazilian Political Risk Rising Again Brazil has a high number of coronavirus deaths per million people relative to other emerging markets with similar health capacity and susceptibility to the disease. This, combined with sharply rising unemployment, could prove toxic for Bolsonaro, who has not received a bounce in popular opinion from the crisis like most other world leaders. Thus on balance we expect the October local elections to mark a comeback for the Worker’s Party. The limited fiscal gains of Bolsonaro’s pension reform are already wiped out by the global recession, which will set back the country’s frail recovery from its biggest recession in a century. The country is still on an unsustainable fiscal path. Bolsonaro does not have a strong personal commitment to neoliberal structural reform, which has been put aside anyway due to the need for government fiscal spending amid the crisis. Unless Bolsonaro’s popularity increases in the wake of the crisis – due to backlash against the state-level lockdowns – the economic shock is negative for Brazil’s political stability and economic policy orthodoxy. Bottom Line: Our rule of thumb about petro-states suggests that they will generally act less aggressive amid a historic oil price collapse, but Iran may prove a critical exception. Investors should not underestimate the risk of a US-Iran conflict this year. Beyond that, the US election will have a decisive impact as the Democrats will seek to resume the Iranian nuclear deal and Iran would eventually play ball. Venezuela is less globally relevant this year – although a “wag the dog” scenario is a distinct possibility – but it may well be a major oil supply surprise in the 2020s. More broadly the takeaway is that oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Investment Takeaways Obviously any conflict with Iran could affect the range of Middle Eastern OPEC supply, not just the portion already shuttered due to sanctions on Iran itself. Any Iran war risk is entirely separate from the risk of supply destruction from more routine state failures in Africa. These shortages have been far less consequential lately and have plenty of room to grow in significance (Chart 20). The extreme lows in oil prices today will create the conditions for higher oil prices later when demand recovers, via supply destruction. Chart 20More Unplanned Outages To Come Chart 21European Political Risk No Longer Underrated An important implication – to be explored in future reports – is that Europe’s neighborhood is about to get a lot more dangerous in the coming years, as the Middle East and Russia will become less stable. Middle East instability will result in new waves of immigration and terrorism after a lull since 2015-16. These waves would fuel right-wing political sentiment in parts of Europe that are the most vulnerable in today’ crisis: Italy, Spain, and France (Chart 21). This should not be equated with the EU breaking apart, however, as the populist parties in these countries are pursuing soft rather than hard Euroskepticism. Unless that changes the risk is to the Euro Area’s policy coherence rather than its existence. Finally Russian domestic instability is one of the major secular consequences of the pandemic and recession and its consequences could be far-reaching, particularly in its great power struggle with the United States. We are reinitiating a strategic long in cyber security stocks, the ISE Cyber Security Index, relative to the S&P500 Info Tech sector. Cyberattacks are a form of asymmetrical warfare that we expect to ramp up with the general increase in global geopolitical tensions. The US’s recent official warning against an unknown actor that apparently intended to attack the health system of the Czech Republic highlights the way in which malign actors could attempt to capitalize on the chaos of the pandemic. We also recommend strategic investors reinitiate our “China Play Index” – commodities and equities sensitive to China’s reflation – and our BCA Infrastructure Basket, which will benefit from Chinese reflation as well as US deficit spending. China’s reflation will help industrial metals more so than oil, but it is positive for the latter as well. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 John Mauldin, "Don't Be So Sure That States Can't Go Bankrupt," Forbes, July 28, 2016, forbes.com.   Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Appendix Table 1 The Global Fiscal Stimulus Response To COVID-19 Section III: Geopolitical Calendar

Highlights Uncertainty over the duration of lockdowns globally will continue to hamper the estimation of the global demand recovery for commodities. This uncertainty will continue to fuel safe-haven demand for USD for the balance of 2Q20. In addition, markets continue to experience a shortage of USD, which can become acute for EM debtors servicing dollar-denominated debt. The combination of safe-haven demand and a continued dollar shortage will keep the USD well bid, which will, at the margin, suppress commodity demand, compounding the effects of COVID-19-induced demand destruction. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions, which also reduces the level of economic activity and commodity demand. Commodity demand will recover in 2H20. Given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the Communist Party of China (CCP) – base metals and grain prices should recover earlier than other commodities.  Oil likely recovers in 3Q20, as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. We remain long gold as a portfolio hedge against continued global policy uncertainty. Feature The short-term path forward for commodity prices will be a function of uncertainty regarding the global economic recovery and its impact on the US dollar, which, at present, remains well bid and is keeping global financial conditions tight. The sharp USD appreciation – mostly vs. EM currencies – is a response to the COVID-19 economic shock, which intensified in March. This significantly tightened global financial conditions (Chart of the Week). EM economies’ capacity to withstand the hit to aggregate demand locally – caused by widespread lockdown measures meant to contain the spread of the virus – has led to capital outflows. EM economies, therefore, are forced to combat a combination of plunging currencies, crumpling domestic and export demand, and increasing financing costs. Low risk appetite globally and diminished liquidity in money and credit markets add to USD demand, and will keep it elevated over the next few months. Chart of the WeekEM Currencies Plunged Vs. The USD Chart 2Commodity-Intensive Industries Are Vulnerable To USD Shocks After that, we expect the dollar will reverse – mostly on the back of massive Fed accommodation to redress these factors – in 2H20. As COVID-19-induced demand destruction abates, this weakening in the USD will propel EM economic growth higher and bolster commodity demand (Chart 2). USD Well Bid On Safe-Haven Demand, Dollar Shortage The dollar could retest its recent highs in the short term. Heightened volatility over the past two months powered a surge in demand for safe havens and highly liquid risk assets globally. We expect this to persist as stringent lockdowns remain in place to combat the COVID-19 pandemic. This will keep economic policy uncertainty elevated. Over the short term, the USD will benefit in this environment. Demand for USD and dollar-denominated assets will remain strong. Indeed, our FX strategists believe the dollar could retest its recent highs (Chart 3).1 Chart 3Global Uncertainty Lifts The US Dollar And Rates Since the Global Financial Crisis (GFC), US dollar movements have been a prime driver of cross-currency basis swaps and can be indicative of risk-taking capacity in capital markets.2 Also, a rising dollar limits the cross-border supply of dollar-denominated loans and increases funding costs. The Fed is monitoring domestic and global liquidity conditions closely, and is fulfilling the role of global USD lender of last resort. Its rapid extension of swap lines to foreign central banks, as well as a temporary repo facility for foreign and international monetary authorities (FIMA), temporarily eased liquidity concerns in some regions (Chart 4). Chart 4Fed Actions Have Eased Global Liquidity Constraints   It is too early to presume the dollar liquidity constraints have been wholly contained. However, it is too early to presume the dollar liquidity constraints have been wholly contained. The Fed cannot force foreign central banks to direct these dollars to the sectors in which they are needed in their domestic economies. Besides, not all EMs have access to these swap lines. This means much-needed swap lines are inaccessible to a significant portion of the global financial system. In addition, close to 60% of outstanding foreign exchange swaps/forwards involve non-bank financial and other institutions.3 It is highly likely, therefore, the Fed will have to provide additional liquidity to struggling foreign entities. We believe the Fed is well aware of these constraints on global growth and is addressing the need for additional global USD liquidity. However, as has been the case throughout the post-GFC period, policy action will continue to be uncertain as to its duration and its effectiveness. Combined with expanding fiscal deficits in the US, we believe this extraordinary accommodation by the Fed will considerably increase USD supply this year. Following a volatile 2Q20, we expect the US dollar will face severe downward pressures – assuming lockdown measures are successful in containing the pandemic and are gradually lifted. With interest rates now close to zero in most DM economies, relative balance-sheet dynamics will become important drivers of exchange rates (Chart 5). Ample liquidity globally will propel pro-cyclical currencies up and the combination of fiscal and monetary easing could lead to a debasing of the dollar next year as inflationary pressures intensify. Momentum will start working against the dollar in 2H20. Chart 5Massive QE In The US Will Pressure The USD Downward USD Strength Hinders Global Growth The dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened. The strong dollar remains a headwind to global growth – particularly in EM economies – as it pushes up funding costs and tightens financial conditions. This negative dollar shock adds to the devastating effects of lockdowns, record portfolio outflows, and collapsing commodity prices on EM economies (Chart 6). Since the GFC, the dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened (Chart 7). EM economies’ rising responsiveness to dollar movements is in part explained by their growing share of foreign USD-denominated debt, a larger foreign ownership of their sovereign debt, and increasing integration into global supply chains, in which transactions typically are invoiced in dollars (Chart 8). Chart 6Record Portfolio Outflows From EM   Chart 7Brent Prices Are Closely Correlated With EM Currencies Post-GFC Chart 8EM Vulnerability To The USD Increased Since The GFC Elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Thus, elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Interestingly, this relationship is non-linear and asymmetric – i.e. the dollar’s impact on commodity prices is higher in dollar bull markets, and positive dollar changes have a greater impact. For instance, its impact on oil prices is 30% stronger in dollar-appreciation cycles. Large increases in the relative value of the USD – on a monthly, weekly, or daily basis – have a disproportionate negative impact on oil prices compared to large decreases (Chart 9). Hence, sudden rushes to safe and liquid assets in periods of rising global economic uncertainty have a magnified negative effect on commodity prices. This means the recovery in commodity prices will be more gradual. Chart 9Asymmetric Impact Of USD Changes On Commodity Prices Base Metals Could Recover In 2Q20 Gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. The USD strength is keeping commodity demand growth in check. Until uncertainty re the speed of economic recovery dissipates – mainly vis-à-vis EM economies – commodity prices will remain under pressure (Chart 10). Base metals and grain prices could recover earlier than other commodities given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the CCP. Specifically, copper prices could decouple from the USD, following China’s economic growth as it contributes close to 50% of both supply and demand of refined copper (Chart 11). Chart 10USD Strength Will Weigh Down Commodity Prices In 2Q20 Chart 11Metals' Prices Will React To China's Economic Recovery Oil will rebound in 3Q20 as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. China consumes a smaller 14% of world oil demand, which is not sufficient to support a sustainable rally in prices on its own. For 2Q20, the correlation with the USD will intensify and weigh down its price (Chart 12). Lastly, gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. Bottom Line: As the global economy recovers from the COVID-19 pandemic and things get back to normal in 2H20, the USD will weaken and commodity prices will rebound. These two factors will halt the deflationary impulse from the COVID-19 demand shock. On the back of this improvement, we expect inflation expectations to recover throughout 2021 (Chart 13). Chart 12Oil Prices' Correlation With The USD Increases In Contango Chart 13Weaker USD, Rising Commodity Prices Will Revive Inflation Expectations   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Oil price volatility as measured by the Crude Oil ETF Volatility Index (OVX) surged to above 300% earlier this week as WTI futures for May 2020 delivery fell to a low of -$40.40/bbl (Chart 14). Unprecedented negative pricing for the North American benchmark crude oil will accelerate supply destruction and bankruptcies among highly levered, unprofitable E+P companies operating in the principal shale basins, particularly the Permian. We will be looking at the supply-side implications of the massive price volatility, coupled with the first-ever negative pricing for the benchmark crude oil in next week’s publication. We currently expect US production to fall 1.5mm b/d this year. Base Metals: Neutral Front month Singapore Iron Ore Futures continue to perform relatively well, with the 62% Fines contracts hovering around $83/MT. This contract is down 5.3% ytd, after having peaked in January at $92/MT. Chinese steel inventories while elevated, have started to turn the corner since Mid-March when they reached a record 26 Mn MT (Chart 15). Resilience in iron ore and steel reflects favorable fundamentals, as Chinese manufactures starting to get back to business are reviving demand in China, and as supply concerns stemming from reduced mine activity among major mining groups around the world persist. Precious Metals: Neutral We are going long palladium at tonight’s close, following its break below $2,000/oz. We expect the global economy to recover in 2H20 on the back of massive fiscal and monetary stimulus. We expect this will be supportive of consumer spending, particularly automobiles. Palladium is essential to pollution-abatement technology in gasoline-powered cars. While work is being undertaken to rehabilitate South Africa’s derelict power grid, this is at least a five-year effort. In the meantime, rolling backouts will continue to threaten the 73% of global palladium supply produced in South Africa. Ags/Softs:  Underweight CBOT corn May futures fell 1.55% on Tuesday, closing at $3.09/bu, the lowest level since 2009. Corn has been under pressure in recent weeks as the COVID-19 pandemic caused large demand destruction for this grain. Initially, this stemmed from a lower ethanol demand. However, concerns over a slowdown in demand for cattle feed has impacted corn demand as meat plants close in North America. Chart 14Crude Oil ETF Volatility Index Surged Over 300% Chart 15Chinese Steel Inventories Have Turned The Corner     Footnotes 1     Please see QE And Currencies, published by BCA Research’s Foreign Exchange Strategy April 17, 2020. It is available at fes.bcareserach.com. 2     Please see Avdjiev, Stefan, Wenxin Du, Cathérine Koch, and Hyun Song Shin. 2019. "The Dollar, Bank Leverage, and Deviations from Covered Interest Parity." American Economic Review: Insights, 1 (2): 193-208. 3     Please see Capitulation?, published by BCA Research’s Foreign Exchange Strategy April 3, 2020. It is available at fes.bcareserach.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights Yesterday we published a Special Report titled EM: Foreign Currency Debt Strains. We are upgrading our stance on EM local currency bonds from negative to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies. We recommend receiving long-term swap rates in Russia, Mexico, Colombia, China and India. EM central banks’ swap lines with the Fed could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures warrant weaker EM currencies. For the rampant expansion of US money supply to produce a lasting greenback depreciation, US dollars should be recycled abroad. This is not yet occurring. Domestic Bonds: A New Normal Chart I-1Performance Of EM Domestic Bonds In The Last Decade In recent years, our strategy has favored the US dollar and, by extension, US Treasurys over EM domestic bonds. Chart I-1 demonstrates that the EM GBI local currency bond total return index in US dollar terms is at the same level as it was in 2011, and has massively underperformed 5-year US Treasurys. We are now upgrading our stance on EM local currency bonds from negative to neutral. Consistently, we recommend investors seek longer duration in EM domestic bonds while remaining cautious on the majority of EM currencies. Before upgrading to a bullish stance on EM local bonds, we would first need to upgrade our stance on EM currencies. Still, long-term investors who can tolerate volatility should begin accumulating EM local bonds on any further currency weakness. Our upgrade is based on the following reasons: First, there has been a fundamental shift in EM central banks’ policies. In past global downturns, many EM central banks hiked interest rates to defend their currencies. Presently, they are cutting rates aggressively despite large currency depreciation. This is the right policy action to fight the epic deflationary shock that EM economies are presently facing. There has been a fundamental shift in EM central banks’ policies. They are cutting rates aggressively despite large currency depreciation. Historically, EM local bond yields were often negatively correlated with exchange rates (Chart I-2, top panel). Similarly, when EM currencies began plunging two months ago, EM local bond yields initially spiked. However, following the brief spike, bond yields have begun dropping, even though EM currencies have not rallied (Chart I-2, bottom panel). This represents a new normal, which we discussed in detail in our October 24 report. Overall, even if EM currencies continue to depreciate, EM domestic bond yields will drop as they price in lower EM policy rates. Second, the monetary policy transmission mechanism in many EMs was broken before the COVID-19 outbreak. Even though central banks in many developing countries were reducing their policy rates before the pandemic, commercial banks’ corresponding lending rates were not dropping much (Chart I-3, top panel). Chart II-2EM Local Bond Yields And EM Currencies Chart I-3EM ex-China: Monetary Transmission Has Been Impaired   Further, core inflation rates were at all time lows and prime lending rates in real terms were extremely high (Chart I-3, middle panels). Consequently, bank loan growth was slowing preceding the pandemic (Chart I-3, bottom panel). The reason was banks’ poor financial health. Saddled with a lot of NPLs, banks had been seeking wide interest rate margins to generate profit and recapitalize themselves. With the outburst of the pandemic and the sudden stop in domestic and global economic activity, EM banks’ willingness to lend has all but evaporated. Chart I-4 reveals EM ex-China bank stocks have plunged, despite considerable monetary policy easing in EM, which historically was bullish for bank share prices. This upholds the fact that the monetary policy transmission mechanism in EM is broken. Mounting bad loans due to the pandemic will only reinforce these dynamics. Swap lines with the Fed cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. In brief, EM lower policy rates will not be transmitted to lower borrowing costs for companies and households anytime soon. Loan growth and domestic demand will remain in an air pocket for some time.    Consequently, EM policy rates will have to drop much lower to have a meaningful impact on growth. Third, there is value in EM local yields. The yield differential between EM GBI local currency bonds and 5-year US Treasurys shot up back to 500 basis points, the upper end of its historical range (Chart I-5). Chart I-4EM ex-China: Bank Stocks Plunged Despite Rate Cuts Chart I-5The EM Vs. US Yield Differential Is Attractive   Bottom Line: Odds favor further declines in EM local currency bond yields. Fixed-income investors should augment their duration exposure. We express this view by recommending receiving swap rates in the following markets: Russia, Mexico, Colombia, India and China. This is in addition to our existing receiver positions in Korean and Malaysian swap rates. For more detail, please refer to the Investment Recommendations section on page 8. Nevertheless, absolute-return investors should be cognizant of further EM currency depreciation. EM Currencies: At Mercy Of Global Growth Chart I-6EM Currencies Correlate With Commodities Prices The key driver of EM currencies has been and remains global growth. The latter will remain very depressed for some time, warranting patience before turning bullish on EM exchange rates. We have long argued that EM exchange rates are driven not by US interest rates but by global growth. Industrial metals prices offer a reasonable pulse on global growth. Chart I-6 illustrates their tight correlation with EM currencies. Even though the S&P 500 has rebounded sharply in recent weeks, there are no signs of a meaningful improvement in industrial metals prices. Various raw materials prices in China are also sliding (Chart I-7). In a separate section below we lay out the case as to why there is more downside in iron ore and steel as well as coal prices in China. Finally, the ADXY – the emerging Asia currency index against the US dollar – has broken down below its 2008, 2016 and 2018-19 lows (Chart I-8). This is a very bearish technical profile, suggesting more downside ahead. This fits with our fundamental assessment that a recovery in global economic activity is not yet imminent. Chart I-7China: Commodities Prices Are Sliding Chart I-8A Breakdown In Emerging Asian Currencies   What About The Fed’s Swap Lines? A pertinent question is whether EM central banks’ foreign currency reserves and the Federal Reserve’s swap lines with several of its EM counterparts are sufficient to prop up EM currencies prior to a pickup in global growth. The short answer is as follows: These swap lines will likely limit the downside but cannot preclude further depreciation. With the exception of Turkey and South Africa, virtually all mainstream EM banks have large foreign currency reserves. On top of this, several of them – Brazil, Mexico, South Korea and Singapore– have recently obtained access to Fed swap lines. Their own foreign exchange reserves and the swap lines with the Fed give them an option to defend their currencies from depreciation if they choose to do so. However, selling US dollars by EM central banks is not without cost. When central banks sell their FX reserves or dollars obtained from the Fed via swap lines, they withdraw local currency liquidity from the system. As a result, banking system liquidity shrinks, pushing up interbank rates. This is equivalent to hiking interest rates. The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Hence, the cost of defending the exchange rate by using FX reserves is both liquidity and credit tightening. In such a case, the currency could stabilize but the economy will take a beating. Since the currency depreciation was itself due to economic weakness, such a policy will in and of itself be self-defeating. The basis is that escalating domestic economic weakness will re-assert its dampening effect on the currency. Of course, EM central banks can offset such tightening by injecting new liquidity. However, this could also backfire and lead to renewed currency depreciation. Bottom Line: EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. What About The Fed’s Money Printing? Chart I-9The Fed Is Aggressively Printing Money The Fed is printing money and monetising not only public debt but also substantial amounts of private debt. This will ultimately be very bearish for the US dollar. Chart I-9 illustrates that the Fed is printing money much more aggressively than during its quantitative easing (QE) policies post 2008. The key difference between the Fed’s liquidity provisions now and during its previous QEs is as follows: When the Fed purchases securities from or lends to commercial banks, it creates new reserves (banking system liquidity) but it does not create money supply. Banks’ reserves at the Fed are not a part of broad money supply. This was generally the case during previous QEs when the Fed was buying bonds mostly – but not exclusively – from banks, therefore increasing reserves without raising money supply by much. When the Fed lends to or purchases securities from non-banks, it creates both excess reserves for the banking system and money supply (deposits at banks) out of thin air. The fact that US money supply (M2) growth is now much stronger than during the 2010s QEs suggests the recent surge in US money supply is due to the Fed’s asset purchases from and lending to non-banks, which creates money/deposits outright.  The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: 1. US imports should expand, reviving global growth, i.e., the US should send dollars to the rest of the world by buying goods and services. This is not yet happening as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. 2. US investors should channel US dollars to EM to purchase EM financial assets. In recent weeks, foreign flows have been returning to EM due to the considerable improvement in EM asset valuations. However, the sustainability of these capital flows into EM remains questionable. The main reasons are two-fold: (A) there is huge uncertainty on how efficiently EM countries will be able handle the economic and health repercussions of the pandemic; and (B) global growth remains weak and, as we discussed above, it has historically been the main driver of EM risk assets and currencies.  Bottom Line: The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Overall, we recommend investors to stay put on EM risk assets and currencies in the near-term. Investment Recommendations Chart I-10China: Bet On Lower Long-Term Yields We have been recommending receiving rates in a few markets such as Korea and Malaysia. Now, we are widening this universe to include Russia, Mexico, Colombia, China, and India. In China, the long end of the yield curve offers value (Chart I-10, top panel). The People’s Bank of China has brought down short rates dramatically but the long end has so far lagged (Chart I-10, bottom panel). We recommend investors receive 10-year swap rates. Fixed-income investors could also bet on yield curve flattening. The recovery in China will be tame and the PBoC will keep interest rates lower for longer. Consequently, long-dated swap rates will gravitate toward short rates.  We are closing three fixed-income trades: In Mexico, we are booking profits on our trade of receiving 2-year / paying 10-year swap rates – a bet on a steeper yield curve. This position has generated a 152 basis-point gain since its initiation on April 12, 2018. In Colombia, our bet on yield curve flattening has produced a loss of 28 basis points since January 17, 2019. We are closing it. In Chile, we are closing our long 3-year bonds / short 3-year inflation-linked bonds position. This trade has returned 2.0% since we recommended it on October 3, 2019. For dedicated EM domestic bond portfolios, our overweights are Russia, Mexico, Peru, Colombia, Korea, Malaysia, Thailand, India, China, Pakistan and Ukraine. Our underweights are South Africa, Turkey, Brazil, Indonesia and the Philippines. The remaining markets warrant a neutral allocation. Regarding EM currencies, we continue to recommend shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Heading South Chart II-1Steel, Iron Ore And Coal Prices: More Downside Ahead? Odds are that iron ore, steel and coal prices will all continue heading south (Chart II-1). Lower prices will harm both Chinese and global producers of these commodities. Steel And Iron Ore The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. First, Chinese output of steel products has not contracted even though demand plunged in the first three months of the year, creating oversupply. Despite falling steel prices and the demand breakdown resulting from the COVID-19 outbreak, Chinese crude steel output still grew at 1.5% and its steel products output only declined 0.6% between January and March from a year ago (Chart II-2). Chart II-2Steel Products Output In China: Still No Contraction The profit margin of Chinese steel producers has compressed but not enough to herald a sizable cut in mainland steel production. Despite oversupply, Chinese steel producers are reluctant to curtail output to prevent layoffs. This year, there will be 62 million tons of new steel production capacity while 82 million tons of obsolete capacity will be shut down. As the capacity-utilization rate (CUR) of the new advanced production capacity will be much higher than the CUR on those soon-to-be-removed capacities in previous years, this will help lift steel output.   Second, Chinese steel demand has plummeted, and any revival will be mild and gradual over the next three to six months. Construction accounts for about 55% of Chinese steel demand, with about 35% coming from the property market and 20% from infrastructure. Additionally, the automobile industry contributes about 10% of demand. All three sectors are currently in deep contraction (Chart II-3). Looking ahead, we expect that the demand for steel from property construction and automobile production will revive only gradually. Overall, it will continue contracting on a year-on-year basis, albeit at a diminishing rate than now. While we projected a 6-8% rise in Chinese infrastructure investment for this year, most of that will be back-loaded to the second half of the year. In addition, modest and gradual steel demand increases from this source will not be able to offset the loss of demand from the property and automobile sectors. The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. Reflecting the disparity between weak demand and resilient supply, steel inventories in the hands of producers and traders are surging, which also warrants much lower prices (Chart II-4).   Chart II-3Deep Contraction In Steel Demand From Major Users Chart II-4Significant Build-Up In Steel Inventories   Chart II-5Chinese Iron Ore Imports Will Likely Decline In 2020 Regarding iron ore, mushrooming steel inventories in China and lower steel prices will eventually lead to steel output cutbacks in the country. This will be compounded by shrinking steel production outside of China, dampening global demand for iron ore. Besides, in China, scrap steel prices have fallen more sharply than iron ore prices have. This makes the use of scrap steel more appealing than iron ore in steel production. Chinese iron ore imports will likely drop this year (Chart II-5). Finally, the global output of iron ore is likely to increase in 2020. The top three producers (Vale, Rio Tinto and BHP) have all set their 2020 guidelines above their 2019 production levels. This will further weigh on iron ore prices. Coal Although Chinese coal prices will also face downward pressure, we believe that the downside will be much less than that for steel and iron ore prices. Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. Prices had not dropped below this level since September 2016. In the near term, prices could go down by another 5-10%, given that record-high domestic coal production and imports have overwhelmed the market (Chart II-6). Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. However, there are emerging supportive forces. China Coal Transport & Distribution Association (CCTD), the nation’s leading industry group, on April 18, called on the industry to slash production (of both thermal and coking coal) in May by 10%. It also proposed that the government should restrict imports. The CCTD stated that about 42% of the producers are losing money at current coal prices. The government had demanded producers make similar cuts for a much longer time duration in 2016, which pushed coal to sky-high prices.  The outlook for a revival in the consumption of electricity and, thereby, in the demand for coal is more certain than it is for steel and iron ore. About 60% of Chinese coal is used to generate thermal power. Finally, odds are rising that the government will temporarily impose restrictions on coal imports as it did last December – when coal imports to China fell by 70% as a result. Investment Implications Companies and countries producing these commodities will be hurt by the reduction of Chinese purchases. These include, but are not limited to, producers in Indonesia, Australia, Brazil and South Africa. Iron ore and coal make up 10% of total exports in Brazil, 6% in South Africa, 18% in Indonesia and 32% in Australia. Investors should avoid global steel and mining stocks (Chart II-7). Chart II-6Chinese Coal Output And Imports Are At Record Highs Chart II-7Avoid Global Steel And Mining Stocks For Now   We continue to recommend shorting BRL, ZAR and IDR versus the US dollar. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations