Financial Markets

Dear Client, Please join me and my fellow BCA Strategists Caroline Miller and Arthur Budaghyan for a live webcast tomorrow, Friday, April 24 at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8:00 PM HKT) where we will discuss the outlook for developed and emerging market equities over the immediate (0-3 month) and cyclical (12 month) horizon. In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will discuss the global fiscal response to the COVID-19 pandemic, and will provide some perspective on whether the response will be enough to prevent an "L-shaped" economic outcome. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Theoretically, the pandemic could raise the long-term fair value of equities – as proxied by the present value of future cash flows – if it causes the discount rate to fall by more than enough to offset the decline in corporate earnings. While such a seemingly bizarre outcome is not our base case, it cannot be easily dismissed, especially since the evidence suggests that real long-term interest rates have fallen a lot more since the start of the pandemic than have earnings estimates. We consider a number of challenges to this claim, including: current earnings estimates are too optimistic; long-term interest rates are being distorted by QE and other factors; and the equity risk premium will be higher in a post-pandemic world. While all these counterarguments have merit, none of them are airtight. Even if the pandemic ultimately boosts stock prices, the path to new highs will be a bumpy one. In the near term, a slew of bad economic data could cause another bout of market turbulence. Nevertheless, over a 12-month horizon, investors should continue to overweight equities relative to cash and bonds. The plunge in front-end oil futures this week was a timely reminder of the extent to which the pandemic has suppressed crude demand. Oil prices should bounce back later this year as global growth recovers, the dollar weakens, and more oil supply is taken offline. A Counterintuitive Scenario Chart 1EPS Growth Scenarios Could the pandemic end up raising the long-term fair value of equities – as proxied by the present value of future cash flows – compared with a scenario in which the virus never emerged? Such an outcome sounds far-fetched but could occur if the pandemic causes the discount rate to fall by more than enough to offset the decline in corporate earnings. How likely is such an outcome? To get a sense of the answer, let us consider a simple example where, prior to the pandemic, cash flows to shareholders were expected to grow by 2% per annum, the risk-free interest rate was 2%, and the equity risk premium was 5% (implying a discount rate of 7%). Let us suppose that the pandemic temporarily reduces corporate profits by 60% in 2020, 40% in 2021, and 20% in 2022 relative to the aforementioned baseline, with earnings returning to trend beyond then (Chart 1, Scenario 1). All things equal, an earnings shock of this magnitude would reduce the present value of corporate profits by 5.4%. For the present value to return to its original level, the discount rate would have to fall by 27 bps. How does this example square with reality? While it is impossible to know what would have happened in the absence of the pandemic, we can observe that S&P 500 EPS estimates have so far fallen by 22% for 2020 and 11% for both 2021 and 2022 since the start of the year. Meanwhile, the 30-year TIPS yield – a proxy for long-term real interest rates – has fallen by 75 bps, and is down 138 bps since the beginning of 2019. Based on this comparison, one can conclude that the decline in rate expectations has been large enough to offset the drop in projected earnings. Four Counterarguments The discussion above makes a number of assumptions that could easily be challenged. Let us consider four counterarguments to the claim that the pandemic has increased the long-term fair value of equities. As we shall see, while all four counterarguments are valid, none of them are bulletproof. Bottom-up earnings estimates are too optimistic. As estimates come down, so will stock prices. Calculations of long-term risk-free rates are being distorted by QE and other factors. If a more cautious mindset results in a lower risk-free rate, it should also result in a higher equity risk premium (ERP). A higher ERP would push up the discount rate, reducing the fair value of the stock market. The pandemic could lead to a variety of investor-negative outcomes, including further deglobalization, higher corporate taxes, and the loss of policy maneuverability during the next downturn. Let us examine all four of these counterarguments in turn. 1.   Are Earnings Estimates Too Optimistic? BCA’s US equity strategists expect S&P 500 companies to generate $104 in EPS this year and $162 in 2021. A simple weighted-average of these estimates implies a forward 12-month EPS of $123, compared with the current consensus of $140. Could the pandemic end up raising the long-term fair value of equities? Granted, consensus estimates for any given calendar year usually start high and drift lower over time, reflecting the overoptimistic bias of bottom-up analysts (Chart 2). Nevertheless, the gap between where consensus is today and where we think it will end up is large enough that further negative revisions could still weigh on stocks. As evidence, note that stock prices tend to move in the same direction as earnings revisions and 12-month ahead earnings estimates (Chart 3). Chart 2Are Earnings Estimates Too Optimistic? Chart 3Negative Earnings Revisions Will Weigh On Stocks In The Near Term The discussion above suggests that stocks could face some downward pressure in the near term, reflecting the tendency for investors to myopically focus on earnings over the next 12 months. This does not, however, negate the possibility that the pandemic could raise the long-term present value of future cash flows. After all, even the earnings projections from our equity strategists are much more benign than those in the stylized example of a 60%, 40%, and 20% decline in EPS for the next three years. In fact, to get something that fully offsets the decline in real yields since the start of the year requires a scenario that not only assumes a 60%, 40%, and 20% drop in earnings, but also assumes that profits remain 10% lower forever relative to the baseline (Chart 1, Scenario 2). 2.    Are Estimates Of Long-Term Risk-Free Rates Distorted To The Downside? Chart 4Rate Expectations Have Come Down So far, we have argued that earnings are unlikely to fall by enough over the next few years to counteract the steep drop in long-term interest rates. But, perhaps the problem is not with the earnings projections? Perhaps the problem is with the estimates of the long-term risk-free rate? Conceptually, long-term government bond yields should incorporate the market’s expectation of how short-term interest rates will evolve over the life of the bond plus a “term premium.” The inelegantly named term premium is a catch-all, unobservable variable that captures everything that affects bond yields other than changes in rate expectations. Term premia have fallen in global bond markets since the start of the year, partly because central banks have ramped up bond buying programs with the express intent of pushing down long-term yields. Nevertheless, rate expectations have also come down, as can be gleaned from forward contracts linked to expected overnight rates (Chart 4). This suggests that expectations of lower rates have played an important role in explaining the decline in bond yields. In any case, it is not clear why one should control for the term premium in calculating discount rates. If the idea is to compare bonds with stocks, then one should look at bond yields directly, rather than trying to ascertain what yields would hypothetically be in the absence of various distortions – especially if these distortions are unlikely to go away anytime soon. You can’t eat hypothetical profits. 3.    Projecting The Equity Risk Premium If overly optimistic earnings estimates and a distorted risk-free rate cannot fully counteract the claim that the pandemic has raised the long-term fair value of equities, what about the third driver of present value calculations: the equity risk premium (ERP)? While the ERP cannot be observed directly, it is possible to infer it by looking at the difference between the long-term earnings yield and the real bond yield. Under some simplifying assumptions, the earnings yield provides a good estimate of the long-term real total return to holding stocks.1 To the extent that the earnings yield has risen this year, while the risk-free rate has fallen, one can infer that the equity risk premium has gone up. However, there is no money in observing today’s equity risk premium; the money is in projecting it. The equity risk premium can shift a lot over the course of the business cycle. This is why the stock-to-bond ratio moves so closely with, say, the ISM manufacturing index (Chart 5). Chart 5Stock-To-Bond Ratio And Economic Growth Go Hand-In-Hand Like many financial market variables, the ERP has tended to be mean reverting. Today, the ERP is above its long-term average both in the US and the rest of the world, which suggests that it may decline over time (Chart 6). If that were to happen, stocks would almost certainly outperform bonds. Chart 6Favor Equities Over Bonds Over A 12-Month Horizon Yet, in an environment where caution reigns supreme, might the ERP stay elevated? After all, if risk-free bond yields remain low because people are more reluctant to spend, wouldn’t that mean that investors will continue to demand an additional premium to holding stocks? Perhaps, but this assumes that bonds will retain their safe-haven characteristics. There are two reasons to think that these characteristics may fray in a post-pandemic world. First, with policy rates now close to zero in most markets, there is a limit to how much further bond yields can decline. This means that bond prices will not rise much even if the recession lasts much longer than expected  (Table 1). Table 1Bonds Won't Provide Much Of A Hedge Even In A Severe Recession Scenario Second, looking further out, highly indebted governments may try to dissuade central banks from raising rates even once unemployment has fallen back to normal levels. This could lead to higher inflation, imperiling bond investors. While such an outcome would not necessarily be good for stocks, equities will be more insulated than bonds because nominal profits tend to rise more quickly in an environment of higher inflation. As such, one could plausibly argue that the equity risk premium should not be any higher, and conceivably should be lower, in a post-pandemic world. 4.     Unintended Consequences Chart 7Global Trade Was Already Stalling While it is too early to say with any confidence what the long-term effects of the pandemic will be, it is certainly possible that they will be momentous. Globalization had already stalled before the eruption of the Sino-US trade war (Chart 7). It could go into reverse if trade tensions remain elevated and countries increasingly focus on ensuring that they have enough domestic capacity to produce various essential goods. Support for pro-business, laissez-faire policies could also wane further. Prior to the pandemic, BCA’s geopolitical team gave President Trump a 55% chance of being re-elected. Now, with the economy in shambles, they only give him a 35% chance. If the Democrats take control of the White House and both Houses of Congress, Trump’s corporate tax cuts are sure to be watered down if not fully reversed. The pandemic could also limit the ability of policymakers to respond to the next downturn. Interest rates cannot be cut further and high debt levels may limit fiscal maneuverability, especially for countries that do not have access to their own printing press. To be sure, there could be some silver linings. Many lessons have been learned over the past few months. If another pandemic were to occur, we will be better prepared. Meanwhile, gratuitous business travel will be curtailed now that people have grown more comfortable with videoconferencing. And just like the space race inspired a generation of scientists and engineers, the pandemic could motivate more young people to pursue a career in medical research. Investment Conclusions While not our base case, we would subjectively assign a 25% probability to an outcome where the pandemic ends up raising the long-term present value of corporate cash flows by pushing down the discount rate by more than enough to offset the near-term drop in profits. Chart 8Don't Rush Into Growth Stocks Just Yet, As Value Stocks Are Still Cheap Even if the pandemic leaves stocks lower than they otherwise would have been, the current equity risk premium is high enough to warrant overweighting global equities over bonds on a 12-month horizon. Of course, stocks are unlikely to sail smoothly to new highs on the back of lower interest rates alone. As we discussed last week in a reported entitled “Still Stuck in The Tree,” it will be difficult to dismantle ongoing lockdown measures until a mass-testing regime is put in place, something that is still at least a few months away at best.2 With the data on the economy and corporate earnings set to disappoint in the near term, stocks could give up some of their recent gains. Thus, while we are still bullish on equities on a long-term horizon, we are more cautious on a short-term, 3-month horizon.  Drilling further down, the decline in long-term rates this year is likely to create winners and losers across all asset classes. Some of the winners and losers are fairly straightforward to identify. For instance, growth stocks, whose market value hinges on anticipated cash flows that may not be realized until far into the future, gain relatively more from lower rates than value stocks. Banks, which are overrepresented in value indices, have suffered from the flattening of yield curves and lower rates in general. That said, given that value stocks currently trade at a multi-decade discount to growth stocks, we would not recommend that clients chase growth stocks at this juncture (Chart 8). Other winners and losers from lower rates may be less readily discernible. For example, consider the US dollar. The greenback benefited over the past few years from the fact that US rates were higher than those abroad. That rate differential has narrowed significantly recently as the Fed brought interest rates down to zero (Chart 9). Yet, the dollar has managed to remain well bid thanks to safe-haven flows into the Treasury market. Looking out, if the Fed succeeds in easing dollar funding pressures, as we expect will be the case, the dollar will weaken. Chart 9Rate Differentials Are No Longer A Tailwind For The US Dollar The plunge in near-term oil futures this week was a reminder of the extent to which the pandemic has suppressed crude demand. Transportation accounts for over half of global oil usage. Going forward, the combination of a weaker dollar, increased supply discipline, and a rebound in global growth in the second half of this year will help lift oil prices (Chart 10). Our energy analysts see WTI and Brent returning to $38/bbl and $42/bbl, respectively, by the end of the year following the drumming they received this week (Chart 11).3 Chart 10Commodity Prices Usually Rise When The Dollar Weakens Chart 11Oil Prices Expected To Recover Oil prices tend to be strongly correlated with inflation expectations (Chart 12). As inflation expectations rise, real rates could fall further, giving an additional boost to equity valuations.   Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  For a more in-depth discussion on this, please see Global Investment Strategy Special Report, “TINA To The Rescue,” dated August 23, 2019. 2  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 3  Please see Commodity & Energy Strategy Weekly Report, “USD Strength Restrains Commodity Recovery,” dated April 23, 2020; Special Alert, “WTI In Free Fall,” dated April 20, 2020; and Weekly Report, “US Storage Tightens, Pushing WTI Lower,” dated April 16, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks.  We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies.  Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated.  Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3  However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER).  Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7).  Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more.  The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms.  Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed?   A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12).    Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one.  At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming.  But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization.  When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14).  But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15).  Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve   All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm  6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations

Highlights Q1/2020 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -40bps during the first quarter of the year – a number that would have been far worse if not for the changes in exposures for duration (increased) and spread product (decreased) made in early March. Winners & Losers: Underperformance was concentrated in sovereign debt, US Treasuries in particular (-94bps), as yields plummeted. This detracted from the outperformance in spread product (+51bps) led by US investment grade corporates (+34bps) and emerging markets (+20bps). Scenario Analysis For The Next Six Months: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Feature Global bond markets were roiled in the first quarter of 2020 by the economic fallout from the COVID-19 pandemic. Government bond yields crashed to all-time lows while volatility reached extremes across both sovereign debt and credit. The quick, coordinated policy response from global monetary and fiscal authorities – which includes unprecedented levels of direct central bank asset purchases, both in terms of size and the breadth across markets and counties - has helped stabilize global credit spreads and risk assets, more generally. The outlook remains highly uncertain, however, with many governments worldwide looking to reopen their collapsed economies, risking the potential resurgence of a virus still lacking effective treatment or a vaccine. We are focusing more on relative value between counties and sectors. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful first quarter of 2020. We also present our updated recommended positioning for the portfolio for the next six months. The main takeaway there is that we are focusing more on relative value between counties and sectors while staying close to benchmark on both overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 1Q1/2020 Performance: Lagging, But It Could Have Been Much Worse As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2020 Model Portfolio Performance Breakdown: A Missed Rally In Sovereigns, Outperformance In Credit The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -0.1%, underperforming the custom benchmark index by -40bps (Chart 1).1 That relative underperformance came from the government bond side of the portfolio, while our spread product allocation outperformed the benchmark. US Treasuries underperformed the most (-91bps) with losses concentrated in the +10 year maturity bucket. (Table 2). After US Treasuries, euro area high-yield corporates were the second worst performer, underperforming the benchmark by -10bps. Outperformance in spread product was driven by US investment grade industrials (+22bps) and EM credit (+20bps). Table 2GFIS Model Bond Portfolio Q1/2020 Overall Return Attribution The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. Our decision to raise overall global duration exposure to neutral at the beginning of March helped shield the portfolio as yields plummeted.2 We followed this by upgrading sovereign debt in the US and Canada, both higher-beta countries, to overweight while moving to an underweight stance on US high-yield debt, euro area investment-grade and high-yield debt, and emerging market (EM) USD-denominated sovereign and corporate debt.3 In an environment of rampant uncertainty, these allocation changes helped prevent catastrophic losses in the model portfolio that had previously been positioned for a pickup in global growth. The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -91bps of underperformance versus our custom benchmark index while the latter outperformed by +51bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q1/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2020 Spread Product Performance Attribution By Sector The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+22bps) Underweight euro area investment grade corporate bonds (+16bps) Underweight EM USD-denominated corporates (+12bps) Overweight US investment grade financials (+10bps) Underweight Japanese government bonds with maturity greater than 10 years (+8bps) Biggest Underperformers Underweight US government bonds with maturity greater than 10 years (-36bps) Underweight US government bonds with maturity of 3-5 years (-17bps) Underweight US government bonds with maturity of 5-7 years (-16bps) Underweight US government bonds with maturity of 1-3 years (-13bps) Underweight US government bonds with maturity of 7-10 years (-12bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2020. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Predictably, government debt performed the best in Q1/2020 as global bond yields fell and monetary authorities raced to support economies and inject liquidity. UK, US, and Canadian government debt delivered the best returns this quarter. While we started the year neutral or underweight those assets, we moved to an overweight allocation in March, which helped salvage some returns. Also worth noting is that Australian government debt, where we have maintained a structural overweight stance, was one of the top performing markets during the first quarter. The deepest losses were sustained in EM USD-denominated sovereign and corporate debt, and euro area high-yield. Although it seems a distant memory at this point, we did start this quarter on an optimistic note and expected spreads on these products to narrow as global growth picked up. However, we were able to shield our portfolio against excessive losses in these products by moving to an underweight stance in March once the severity of the COVID-19 global economic shock become apparent. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the first quarter of the year. The underperformance was concentrated in government bonds, which rallied on the back of the global pandemic. However, the portfolio outperformed the benchmark in spread products, where the combination of massive fiscal/monetary easing and direct central bank asset purchases have brought credit spreads under control. Future Drivers Of Portfolio Returns Typically, in these quarterly performance reviews of our model bond portfolio, we attempt to make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. In the current unprecedented economic and financial market environment, however, we are reluctant to rely on model coefficients and correlations to estimate expected returns. Instead, in this report, we will focus on discussing the logic behind our current model portfolio positioning and how those allocations should expect to contribute to the overall portfolio performance over the next six months. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: Our recommended overweight stance on US spread product that is backstopped by the Fed—US investment grade corporates, Agency CMBS, and Ba-rated high-yield; Our recommended overweight stance on relatively higher-yielding sovereigns like the US and Italy; Our recommended underweight stance on EM USD-denominated corporates and sovereigns, where the specter of defaults and liquidity crunches looms. In terms of specific weightings in the GFIS model bond portfolio, we have moderated our stance on global spread product since our previous review of the portfolio.5 While the monetary liquidity backdrop is highly bullish, with central banks aggressively buying bonds and keeping policy rates at the zero lower bound, it is still unclear if and when economies will be able to successfully reopen and put an end to the COVID-19 recession. We are now recommending only a small relative overweight of two percentage points for spread product versus the benchmark index (Chart 5), leaving room to add more should the news on the virus and global growth take a turn for the better. Chart 5Overall Portfolio Allocation: Slightly Overweight Credit We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has plunged and is signaling bond yields will stay depressed over the next six months (Chart 6). Yet at the same time, yields in most countries have been unable to hit new lows after the panic-driven bond rally in late February and early March, even as global oil prices have collapsed and inflation expectations remain depressed, suggesting that yields already discount a lot of bad news. Chart 6Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low We do not see much value in taking a big directional bet on yields through overall duration exposure at the present time. We also think it is far too early to contemplate reducing duration – even with many global equity and credit markets having rallied sharply off the lows – given the persistent uncertainty over the timing of a recovery in global growth. Thus, we are maintaining a neutral overall portfolio exposure (Chart 7). Chart 7Overall Portfolio Duration: At Benchmark Chart 8Country Allocation: Favor Those With Higher Betas To Global Yields Within the government bond side of the model bond portfolio, we recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and peripheral Europe while maintaining underweights in core Europe and Japan, where yields have relatively little room to fall. That allocation also lines up with the sensitivity of each market to changes in the overall level of global bond yields, i.e. the yield beta (Chart 8). By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields, while still maintaining an overall neutral level of portfolio duration. By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields. Turning to spread product allocations, we recommend focusing more on policymaker responses to the COVID-19 recession rather than the downturn itself. Yes, the earlier widening of global high-yield spreads is forecasting a sharp plunge in global growth and rising unemployment rates (Chart 9, top panel). At the same time, the now double-digit year-over-year growth in global central bank balance sheets - a measure that has led global high-yield bond excess returns by one year in the years after the Global Financial Crisis (bottom panel) – is pointing to a period of improved global corporate bond market performance over the next 6-12 months. Chart 9Global Corporate Performance Should Benefit From Global QE In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. Chart 10Credit Allocation: Buy What The Central Banks Are Buying That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets. That means concentrating spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). We are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed is now allowed to hold in its corporate bond buying program, and euro area investment grade corporate bonds (excluding bank debt) that the ECB is also buying in its increased bond purchase programs. Chart 11Stay Underweight EM Credit One new change we are making this week is upgrading US agency commercial mortgage-backed securities (CMBS) to overweight, funding by a reduction in US agency residential mortgage-backed securities (MBS) to underweight. While the Fed is still buying agency MBS debt in its new QE programs, MBS spreads have already compressed substantially and are now exposed to potential refinancing risk as eligible US homeowners look to take advantage of the recent plunge in US mortgage rates. We prefer to increase the allocation to agency CMBS, which the Fed can now buy within its expanded QE programs and which offer more attractive spreads than agency MBS (middle panel). One part of the spread product universe where we continue to recommend an underweight stance is USD-denominated EM corporate and sovereign debt. The time to buy those markets will be when the US dollar has clearly peaked and global growth has clearly bottomed. Neither of those conditions is in place now, with the price momentum in both the EM currency index and the trade-weighted US dollar still tilted towards a stronger greenback. That backdrop is unlikely to change in the next few months, suggesting a defensive stance on EM credit is still warranted (Chart 11). A defensive stance on EM credit is still warranted. Model bond portfolio yield and tracking error considerations The selective global government bond and credit portfolio we have just outlined does not come without a cost. While we are currently overweight countries with higher-yielding government bonds, our underweight positions on riskier spread product like EM debt and lower-rated US junk bonds bring the yield of our model portfolio down to 1.8%, –15bps below the yield of the model portfolio benchmark index (Chart 12). We feel that is an acceptable level of “negative carry” given the still heightened levels of uncertainty over global growth. This leads us to focus more on relative value between countries and sectors to generate outperformance that we expect to offset the impact of underweighting the highest yielding credit markets. Chart 12Portfolio Yield: Moderately Below Benchmark Chart 13Portfolio Volatility: Currently High, But Expected To Fall Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. However, given our pro-risk positioning in the first two months of 2020, combined with the extreme volatility in markets during the first quarter, the realized portfolio tracking error blew through our self-imposed ceiling of 100bps (Chart 13). We expect this to settle down in the coming months as the recent changes in our positioning start to be reflected in the trailing volatility of our portfolio. Bottom Line: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "What Bond Investors Should Do After The 'Great Correction'", dated March 3 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q1/2020 will have multiple colors in the respective bars in Chart 4. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "2019 GFIS Model Bond Portfolio Performance Review: Praise Credit & Blame Duration", dated January 14, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: While it’s possible that we are close to the US economic trough, we don’t see any immediate upside in Treasury yields. Investors should keep portfolio duration at benchmark and await signs of recovery in our preferred global growth indicators. Spread Product: Investors should buy spread products that offer attractive spreads relative to history and that benefit from Fed support. We favor: Aaa non-agency CMBS, Agency CMBS, Aaa ABS, municipal bonds and investment grade corporate bonds. High-Yield: We recommend an overweight allocation to Ba-rated high-yield corporates and an underweight allocation to high-yield bonds rated B and lower. Ba-rated bonds will benefit from Fed support and value in the B-rated and below credit tiers does not adequately compensate for likely default losses. Feature Chart 1Fed Actions Spur Rally Even though the economy remains closed and most of us are still confined to our homes, the mood in financial markets has shifted during the past few weeks. Risk assets are rallying as investors react to a cresting in the number of new COVID-19 cases and an unprecedented fiscal and monetary response. Since the Fed announced that it would step into the corporate bond market on March 23, equities have outpaced Treasuries by 28% and high-yield bonds have beaten the Treasury benchmark by 15% (Chart 1). Treasury securities initially rallied after the landmark Fed announcement but have only kept pace with cash during the past two weeks (Chart 1, bottom panel). This reversal in markets begs the question: Is the bottom already in? In this week’s report we ask that question about several different US bond sectors. Too Early To Call The Bottom In Treasury Yields At least in the Treasury market, we think it is premature to call the bottom in yields. Chart 2The Depths Of The Downturn In prior reports we outlined a checklist to call the trough in Treasury yields.1 Two of the items on that checklist were: a severe deterioration in the US economic data and signs of economic recovery in the rest of the world, particularly in those places where the pandemic struck first – like China. We are certainly now seeing the bad US economic data. The Economic Surprise Index is just off its all-time low and a composite of 10 high-frequency economic indicators compiled by the New York Federal Reserve is at its lowest point since the series began in 2008 (Chart 2). Similarly, weekly initial jobless claims set a record three weeks ago. Though they remain extremely elevated, new claims have declined in each of the past two weeks (Chart 2, bottom panel). All this at least raises the possibility that we are close to the trough in US economic growth. However, our second criterion of improving demand outside the US, particularly in China, has not been met. This is crucial because bond investors will need to see that there is light at the end of the tunnel before concluding that US economic activity will trend higher. China’s Manufacturing PMI bounced to just above 50 in March, suggesting that only a small majority of firms experienced better economic conditions in March compared to February. China’s credit impulse is advancing, demonstrating that policymakers are pumping a large amount of stimulus into the economy. But high-frequency growth barometers – like the CRB Raw Industrials index, the performance of cyclical versus defensive equity sectors and the trend in Emerging Market currencies – all remain downbeat (Chart 3). Bond investors will need to see improving demand outside the US before concluding that US economic activity will trend higher. For Treasury yields, the broad CRB Raw Industrials commodity benchmark is particularly important. This is because the ratio between the CRB index and the price of gold closely tracks the 10-year Treasury yield (Chart 4). In a typical economic downturn, we first see Treasury yields and the CRB index fall together as global demand weakens. Then, monetary policy responds by turning more accommodative, leading to a rebound in the price of gold as investors start to reckon with the potential long-run inflationary impact of monetary stimulus. Eventually, bond yields will bottom. But this will only occur once the stimulus seeps through to the real economy and gains in the CRB index start to outpace gains in gold. Chart 3No Global Growth Recovery Yet Chart 4Track The CRB/Gold Ratio The dynamic described above means that we should expect Treasury yields to lag risk assets as the market bottoms. In other words, we will see a sustained rebound in equity prices and corporate bond excess returns before Treasury yields move meaningfully higher. This is especially true in this cycle because the Fed has indicated that it will be slow to shift away from its accommodative policy stance. Bottom Line: While it’s possible that we are close to the US economic trough, we don’t see any immediate upside in Treasury yields. Investors should keep portfolio duration at benchmark and await signs of recovery in our preferred global growth indicators. To hedge against the risk of higher Treasury yields without making a large duration bet, investors should implement duration-neutral curve steepeners. We recommend going long the 5-year bullet and short the duration-matched 2/10 barbell.2 Is The Bottom In For Investment Grade Spread Product Excess Returns? We hesitate to call the bottom in overall spread product returns versus Treasuries. However, we do see many buying opportunities in specific US fixed income sectors. In deciding which sectors to own, we advise investors to search for sectors that: (A)  Have attractive spreads and (B)  Benefit from one or more of the Fed’s recently announced programs We described each of the Fed’s different lending facilities in last week’s Special Report, and will not repeat that exercise this week.3 Instead, we run through a list of sectors where we think spreads have already peaked and that bond investors should own today. Aaa CMBS Aaa-rated CMBS, both non-agency and agency-backed, meet our two criteria of offering attractive spreads and benefiting from Fed support (Chart 5). The Aaa non-agency CMBS index spread is 119 bps wider than at the end of 2019, and the securities can be used as collateral under the Fed’s Term Asset-Backed Loan Facility (TALF). Specifically, bondholders can borrow from TALF against their Aaa non-agency CMBS collateral at a rate of OIS + 125 bps (Chart 5, panel 2). TALF will also impose a haircut of around 15% on CMBS collateral. Chart 5Buy Aaa CMBS Agency-backed CMBS are even more attractive on a risk-adjusted basis. The Agency CMBS index spread is 50 bps above its end-2019 level and the Fed is directly purchasing Agency CMBS as part of its ongoing mortgage-backed securities purchases. As of April 15, the Fed had purchased $5.7 billion of Agency CMBS since it announced CMBS purchases on March 23. The outstanding par value of the Bloomberg Barclays Agency CMBS index is about $204 billion. If the Fed’s current pace of purchases continues for one year, it will own just under half of the index’s par value. Aaa ABS Though the spread is not quite as attractive as for Aaa non-agency CMBS, the spread on Aaa-rated consumer ABS is 115 bps wider since the end of 2019 (Chart 6). As with CMBS, this sector also benefits from TALF with an interest rate of OIS + 125 bps, and an even smaller haircut. Chart 6Buy Aaa Consumer ABS & Munis Municipal Bonds We also like the opportunity in municipal bonds. Spreads between Aaa-rated municipal bond yields and Treasuries have come down off their recent all-time highs but remain attractive compared to historical levels (Chart 6, bottom panel). The Fed’s Municipal Liquidity Facility (MLF) offers direct 2-year loans to state & local governments. This will provide a back-stop for municipal debt with a maturity of 2 years or less but will also help municipalities meet interest payments on longer-maturity bonds when they are due. Aaa-rated CMBS, both non-agency and agency-backed, meet our two criteria of offering attractive spreads and benefit­ing from Fed support. We would therefore advise investors to buy municipal bonds at both the short and long ends of the curve. We also do not rule out further Fed measures to support the municipal bond market in the coming weeks, possibly even secondary market bond purchases. The amount of Fed support for state & local governments so far is much less than what is being done for the corporate sector. There is also no convincing moral hazard argument against scaling-up support for investment grade rated munis, especially when the Fed is already supporting some parts of the high-yield corporate market. Investment Grade Corporates As mentioned above, the Fed is providing an exceptional amount of policy support to the investment grade corporate bond market, mainly through three facilities: The Secondary Market Corporate Credit Facility (SMCCF) that will purchase corporate bonds and ETFs in the secondary market. The Primary Market Corporate Credit Facility (PMCCF) that will purchase new bond issues in the primary market. The Main Street New and Expanded Lending Facilities (MSNLF & MSELF) that will purchase corporate loans from banks, removing them from bank balance sheets. All three of these facilities support the investment grade corporate bond market, and investment grade corporate spreads remain elevated compared to history across all credit tiers (Chart 7). Chart 7Buy Investment Grade Corporates Bottom Line: Investors should buy spread products that offer attractive spreads relative to history and that benefit from Fed support. We favor: Aaa non-agency CMBS, Agency CMBS, Aaa ABS, municipal bonds and investment grade corporate bonds. Have High-Yield Spreads Already Peaked? In the high-yield market we follow the same rules we applied in the previous section. We want to buy sectors that have attractive spreads and that benefit from Fed support. Within high-yield, the Ba credit tier meets these criteria as it offers an elevated spread and loans to Ba-rated issuers are eligible under the MSNLF and MSELF. The SMCCF will also purchase some high-yield ETFs and both the SMCCF and PMCCF will purchase securities that were recently downgraded to Ba from Baa. However, for the most part, securities rated B and below will not benefit from the Fed’s new facilities and thus will trade purely on fundamentals.4 This demarcation between securities rated Ba and above and those rated B and below is already showing up in excess returns. Since the Fed first announced corporate bond purchases on March 23, Ba-rated junk bonds have outperformed Treasuries by 16.88%, beating B-rated bonds (13.84%), Caa-rated bonds (9.53%) and the lowest Ca/C-rated credit tier (6.85%) (Table 1). Table 1Corporate Bond Performance Since Announcement Of Fed Purchases Assessing High-Yield Fundamentals Even without Fed support, lower-tier junk bonds are still worth buying if spreads provide adequate compensation for expected defaults. We assessed the likely magnitude of the looming default cycle in a recent Special Report.5 One main conclusion from that report is that, due to elevated corporate sector leverage, the recovery rate on defaulted debt will likely be low during the next 12 months – on the order of 20-25%. Second, based on the expected magnitude and duration of the current economic shock, we expect a significant surge in the speculative grade corporate default rate during the next 12 months, likely hitting a range of 9%-13%. Even without Fed support, lower-tier junk bonds are still worth buying if spreads provide adequate compensation for expected defaults.  With these default loss assumptions in hand, we can see what sort of buffer is priced into different high-yield credit tiers. Charts 8-10 show calendar-year excess returns for Ba, B and Caa-C high-yield credit tiers on the vertical axes. On the horizontal axes, the charts show the index spread at the start of the 12-month investment horizon less realized default losses over the course of the year.6 Chart 8Ba Default-Adjusted Spread Chart 9B Default-Adjusted Spread Chart 10Caa-C Default-Adjusted Spread We first observe that a Default-Adjusted Spread below 200 bps usually coincides with negative excess returns for all three credit tiers. In fact, for the Caa-C tier, we’d like to see a Default-Adjusted Spread above 500 bps before going long. Second, the green diamonds in all three charts identify likely outcomes for the next 12 months in three different default loss scenarios. The “Mild Scenario” is defined as a 6% speculative grade default rate and 25% recovery rate. The “Moderate Scenario” is defined as a 9% speculative grade default rate and 25% recovery rate. The “Severe Scenario” is defined as a 12% default rate and 25% recovery rate.7 Based on those choices, we’d place our base case default loss assumptions for the next 12 months somewhere between the Moderate and Severe scenarios. Charts 8-10 clearly show that, while Ba-rated issuers might still perform decently, the B-rated and below credit tiers are not priced at all for our base case default outlook. Note that this analysis does not consider Fed support in any way. Factoring that in, Ba-rated bonds look even better compared to bonds rated B and below. Bottom Line: We recommend an overweight allocation to Ba-rated high-yield corporates and an underweight allocation to high-yield bonds rated B and lower. Ba-rated bonds will benefit from Fed support and value in the B-rated and below credit tiers does not adequately compensate for likely default losses.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 For more details on why we recommend this yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 3 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 4 As we noted in last week’s Special Report, some B-rated issuers will benefit from the MSELF. But this support is minor compared to what is being offered to securities rated Ba and higher. 5 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6  We use Ba and Caa-C default losses for those credit tiers. For B-rated bonds, we found that overall speculative grade default losses work slightly better than default losses for the B credit tier specifically. 7 We use historical correlations to translate overall speculative grade default rate assumptions into default rate assumptions for the Ba and Caa-C credit tiers. Fixed Income Sector Performance Recommended Portfolio Specification

WTI crude oil delivered to Cushing in May 2020 is trading below $0.00/bbl as this note is typed, and falling fast (Chart 1). This is an historical print. WTI for June delivery is trading at ~ $22.00/bbl. What we are observing is the last of the May 2020 futures longs getting out of their positions before the contract goes off the board tomorrow. People tend to forget that the so-called WTI "paper" market – i.e., futures – is actually a market in which contracts for physical delivery at Cushing, OK, actually change hands. If you are left long when the contract for May delivery stop trading – tomorrow at the close of business – you will have to stand for physical delivery. If you are short, you must deliver physical barrels. These are binding, legal contracts. Chart 1Crude Oil In Extremis Liquidity is extremely low, as most everyone with any exposure in May 2020 WTI is out of their position. Storage is scarce. Anyone with storage can name their price – literally – as most of the storage in Cushing obviously is close to being full. Refiners are drastically reducing runs, and refined products are sitting in storage, as the US remains in shut-down. What we are observing is the physical market pricing a near-complete lack of storage in Cushing. Physical-market participants also are aware there’s 12mm barrels of crude from Saudi Arabia arriving in the US Gulf, following KSA’s chartering of 19 very large crude carriers (VLCCs) in March, six of which are bound for the US Gulf. There is no place to store the crude that’s going to be arriving in the Gulf and that’s backed up in Cushing. This situation should begin to reverse on May 1, as the COVID-19 demand destruction levels off and the global economy starts to return to normal. On the supply side, the OPEC 2.0 producers begin cutting production next month, and highly levered unhedged producers will be forced to shut in production and file for bankruptcy. The lower prices go in the short term – and the more damage this causes on the production side – the sharper the recovery later this year.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com  

Highlights Portfolio Strategy Our conservative dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – result in an SPX 3,000 fair value target. Relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. An upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all warrant an overweight stance in the S&P software index. Recent Changes Trim the S&P packaged foods index to neutral today, which pushes the S&P consumer staples sector to a benchmark allocation. Boost the S&P software index to overweight today, which lifts the S&P tech sector to a benchmark allocation. Table 1 Feature The SPX jumped to a five-week high last week, on the back of news that the economy will gradually reopen next month. In other news, GILD’s remdesivir drug showed some positive early signs in fighting off the coronavirus, sparking an impressive late-week rally in the SPX. From a macro perspective, flush monetary liquidity and extremely easy fiscal policy remain the dominant market forces. While we remain confident that equities will be higher on a 9-12 month cyclical time horizon, we believe that the easy money since the March 23 lows has already been made and a consolidation phase now looms. Thus, monetizing some of these gains would make sense at the current juncture. Keep in mind that the SPX, junk spreads and the CBOE’s put/call ratio have returned to their respective means since 2018 (horizontal lines denote the historical averages, Chart 1). Tack on the stiff resistance that the S&P 500 will face near the 50-day and 100-week moving averages, and a lateral move is likely in the coming weeks. Meanwhile, in our seminal report “SPX 3,000?” on July 10, 2017 we introduced our SPX dividend discount model (DDM) when we first came up with the SPX 3,000 target.1 It is now custom to update our DDM every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Chart 1Consolidation Mode Chart 2Dividends Rule As a reminder, we have been and remain very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 2). Our 8.2% discount rate mirrors the corporate junk bond yield historical average. This year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. In the spirit of conservatism, we pick the lowest point hit in early April across the different dividend futures expirations. Tables 2 & 3 summarize the results. In the dividend futures derived approach, SPX fair value is close to 2,110. Granted, such dividend contractions for two years running (33% in 2020 and 14% in 2021, Table 2) are extreme and highly unlikely. Moreover, dividend futures have since rebounded violently. However, we stick with them to derive our worst case SPX value. Table 2SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Our own dividend growth estimates result in an SPX 3,000 fair value target (Table 3). While our assumptions are not as dire as the nadir in dividend futures, they are slightly more conservative than the GFC experience. As a reminder, in the aftermath of the GFC dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively (please click here if you would like to receive our DDM and insert your own assumptions). Table 3SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Building up on this analysis, we want to identify sectors that are at risk of a dividend cut, and thus pose the greatest threat to our SPX dividend projections. Table 4 shows the 2019 sectorial dividends, profits, and the payout ratio along with indebtedness. While during the Great Recession financials cut their handsome dividends, the current recession is not a financial crisis and we doubt the financials sector will cut their dividends, at least not as aggressively as in the GFC (Table 5). Table 4S&P 500 GICS1 Sector Dividend Analysis Table 5The GFC S&P 500 GICS1 Sector Dividend Experience Energy is a clear standout, but neither XOM nor CVX will forego their dividend aristocrat status (minimum 25 consecutive years of rising dividends) and chop their dividends. In other words, these Oil Majors will do everything in their power including raising debt to ever so modestly increase their dividends and maintain their aristocrat status. Thus, $24bn of energy sector related dividends are safe or 55% of the overall energy sector’s dividend. Keep in mind that the energy sector increased their dividends in the GFC (Tables 4 & 5). Industrials (GE is no longer a big dividend payer), materials, real estate and select consumer discretionary are sore spots, but not large enough to undermine the SPX (Table 4). Tech, health care and consumer staples are in excellent shape and judging by JNJ’s and COST’s recent dividend hikes, these sectors that enjoy mostly pristine balance sheets may even increase their payouts as they did during the GFC (Tables 4 & 5). While utilities and telecom services are debt saddled, their defensive stature and stable cash flow streams along with their history of steady dividend payments also do not pose a real threat to the SPX’s dividend (Tables 4 & 5). This leaves financials as the key sector to monitor for a possible large inflicted wound to the SPX dividend. In the most adverse scenario where the Fed instructs banks to eliminate their dividends, as the BoE and the ECB recently did in Europe, then the SPX dividend will contract, but only by 15%, ceteris paribus. This is because last year the tech sector had the highest dividend weight in the SPX and also because the financials sector’s dividend weight has fallen from 30% in 2007 to 15% in 2019 (Tables 4 & 5). Netting it all out, we are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. However, given that the easy SPX gains from the March 23, 2020 lows – when we turned cyclically bullish2 – have been made, opportunistic/nimble investors could monetize at least a part of these massive one-month returns. As aforementioned the SPX may face resistance near the 50-day moving average where it attempts to consolidate its recent gains. This week we are downgrading a defensive group to neutral and boosting a deep cyclical group to an above benchmark allocation. Turning Stale Following up from last week’s report, we heed the message from our research to be wary of staples stocks at the depth of the recession and downgrade the S&P packaged foods index to neutral. This move also pushes the S&P consumer staples sector down to a benchmark allocation from previously overweight. While this defensive index had been severely bruised from the accounting scandal at Kraft/Heinz, it has really flexed its safe haven muscles year-to-date. We use this opportunity to trim exposure down to neutral as we deem that this relative advance has run out of steam, despite the once in a lifetime jump in a number of key demand indicators. Chart 3 shows that food & beverage store retail sales now garner 17% of total retail sales a percentage last hit in the early 1990s. Impressively, not only did industry sales rise in absolute terms, but also overall retail sales suffered a severe setback accentuating last month’s spike. Similarly, food output hit a high mark last month, outpacing overall industrial production that came to a standstill. Food products resource utilization also soared, outpacing overall capacity utilization by 10% (bottom panel, Chart 3). As a result, relative share price momentum came close to accelerating by triple digits on a short-term rate of change basis (Chart 4). While such euphoria is warranted, we reckon that most if not all the good news is already reflected in prices, especially given the early signs of a possible reopening of the US economy some time next month. Importantly, sell side analyst optimism has climbed to a similar height observed in late-2015/early-2016 when industry 12-month forward EPS were slated to outshine the broad market by over 10% (bottom panel, Chart 4). Chart 3Demand Boost… Chart 4…Is Already Baked In Worrisomely, despite the rising demand profile, operating margins have been drifting lower over the past decade and a further profit margin squeeze remains a high probability outcome (Chart 5). Finally, on the food export front, the rising US dollar is warning that volumes will remain in check in coming quarters (greenback shown inverted, middle panel, Chart 6). All of this is reflected in valuations that have returned to the 25-year mean with packaged food manufacturers now trading at a 9% forward P/E premium to the broad market (bottom panel, Chart 6). Chart 5Margin Trouble Chart 6Past Expiry Date In sum, relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. Bottom Line: Trim the S&P packaged foods index to neutral, today for a loss of 20% since inception. This downgrade also pushes the S&P consumer staples sector to neutral for a loss of 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PACK – MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, GIS, HSY, HRL, K, LW. Boost Software To Overweight We recently monetized over 50% relative gains in our overweight in the S&P software index, but today we are compelled to lift this heavyweight tech sub-index back to an overweight stance. One key reason for our renewed bullishness is that for the second time in the past 15 months, software stocks managed to eke out relative gains when the broad market fell peak-to-trough 20% and 35% in late-2018 and in Q1/2020, respectively (Chart 7). This resilience on the way down confirms both the defensive stature of this services tech subgroup and simultaneously our long held belief that when growth is scarce investors will flock to secular growth stocks. Chart 7Recession Proof As a result and following up from our recent data processing upgrade, another defensive services tech group, we are compelled to augment exposure to the S&P software index to overweight. Last week we showed that the tech sector (along with financials and consumer discretionary) best the broad market from the recessionary troughs onward, signaling that the key software sub group will likely lead the recovery.3 Software investment is on a multi decade upward trajectory and is slated to rise further in coming quarters as overall spending takes the back seat, but defensive software capex remains resilient (Chart 8). Not only do corporate executives upgrade software in downturns as these upgrades yield near instantaneous return on investment and are immediately productivity enhancing, but also the push to cloud-based services will only accelerate during the ongoing recession (bottom panel, Chart 8). Tack on that the global coronavirus social distancing measures are also boosting demand for remote working services specifically, and software sales will continue to grind higher (Chart 9). Chart 8Capex Market Share Gains Chart 9Rising Demand Buoys Sales Meanwhile, industry M&A remains robust and both the number of deals are still rising at a brisk rate and the premia paid remain near historically high levels (Chart 10). Contrary to a slew of corporations that have announced dividend cuts and equity buyback suspensions, pristine software balance sheets underscore that shareholder friendly activities will remain in place, if not accelerate, during the current recession (bottom panel, Chart 10). Chart 10What’s Not To Like? Chart 11Model Says Buy Our macro-based software EPS growth model does an excellent job in capturing all these moving forces and it is signaling that industry profits will continue to expand at a healthy pace for the rest of the year, in marked contrast to the broad market’s expected profit contraction (Chart 11). Adding it all up, an upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all bode well for an earnings-led outperformance phase in the S&P software index. Bottom Line: Boost the S&P software index to overweight, today. This upgrade also lifts the S&P tech sector to neutral for a loss of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, 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 Banks have an unmatched perspective on the entire economy, … : BCA began by tracking money flows through the banking system to gain advance notice of the direction of markets and the economy. … so we review the five largest banks’ earnings calls every quarter to augment our standard macro analysis: We’re looking for insight into borrower performance, lender willingness, consumer behavior, business sentiment and the condition of the banking system. The biggest banks are bearish on the economic outlook, but bullish on their ability to get through it, … : No management teams are looking for a V-bottom, and their expectations about the duration of the downturn sound a good bit more pessimistic than most investors’. They all expressed confidence in their institutions’ preparedness, however, citing sizable capital buffers and high-quality loan portfolios. … and we agree with their self-assessment: Analysts were skeptical that the banks have adequately reserved for coming loan losses, but we take the more optimistic view that their earnings power will allow them to absorb repeated iterations of reserving while barely scuffing book value. Follow The Money The big banks reported their first quarter earnings last week, and equity investors were decidedly unimpressed, knocking the stocks down 15-19% through Thursday’s close while the S&P 500 was flat. We listen to the calls to hear banks’ observations about households’ and businesses’ financial activity and glean some insight into where lending might be headed. This time we also wanted to use what we heard to inform our investment view on their stocks. We have long been of the view that post-GFC regulatory reforms left the SIFI banks overcapitalized. Even staring down the barrel of the current downturn, it was our sense that the SIFIs had ample capital buffers to withstand a severely adverse scenario, and the sharp de-rating they’ve been subjected to was excessive. With the potential range of credit outcomes so wide, however, it was hard to assess how much their per-share book values might fall, and so we couldn’t state with conviction whether or not the SIFIs’ stocks were as cheap as they appeared to the naked eye. The uncertainty remains, but we heard enough on the calls to conclude that book values are likely to remain resilient. 4Q19 Big Bank Beige Book As a group, the banks offered a pretty grim take on the economy. JPMorgan Chase built its in-house economists’ late-March forecast of a 25% decline in 2Q GDP and an unemployment rate above 10% into its model for calculating its 1Q loan-loss reserve, only to have them revise their forecasts lower, to -40% and 20%, respectively, after the bank closed its books. The rest of the banks, which offered directional GDP and unemployment views instead of point forecasts, uniformly called for weakness well into 2021. The banks were downbeat on the economy, but confident in their ability to manage through it, and not a single one has any intention of cutting its dividend. On the bright side, every bank cited its sizable capital buffer when arguing that it is in a better position than it was in 2008. The banks’ contention that the mix and quality of their loan books makes them safer than they were then didn’t seem to get much traction. The mortgages they hold today were much more carefully underwritten than the ones they held in 2008, but the quality of the banks’ overall loan books won’t be known until the recession has run its course. Many business borrowers are weaker credits that they were when their loans were extended, though the record-low growth in bank lending in the expansion just concluded suggests that the banks committed fewer excesses in this cycle than they normally do (Chart 1). Chart 1An Expansion Without Bank Lending Excesses Businesses drew down their credit lines at a frenzied pace over the last two weeks of March (Chart 2), a sure sign that they feared that liquidity would be in short supply. Since many of the banks saw the funds return to them as deposits (Chart 3), it seems that the draws were precautionary, rather than emergency, measures. It is entirely possible that the lines will be paid down once businesses replace them with forgivable 1% loans from the Paycheck Protection Program (PPP) funded by the SBA,1 though legislative attempts to replenish the PPP's rapidly consumed initial resources are currently in limbo. Chart 2Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Chart 3... Only To Put It Back In The Bank Every bank asserted that it had the capacity to continue to pay its dividend, and pledged to do so as long as conditions didn’t deteriorate dramatically. Operationally, the banks were largely able to perform their standard functions without interruption, despite having the majority of their employees working from home. Successful remote operations bode well for future productivity and profitability as they may herald a future in which banks are able to reduce their costly branch footprints. They also suggest that their ongoing IT investments are paying dividends. A Sudden Stop In Household Spending (Chart 4) And Borrowing Chart 4Sudden Stop [I]n March, we saw a rapid decline in spend initially in travel and entertainment, which then spread to restaurants and retail as social distancing protocols were implemented more broadly. … [W]e did see an initial boost to supermarkets, wholesale clubs and discount stores as people stocked up on provisions, but even that is now starting to normalize. (Piepszak, JPM CFO) [Credit card] spend in aggregate was down 13% in the month of March, year-over-year, and we are seeing trends like that continue here in April. (Piepszak, JPM) Consumer spend is down over 25% year-over-year this past week with food and drug increasing and other spend down significantly. (Scharf, WFC CEO) March 2020 [card] volumes declined approximately 15% from March 2019. (Shrewsberry, WFC CFO) [Our customers’] … overall spending … seems to have stabilized in the last few weeks. During mid-April, we’re seeing [weekly] spending running about a low $50 billion average level compared to $60 billion … before the crisis. (Moynihan, BAC CEO) [T]he last week of March, the card spend activity just broadly for us was down about 30%. … [W]e would expect there to be continued pressure on purchase sale volumes through most of the second quarter. (Mason, C CFO) A Sharp Rise In Credit Line Utilization, … C&I loans were up 26% [year-on-year] as revolver utilization increased to 44%, which is an all-time high. … [E]arly here in the second quarter, we have seen a pause on revolver draws but … we are assuming … that we will see [them] continue in the second quarter, albeit at lower levels than the first quarter. (Piepszak, JPM) [The draws] really have flattened out, and they have been negligible for the last several days, more than a week. And so they probably peaked at the end of the third week of March, and then came right back down. … It’s worth noting that the high rate of [utilization] growth … has backed off since credit markets have reopened. (Shrewsberry, WFC) The draw activity was pretty normal through the first week of March, but ramped up in the second week before peaking in the third. The requests have come down in every one of the last three weeks. (Moynihan, BAC) [C]oming into the second quarter, we’ve actually seen really de minimis draws on the facilities and … we don’t see or feel that [drawdown] pressure now. (Corbat, C CEO) [T]he drawdowns were high in the third and fourth week in March and started to level out in early April. So I think we saw the peak already occurring. (Dolan, USB CFO) … Accompanied By A Surge In Deposits [A]bout half of [the increase in deposits came] from clients drawing on their credit lines and holding their cash with us as they look to secure liquidity. (Piepszak, JPM) It’s worth noting [that] ... we saw many of those draws come back … as deposits. [T]he 75% of loan draws [that] were not used for other paydowns ended up as deposits with [us]. (Moynihan, BAC) The Current Situation Is Unprecedented, … [T]here is no model that [has] dealt with GDP down 40%, unemployment growing that rapidly. … [There are] no models that ever dealt with a government which is doing a PPP program which might be ... $550 billion, unemployment where it looks like 30-40% [of those unemployed will have] higher income than before they went on unemployment, … or that the government is going to make direct payments to people. So what does that mean for credit card [performance]? (Dimon, JPM CEO) The economy is in an unprecedented situation, but not all of the unknowns are bad. The monetary and fiscal stimulus programs will undoubtedly help at the margin, and they may dramatically reduce the second-round effects of the social distancing measures that have strangled activity. We all know we haven’t seen anything like this before. There is no clear path … with a narrow range of outcomes. And so [I just have a very hard time] making an analogy of what this environment is to other environments. Having said that, … we feel like the portfolios that we have are stronger than they were at other downturns as I think they certainly are in many banks out there. (Scharf, WFC) I would just [dis]courage anyone from imagining that at this point in time that any bank has got perfect clairvoyance about … the future …, and whether it gets better or … worse. (Shrewsberry, WFC) Obviously there are many unknowns including how government fiscal and monetary actions will impact the outcome and how our own deferral programs will impact losses, or perhaps the biggest unknown is how long economic activity and conditions will be significantly impacted by the virus. (Donofrio, BAC CFO) … But Credit Performance Might Not Be Horrendous The real question will ultimately be how long this shutdown actually continues, … but in addition to that, how our actions, … the things that we’re doing very actively to help our clients, and the huge amount of government intervention, whether those things will … bridge individuals and small businesses and larger corporations to the other side of this. (Scharf, WFC) It wouldn’t surprise me to continue to have to add to reserves, … [b]ut … what we know is, we’re strong and the industry is strong to be able to handle this. (Scharf, WFC) For years now, we have been focused on client selection. As you all know, what really impacts banks in recession is not the loans put on your books during stress, but rather the quality of your portfolio booked during the years leading up to the stress. (Donofrio, BAC) [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass. (Corbat, C) I think, generally speaking, all banks are in a good position right now, which is why we’re all able to help our customers while protecting employees. (Cecere, USB CEO) Today we received the first major distribution of the direct payments in terms of the $1,200 stimulus payment. We’re seeing now the unemployment benefits, the extra $600 … coming through. [T]hose programs are just barely hitting the general consumer, general business, et cetera. And so … the stimulus they’ll provide is actually going to be from now on, not from now backwards, because this is a program that didn’t exist literally three weeks ago. (Moynihan, BAC) [T]hese [fiscal and monetary] programs … are extraordinary and should have an extraordinary impact. (Piepszak, JPM) Buy The Banks? The uncertainty around loan losses remains extremely high. No one knows how long the economy will remain locked down, or how long it will take to restart the economy once the most restrictive social distancing measures begin to be relaxed. No one knows how large the package of fiscal and monetary assistance will become, or how effective it will ultimately be. Analysts were clearly skeptical that the amounts the banks set aside in the first quarter as reserves against future losses will be sufficient. They were concerned about the gaps between current reserve levels and the losses the banks realized in the global financial crisis, and the cumulative losses projected under the severely adverse scenario of the 2019 iteration of the Fed’s annual stress tests (Table 1). If the virus drag on the economy persists into the third quarter, as our base-case scenario projects, the banks will likely have to step up their reserving activity aggressively. Given that they were able to do so in the first quarter without impairing their book values (Table 2), however, we think they can handle it. Table 1Loan Loss Reserves Vs. Stress Test Projections Table 2Big Bank Book Values The bull case, as BAC’s CEO put it on the call, rests on the idea that the banks’ quarterly pre-tax pre-provision net revenue – their earnings power – is large enough to absorb the gathering tide of writedowns. After seeing the first quarter results, and believing that monetary and fiscal policy will be able to reduce the overall level of credit losses and spread them out across several quarters, provided the shutdown doesn’t last more than six months, we subscribe to it. We are a buyer of the largest banks on the view that the monetary and fiscal support will reduce and stretch out the inevitable writedowns enough to allow the banks to earn their way through them without suffering meaningful book-value declines. Let’s go back to the beginning on the pre-tax PPNR[.] [W]e feel [that earnings power] has us in good stead in terms of [our] ability to absorb whatever circumstances play out here. The reality is how much earnings capacity [we] have to keep generating capital and … earnings that [we] can offset whatever comes at [us] and that’s what we feel good about. (Moynihan, BAC) Table 3A Solid Month's Work The SIFI put options we flagged four weeks ago have expired worthless, yielding a tidy 9% one-month gain for investors who wrote them (Table 3). That call was founded on the interaction between low book-value multiples and astronomical implied volatilities, but didn’t fully embrace the banks. We are ready to take the next step now because we believe pre-provision earnings will match or exceed the somewhat attenuated stream of credit losses, allowing investors to buy the biggest banks at a price-to-tangible-book multiple with a margin of safety that would comfort Benjamin Graham. We recommend overweighting the largest banks in US equity portfolios.2   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com. 2 Our US Equity Strategy service rates the S&P 500 banks group overweight, albeit with a downgrade alert.

Highlights The May-June WTI spread settled earlier in the week at a $7.29/bbl contango, the widest level since February 2009 during the GFC. This reflects an extraordinarily tight storage market in the US Gulf and Midcontinent. WTI for May delivery breached $20/bbl Wednesday, touching a 18-year low (Chart of the Week). Output cuts starting in May agreed by OPEC 2.0 over the weekend will remove 6.1mm b/d on average for May-December vs. 1Q20 levels. Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y. We raised our estimate of COVID-19-induced demand destruction in 2Q20 to 14.6mm b/d from 12.1mm b/d. We expect demand to fall ~ 8mm b/d in 2020 vs. our previous estimate of 4mm b/d, as global fiscal and monetary stimulus revives growth in 2H20. We expect 2021 demand to rise 7.7mm b/d, averaging 100.6mm b/d. In our updated forecast, Brent is expected to average $39/bbl – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Our Brent forecast for 2021 remains ~ $65/bbl. WTI will trade $2-$4/bbl lower. Feature   April is the cruellest month … - T.S. Eliot, The Waste Land1 Global oil logistical capacity will be tested in extremis this month, as cargoes laden with oil arrive in ports that have no need for ready supply and few storage options to hold the crude until its needed. This is filling traditional global storage, inland pipelines and ships, which, as typically occurs in extremis, are used as floating storage (Chart 2). Chart of the WeekCrude Oil In Extremis Chart 2Floating Storage Volumes Soar As Terminals and Pipelines Fill The most extreme testing of global logistics likely will occur in this cruel month, to borrow once again from the laureate, as markets are forced to absorb the production surge from OPEC 2.0 – mostly from KSA and its allies. Repeated excursions to and through $10/bbl in physical markets, as already have been registered in Canada and US shale basins, can be expected this month (Chart 3). Indeed, we expect price pressures to reduce US oil ouput – mostly in the shales – by 1.5mm b/d or more.2 Beginning in May, OPEC 2.0 will begin cutting production, with its putative leaders – KSA and Russia – accounting for 1.3mm b/d and 2.1mm b/d, respectively, of the coalition’s total pledged cuts of 7.6mm b/d vs. 1Q20 production levels. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to 9.7mm b/d for May-June, and 7.7mm b/d for 2H20).3 Chart 3Cash Markets Pressing /bbl While the official OPEC communique notes the coalition also will implement a 6mm b/d cut from January 2021 to April 2022, we doubt this will be necessary. The coalition meets again in June, and KSA’s Energy Minister, Prince Abdulaziz bin Salman, said the Kingdom is prepared to increase its cuts if needed.4 Based on historical experience, we expect KSA to over-deliver on cuts, and for Russia to gradually meet its pledged volumes. We are haircutting other states’ production cuts based on historical observation, and are projecting cuts of ~ 75% for 2020 and 70% for 2021 compliance (Table 1). Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y on average. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Lowering Our Demand Forecast The COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008. Our estimate of COVID-19-induced demand destruction in 2Q20 is now 14.6mm b/d, up from 12.1mm b/d. For all of 2020, we expect demand to fall 7.9mm b/d in our base case vs. our previous estimate of 4mm b/d. These estimates are highly conditional on the trajectory of the containment of the COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global real GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008 (Chart 4). Nonetheless, we believe the massive global fiscal and monetary stimulus now being deployed will restore growth beginning in 2H20 and carrying through to expect 2021 demand to rise 7.7mm b/d, and to average 100.6mm b/d (Chart 5). Chart 4COVID-19 Real GDP Hits Dwarf 2009 GFC Recession Chart 5Massive Stimulus Will Revive Demand We assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. While our demand expectations are slightly weaker, in our modeling we see supply being curtailed sufficiently to produce a physical deficit beginning in 3Q20 (Chart 6). Our supply-demand trajectory projects a peak in OECD storage of 3.7 billion barrels in May, after which inventories fall sharply (Chart 7). Indeed, we assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. Chart 6Oil Supply-Demand Balances Point To Physical Deficit By 4Q20 Chart 7Inventories Spike, Then Draw Sharply Two-Way Price Risk Our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. In our updated forecast, we see Brent averaging $39/bbl this year – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Next year, our expectation remains ~ $65/bbl. WTI will trade $2-$4/bbl lower (Chart 8). As noted above, our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. However, as the pandemic spreads deeper into less-developed EM economies without robust public-health infrastructures, or social security systems providing a basic income in the event of job loss due to recessions the risk of widespread infection rises significantly.5 Chart 8Stronger Price Recovery Expected No amount of fiscal or monetary stimulus will allow an economy to weather such a storm. This is a clear and present danger to the global recovery and to a recovery in commodities generally, oil in particular. Investment Implications Our expectation for prices is reflected in Chart 8, premised, again, on COVID-19 being contained and fiscal and monetary stimulus reviving global growth. We are retaining our long exposure to the market, expecting the supply and demand policies set in motion will be effective. However, there is no way of accurately assessing the likelihood of an uncontained pandemic hitting EM markets, and, from there, re-entering other markets that presumably have dealt with the coronavirus.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight Global oil inventories will be filled rapidly in 2Q20 as major economies remain in lockdowns. High-cost Canadian oil sand producers will be severely hit as their output is landlocked, distant from key demand centers, and facing storage and pipeline infrastructure constraints. More than 500k b/d of production will be shut-in in April and May as crude-by-rail collapses, local and US refinery runs are reduced, and Alberta’s limited inventory moves closer to its maximum capacity – estimated at ~ 90mm bbls (Chart 9). Separately, a €20/MT stop to our EUA futures recommendation was triggered on April 14, 2020, leaving us with a 14.2% gain. Base Metals: Neutral China’s iron ore imports fell to 85.9mm MT in March, a decline 0.6% y/y, after growing 1.5% in January and February. This came as steel mills arranged maintenance or slowed production to deal with record-high inventories after the COVID-19 pandemic curtailed construction and industrial activities. However, in the long run the outlook for iron ore and steel appears to be improving. Mysteel data for China indicates utilization rates at blast furnaces have been rising for four weeks and are now at ~ 79%. Chinese Steel exports also picked up in March, up 2.4% from a year earlier, but are now facing new anti-dumping duties on stainless steel in the EU. Precious Metals: Neutral Gold continues to trade above $1700/oz – reaching its highest level since October 2012 – supported by easing fiscal and monetary policy in the US and fear of a prolonged economic slowdown. A lower US dollar – the DXY index fell back below 100 last week – and depressed real rates supported gold’s move higher (Chart 10). Dollar debasement risks and negative real rates increase gold’s attractiveness as a safe asset. Ags/Softs:  Underweight China’s March soybean imports came in at 4.28mm MT y/y, the lowest level since February 2015. Rains in Brazil delayed that country’s exports to China. The fall also reflects a 6% contraction in soymeal (i.e., the “crush”) consumed by livestock – as the African Swine Fever slashed China’s pig herd by more than 40% and shortages forced operations to grind to a halt. Similarly, meat suppliers in the US and Canada are closing plants temporarily due to COVID-19 cases among employees. As a result, Chicago soybean futures traded 0.8% lower on Tuesday. Chart 9Limited Storage Capacity In Alberta Chart 10Lower US Rates And Dollar Support Gold   Footnotes 1     The Waste Land, by T.S. Eliot, originally was published in 1922 in The Criterion, which was founded and edited by Eliot. 2     The Texas Railroad Commission held day-long hearings April 14 to consider returning to its historic roll as an oil-production regulator on Tuesday.  As we went to press no ruling on the petition to revive pro-rationing was delivered.  The Oklahoma Corporation Commission will hold similar hearings next month.  Please see Texas and Oklahoma weigh production quotas for oil published by washingtonpost.com April 13, 2020. 3    Please see The 10th (Extraordinary) OPEC and non-OPEC Ministerial Meeting concludes, posted by OPEC April 12, 2020. 4    Please see Saudi energy minister leaves door open for more cuts in June, published by worldoil.com April 13, 2020. 5    Please see National governments have gone big. The IMF and World Bank need to do the same. This op-ed by Gordon Brown and Larry Summers, published by washingtonpost.com April 14, 2020, lays out some of the issues that elevate downside risk to a COVID-19 recovery.   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

Special Report

Highlights As government bond yields have fallen to zero or below, many of our clients have asked us how to obtain income from other asset classes. In this report we analyze three income opportunities in the equity market: high-dividend yield stocks, dividend growth stocks, and preferred shares. High-dividend yield stocks have a large style bias to the value factor. Thus, investors who wish to invest in high-dividend yield stocks might be better served by investing in dividend plays in the non-value universe. Dividend growth stocks – such as the ones in the S&P 500 Dividend Aristocrats index – are historically less likely to cut their dividends, thanks to their defensive nature and corporate incentives. The Aristocrats should continue increasing dividends during this crisis. Our screening points to the following as the most attractive: ExxonMobil, Franklin Resources, 3M, Procter & Gamble, AT&T, and Genuine Parts. We would not buy US preferred shares, given that they are heavily weighted to Financials, a sector that will do poorly in an environment of low interest rates. Feature As the crisis caused by COVID-19 has battered risk assets, many of our clients have asked us how to obtain income in this current environment. In the past, investors could rely on a consistent coupon provided by government bonds. However, this is no longer the case. The crisis has dragged DM government bond yields around the world to below or near zero, which means that investors looking for income opportunities must search outside of government bonds, in riskier asset classes. One such asset class is equities. Over the last 50 years, income return has accounted for roughly a third of the total return of global equities (Chart 1, top panel). Moreover, in contrast to other sources of equity return such as earnings growth or multiple expansion, income return is always positive, making it much more consistent through time as well as resilient to recessions (Chart 1, middle and bottom panels). However, there are a couple of drawbacks to equities as income-generating assets: The income yield of equities is not particularly high, especially when one compares them with asset classes such as corporate debt which have similar or lower volatility (Chart 2, top panel). As opposed to fixed-income assets, where a set income return is guaranteed provided there is no default and the security is held to maturity, companies can actually cut their equity dividends when they come under stress. As a consequence, while trailing dividend yield is often an accurate indicator of future income return, it can overestimate it during bear markets (Chart 2, bottom panel). Chart 1Dividends Make Up A Substantial Portion Of Equity Returns Chart 2The Income Return Of Equities Is Low And Can Be Deceiving During Bear Markets In this report we examine two different dividend strategies that try to address the issues above: high-dividend yield stocks and dividend growth stocks. In addition to these strategies within the common equity space, we also explore whether preferred shares can be an attractive income opportunity. For each of these three income strategies we try to answer the following questions: How are these dividend indices constructed? How has each strategy performed historically? How has it performed during bear markets? What is the sector composition of each strategy? How are valuations now? To answer these questions, we examine the MSCI High-Dividend Yield indices, the S&P Dividend Aristocrat indices and the iShares Preferred Shares indices. Moreover, based on our analysis, we also make some recommendations as to which is the best income strategy in equity markets for the current environment. Please see our Investment Implications section for more details. High-Dividend Yield Stocks As their name suggests, high-dividend yield indices select for stocks with the highest dividend yields. In practice however, many more screening criteria are imposed. In order to ensure some stability in dividend payout, MSCI excludes REITs, payout outliers, negative dividend growth stocks, low-quality stocks, and low-performance stocks. Once all of these screening criteria are applied, MSCI selects for stocks which have a dividend yield that is at least 30% higher than its benchmark. Table 1 shows details on these screening criteria. Table 1Criteria For MSCI High-Dividend Yield Indices How has the MSCI High-Dividend index performed historically? Since 1996, high-dividend yield stocks have outperformed the benchmark at the global level by 50% (Chart 3, top panel). This outperformance has been mostly a result of the income advantage this index provides, given that price return has outperformed only by a paltry 3%. It is also worth noting that price performance has been particularly poor since the Financial Crisis, and has actually caused high-dividend yield stocks to underperform on a total return basis over the past decade. Relative performance has been flat to down, even in those markets where high-dividend yield had been very successful previously such as Canada, Japan, and Emerging Markets (Chart 3, bottom panel). What has caused this underperformance? One reason is the low allocation that the high-yield index has to Technology (Chart 4, panel 1). Another reason is style tilt. Factor analysis reveals that the high-dividend yield index has a very strong value bias1 (Chart 4, panel 2). This strong style tilt is likely responsible for the poor relative price performance of high-dividend yield stocks, as value has been notorious for underperforming over the past decade (Chart 4, panel 3). Chart 3High-Dividend Yield Stocks Have Not Outperformed In The Past Decade Chart 4The High-Dividend Yield Index Has A Strong Value Bias   But while high-dividend yield stocks are an implicit bet on value, there is evidence that investing in high-dividend yield stocks within the non-value universe is a profitable strategy. In the paper “What Difference Do Dividends Make?”, Coronover et al. found that high-dividend yield companies actually outperform their low-dividend yield counterparts in the high and median price-to-book universes2 (Table 2). Additionally, they found that high-dividend yield stocks also performed better vis-à-vis low-dividend yield stocks in the mid-cap and large-cap universes. Table 2High-Dividend And Low-Dividend Yield Stocks Sorted By Price-To-Book And Market Cap Dividend Growth Stocks Dividend growth stocks are securities that have increased their dividend for a certain number of consecutive years.  In the US, companies with a track record of at least 25 years of dividend increases are usually called “dividend aristocrats”, while companies with a 10-year track record are known as “dividend achievers”.3 However, the requirements to be classified as a dividend aristocrat or a dividend achiever are not uniform across index providers, and even within providers they are not uniform across different countries, which means that investors need to pay attention to selection criteria when investing in a dividend growth index (Table 3). In this report we will focus on the best-known dividend growth index: the S&P 500 Dividend Aristocrats index. Table 3Different Criteria To Become A Dividend Aristocrat In Different Countries How has this index performed historically? The S&P 500 Dividend Aristocrats index has outperformed the S&P 500 by nearly 60% since 1995 in total-return terms and by more than 30% in price terms. Additionally, it has enjoyed less volatility and has outperformed significantly during recessions (Chart 5, panel 1). Chart 5Dividend Aristocrats Outperform During Bear Markets The main difference between the benchmark and the Aristocrats index comes down to sector tilt and leverage.  The second panel of Chart 5 shows that the Aristocrats index has a large overweight in Consumer Staples and a large underweight in Technology relative to the S&P 500. Meanwhile, while valuations are not that different, and equity profitability is actually lower, the companies in the Aristocrats index are significantly less levered than those of the S&P 500, a testament to their defensive nature (Table 4). Table 4Dividend Aristocrats Have Low Leverage But are dividend aristocrats really a more reliable source of income than the rest of the market? Empirically, they have been. In the US, the likelihood of a dividend increase in any given year has historically been a function of how many consecutive dividend increases a company has done before (Chart 6). Beyond the strong balance sheets and stable business models that dividend aristocrat companies have, this is most likely a result of the incentives created by the asymmetry of the index: A multi-decade policy of dividend increases is a significant investment of time and resources to signal stability to the market. However, the status obtained by this policy – and all the resources devoted to it– is immediately lost the moment dividends are cut, with no possibility of reclaiming it in at least a quarter century.4 Importantly, the longer a company raises dividends the bigger the investment becomes, creating a very high incentive to not cut dividends. That being said, sometimes this incentive is not enough to overcome extreme business conditions, such as those that occurred in 2008. Chart 7 shows that the members of the S&P Dividend Aristocrats index declined by roughly a third during the Financial Crisis, mostly as a result of previously reliable banks that had to cut their dividends in 2008 and 2009.5 Chart 6The Likelihood Of A Dividend Increase Is Higher For Dividend Aristocrats Chart 7Extreme Business Conditions Can Force Some Aristocrats Off The Index   Preferred Shares Preferred shares are securities which have traits of both debt and common equity: Like debt, they have a par value, no voting rights, and they provide a prespecified cash flow. Nevertheless, they do not have a maturity date and they represent an ownership stake in the company, just like common equity. Analyzing the historical performance of preferred shares is difficult since most indices begin only around the Financial Crisis. However, from the limited data we have, we can make some observations: Preferred shares in the US have underperformed common equity, investment- grade debt and high-yield debt since 2004 (Chart 8). They also experienced very deep selloffs during recessions, often similar to the selloffs that common equities have experienced (Table 5). However, preferred shares do seem to have similar return drivers to corporate credit. In particular, much like corporate credit, they tend to fall whenever yields on corporate debt rise (Chart 9). Chart 8Preferred Equity Has Underperformed Credit And Common Equity Table 5Preferred Equity Has Similar Drawdowns To Common Equity During Recessions Chart 9US Preferred Shares React Negatively To Rising Credit Yields Chart 10US Preferred Shares Are Heavily Tilted To Financials In theory, the co-movement of preferred equity and corporate debt is not that surprising. Much like credit, preferred shares are fixed-income securities which are subject to credit risk. Whenever yields on risky credit rise, these fixed-income securities become relatively less attractive, making their price fall. Chart 11Canadian Preferred Shares Are An Oil Play However, what is surprising is that preferred shares have underperformed both investment-grade and high-yield credit. How could an asset that technically has more risk – and thus should offer a better rate of return – underperform for such a long time? One plausible explanation is sector skew. Preferred shares are heavily skewed to Financials, a sector that has underperformed significantly over the past decade (Chart 10). While Financials tend to dominate most preferred indices, other factor may also affect returns. In Canada, the preferred share index is most sensitive to changes in the price of oil – a consequence of both the relatively high weight of Energy in the index, and the importance of the commodity for the Canadian economy (Chart 11). There are many types of preferred shares which include rate-resets, perpetuals, and variable rate. We do not analyze them in this report since indices tracking most of these securities have a very short history. We do advise our clients to be wary of compositional differences between indices, since sector composition could be a larger driver of returns than the type of preferred equity itself. Finally, while it is outside the scope of this report, it is worth remembering that preferred shares might still be worth looking at for taxable investors, given that dividends and interest income are often not taxed at the same rates. Investment Implications Dividend Growth Stocks Investors should consider including dividend growth stocks in their portfolios. Their defensive nature means that they should be able to weather the recession brought about by the coronavirus lockdowns better than the overall market, while their long-term dividend policy implies that these companies will be more reluctant to cut dividends. One drawback of the S&P 500 Dividend Aristocrat index is that it is yielding less than 3%. Thus, investors would be better served by selecting individual securities within the index. In order to help with this exercise, we have ranked the companies in the S&P 500 Dividend Aristocrat index according to our own GAA Income Score. The score is based on the following three traits: Raw Income: the company’s current dividend yield. Yield Stability: the number of consecutive years the company has raised its dividend. Attractiveness: The company’s current score from the BCA Equity Trading Strategy service. Please find the ranking of the S&P 500 Dividend Aristocrats in Appendix A. According to our GAA Income Score the best S&P 500 Dividend Aristocrats are ExxonMobil, Franklin Resources, 3M, Procter & Gamble, AT&T, and Genuine Parts. High-Dividend Yield Stocks What about high-dividend yield stocks? The MSCI All-Country World High-Dividend Yield index is currently yielding a formidable 5%, making it an attractive income opportunity. However, investors should remember that high-dividend yield stocks have a significant exposure to the value factor. GAA is currently neutral on value versus growth, but we are concerned that value continued to underperform when equities were falling and has not been able to outperform in recent weeks as equities rebounded. For those who do not want to take on value exposure, overweighting high-dividend yield within non-value stocks and mid and large caps might be a better option. Preferred Equity Currently preferred shares have a dividend yield of roughly 5%. Do they make an attractive income opportunity? We don’t believe so. Low interest rates and tepid loan growth even after the quarantines are over will likely weigh on Financials – the sector which preferred shares are most exposed to. Moreover, its strong similarity to corporate debt makes this asset somewhat redundant for investors who already own credit. Appendix Juan Correa Ossa  Associate Editor juanc@bcaresearch.com Footnotes 1 This is in part by construction. The MSCI Value index uses dividend yield as one of its variables to asses value. 2 Mitchell Coronover, Gerald R. Jensen, and Marc W. Simpson, “What Difference Do Dividends Make?”, Financial Analyst Journal, Volume 72, Number 6 (2016). 3 Companies which have increased their dividend for at least 50 years are sometimes called “dividend kings”. 4 Eberner Asem and Ahamsul Alam, “The Market’s Reaction To Consecutive Dividend Increases,” (December 2017). 5 Not all companies exit the index due to dividend cuts. Some companies exit because of corporate restructurings or because they no longer meet the minimum market capitalization to qualify.

Highlights Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay. Such testing will become available, but probably not for a few more months.  Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains. Despite the fact that the supply of goods and services has fallen sharply during this recession, the overall effect has been deflationary. Deflationary pressures should subside later this year as demand picks up, commodity prices rise, and the US dollar weakens. Looking several years out, deglobalization and the increasing politicization of central banking could lead to accelerating inflation. Long-term investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. Now What? Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm's way. Or so you think. You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark. This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows. Yet, we have neither a vaccine nor a cure for the virus (although as we go to press, unconfirmed news reports suggest that Gilead’s drug, remdesivir, has had success in treating patients at a Chicago hospital). Chart 1Widespread Social Distancing Dampened The Spread Of All Flus And Colds COVID-19 is part of the coronavirus family, which includes four members that are responsible for up to 30% of common colds (most other colds are caused by rhino-viruses). Social distancing has driven the number of cold and influenza-like cases in the US to very low levels (Chart 1). But does anyone really think that the common cold or flu will be permanently eradicated because of recent measures? If not, what will prevent COVID-19, which is no less contagious than these other illnesses, from resurfacing? In short, the bear is still there, waiting for us to reopen the economy. A Deep Recession As we wait, the economic damage continues to mount. The IMF’s baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is far deeper than during the 2008/09 financial crisis (Chart 2). The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020 relative to the Fund’s already bleak baseline. A second outbreak next year would push global GDP almost 5% below the IMF’s baseline in 2021, while the combination of a longer outbreak this year and a second outbreak next year would cause the level of output to fall 8% below the 2021 baseline (Chart 3). Chart 2Severe Damage To The Global Economy This Year Chart 3Downside Risks To The IMF's Projections The Ties That Bind The sudden stop in economic activity has led to a dramatic surge in unemployment. US initial unemployment claims have risen by a cumulative 22 million over the past four weeks. The true scale of layoffs is probably higher than that, given that some state websites have been unable to handle the flood of insurance applications. Chart 4Only About One-Third Of Those Who Lose Their Jobs Apply For Benefits Historically, only about one-third of those laid off have applied for benefits (Chart 4). While the take-up rate will be higher this time – the CARES Act increases weekly unemployment compensation, while expanding eligibility to self-employed workers – it is still reasonable to assume that the claims data do not capture how much of the workforce has been laid idle. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed. In this respect, the recovery in employment following this recession may end up resembling that of another “man-made” recession: the 1982 downturn (Chart 5). Back then, policymakers felt that a recession was a price worth paying to quash inflation. Once inflation fell, central banks were able to cut rates, allowing economic activity to recover. Today, the hope is that by shutting down all nonessential businesses, the virus will be quashed, and life will return to normal. Chart 5Comparing The 1982 Recession Versus Today: Employment Edition Exit Plans It remains to be seen whether vanquishing the virus will be as straightforward as vanquishing inflation was in the early 1980s. As we noted last week, in the absence of a vaccine or an effective treatment, our best hope is that mass testing will allow businesses to reopen.1 The technology for such tests already exists; it just has yet to become available on a large enough scale. Just like during the Second World War, the production of weapons necessary to fight the virus will grow at an exponential pace (Chart 6). Chart 6Now Let's Do The Same For Test Kits Near-Term Pressures On Risk Assets Exponential change is a difficult concept for the human mind to grasp. What seems painfully slow at first can quickly become unfathomably fast later on. The apocryphal story about the origins of the game of chess comes to mind.2 This puts investors in a bit of a quandary. Growth is likely to recover in the latter half of 2020 as COVID-19 testing becomes pervasive and the effects of fiscal and monetary stimulus make their way through the economy. But, the near-term picture could be soured by news stories of continued acute shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. Indeed, bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. Our US equity strategists are projecting only $100 and $140 in EPS, respectively. Stock prices and earnings estimates generally travel together (Chart 7). On balance, we continue to favor global equities over bonds on a 12-month horizon, owing to the fact that the cyclically-adjusted earnings yield is quite a bit higher than the bond yield (Chart 8). However, we have less conviction about the near-term (3-month) direction of stocks, and would recommend that investors maintain above-average cash levels for now which can be deployed on any major selloff. Chart 7Negative Earnings Revisions Will Weigh On Stocks In The Near Term Chart 8Favor Equities Over Bonds Over A 12-Month Horizon   Inflation And Supply Shocks: A Keynesian Paradox? One of the distinguishing features of this recession is that it has involved a simultaneous supply shock and a demand shock. Businesses have had to curb supply in order to allow workers to stay at home, while workers have reduced spending out of fear of going to stores or other venues where they could inadvertently contract the virus. Worries about job losses have further dented demand.  There is no question about what happens to output when both demand and supply decline: output falls. In contrast, the impact on the price level depends on which shock dominates (Chart 9). Chart 9Inflation And Supply Shocks As Appendix 1 illustrates with a set of simple numerical examples, in theory, a negative supply shock spread evenly across all sectors of the economy should cause the price level to rise. This is because unemployed workers, who are no longer contributing to output, will still end up consuming some goods and services by tapping into their savings, taking on new debt, or by receiving income transfers from the government. In the current situation, however, the supply shock has not been spread evenly throughout the economy. Some businesses have been completely shuttered, while others deemed essential have been allowed to operate. As the appendix shows, in such cases, the drop in aggregate demand is likely to be larger than if all sectors were equally impacted. In fact, it is possible for a supply shock to trigger a demand shock that is larger than the supply shock itself, leading to a perverse situation where a decline in supply results in a surfeit of output. A recent paper by Guerrieri, Lorenzoni, Straub, and Werning argues that the current pandemic represents such a “Keynesian supply shock.”3 Intuitively, such perverse supply shocks can arise if workers are cut off from purchasing many of the goods that they would normally buy. When the menu of available goods shrinks, even workers who are still employed could end up saving much of their income. Deflationary For Now All this implies that the pandemic is likely to be deflationary until more businesses reopen. The data seem to bear this out. The US core consumer price index fell by 0.1% month-over-month in March on a seasonally adjusted basis, led by steep declines in airfares and hotel lodging prices. High-frequency indicators, as well as the prices paid components of various purchasing manager indices, suggest that deflationary pressures have persisted into April (Chart 10). Chart 10Deflation Reigns For NowShelter inflation was reasonably firm in March but should soften over the coming months. A number of major apartment operators have announced rent freezes. In addition, the lagged effects from a stronger dollar and lower energy prices will contribute to lower goods inflation, while higher unemployment will hold back service inflation. Inflation Should Bounce Back In 2021 The discussion of Keynesian supply shocks suggests that aggregate demand will increase faster than supply as more sectors of the economy reopen. This should ease deflationary pressures. In addition, a rebound in global growth starting in the second half of 2020 will prompt a recovery in commodity prices. The forward oil curve is predicting that Brent and WTI crude prices will rise by 42% and 79%, respectively, over the next 12 months (Chart 11). Inflation expectations and oil prices tend to move closely together (Chart 12). Chart 11H2 2020 Rebound In Growth Will Lift Oil Prices Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together As a countercyclical currency, the US dollar will weaken over the next 12-to-18 months as global growth rebounds, providing an additional reflationary impulse (Chart 13). Falling unemployment will also eat into labor market slack, helping to support wages. Chart 13Stronger Global Growth In The Back Half Of The Year Will Weaken The Dollar, Putting Upward Pressure On US Inflation The Structural Outlook For Inflation… And Bond Yields Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or abate. On the one hand, it is possible that the pandemic will cast a pall over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth. On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labor market recovers. This could eventually lead to economic overheating in two-to-three years. Chart 14Global Trade Was Already Stagnating A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up (Chart 14). The pandemic may further inflame nationalist sentiment. Against the backdrop of high unemployment, Donald Trump is likely to campaign as a “war president,” relentlessly chiding Joe Biden for having too cozy a relationship with China. On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on TIPS breakevens. Market-based inflation expectations are even more subdued in most other advanced economies. If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves.   APPENDIX 1: Keynesian Supply Shocks Suppose there are two sectors, A and B. The economy consists of 2,000 workers, with each sector employing 1,000 workers. To keep things simple, assume that workers in each sector evenly split their consumption between the two sectors. Thus, a worker in sector A spends as much on goods from sector A as from sector B, and vice versa. Also assume that each worker, if employed, produces $1,000 of goods and receives a salary of $1,000 for his or her efforts. With this in mind, let us consider three scenarios: Scenario 1: Both Sectors Are Open For Business In this scenario, $1 million of good A and $1 million of good B are produced and supplied to the market. Since each of the 2,000 workers spends $500 on good A and $500 on good B, a total of $1 million of both goods are demanded. Aggregate demand equals aggregate supply. Scenario 2: Partial Closure Of Both Sectors Suppose that half the workers in both sectors are laid off. While the unemployed workers do not earn any income, they still spend half as much as they used to by tapping into their savings ($250 on good A and $250 on good B for each unemployed worker). Each employed worker continues to spend $500 on good A and $500 on good B. Now there is $500,000 in total of each good produced, but $750,000 of each good demanded. Aggregate demand exceeds supply. Scenario 3: Sector A, Deemed The Essential Sector, Remains Completely Open, While B Is Closed In this case, all sector A workers are still employed, earning $1,000 each. Since good B is no longer available for purchase, sector A workers increase spending on good A by 20% (from $500 to $600 per worker). Workers in sector B are all unemployed. However, they continue to tap into their savings. Rather than spending $250 on good A as they did in scenario 2, they increase their expenditures on good A by 20% (from $250 to $300). A total of $900,000 of good A is now demanded ($600*1,000+$300*1,000), which is less than the $1 million of good A supplied. Aggregate supply now exceeds demand for the part of the economy that is still open. The chart and table below summarize the results. The key insight is that a 50% shock to the entire economy curbs aggregate demand less than a 100% shock to half the economy. This implies that demand is likely to grow faster than supply as mass testing allows more of the economy to reopen. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 2  In one account, the King of India was so impressed when the game of chess was demonstrated to him that he offered its inventor any reward he desired. After thinking for a while, the inventor said “Your Highness, please give me one grain of rice for the first square on the chessboard, two grains for the next square, four grains for the one after that, doubling the number of grains until the 64th square.” Stunned that the inventor would ask for such a puny reward, the King quickly agreed. A week later, the King’s treasurer informed His Highness that he would need to give the inventor 18 quintillion grains of rice, which is more than enough rice to cover the entire planet’s surface. “Holy Ganges, what have I done?” the King exclaimed, before having the inventor executed. 3  Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?” NBER Working Paper No. 26918 (April 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores