Fixed Income

Highlights The current pace in the recovery of China’s domestic demand has not been robust enough to fully offset the impact from the collapse in exports. The level of industrial inventory jumped to a five-year high, but it will likely be transitional. We expect the inventory overhang to subside when the recovery speed in demand catches up with supply in H2.  While the gap is widening between stock prices and economic fundamentals in the US, Chinese equity prices have been more “well behaved” in the past month. We continue to overweight Chinese stocks in the next 6 to 12 months and favor Chinese onshore corporate bonds overall and SOEs in particular. Feature China’s Caixin and official PMIs in April highlighted the knock-on effects on the Chinese economy from a collapse in external demand. Although China’s domestic economy continued its rebound, the pace of the improvement has not been robust enough to offset rapidly weakening exports. This was evident in the widening gap between supply and demand in April. The sharp contraction in the global economy in Q1 will likely deepen in Q2 because the lockdowns in Europe and the US started in the later part of Q1 and have mostly remained in place through end-April. We expect global demand to significantly worsen in April and May, generating strong headwinds to China’s near-term recovery. Chinese authorities have been prompted to step up their stimulus efforts due to a fast deterioration in global growth. The government recently approved an additional 1-trillion yuan in local government special-purpose bond issuance, which is scheduled to be fully dispersed by the end of May. China’s stimulus, strongly focused on boosting investment and economic growth, should fuel Chinese stock and industrial metal prices in the next 6 to 12 months. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Chart 1Construction Sector Has Seen The Strongest Rebound Construction Sector Has Seen The Strongest Rebound Construction Sector Has Seen The Strongest Rebound China’s domestic demand partially offset a collapse in exports in April. The official manufacturing PMI slipped to 50.8 in April from 52 in the previous month. The Caixin PMI survey, which is skewed towards smaller and more export-oriented firms, returned to contractionary territory in April following a brief rebound in March. The retreat in both PMI readings highlights how a worldwide lockdown of businesses has shaken China’s manufacturing sector (Chart 1, top panel). This exogenous negative impact will likely worsen in Q2. China's domestic economy continued its slow recovery through April. The official PMI’s new orders subcomponent declined by only 2 percentage points, despite a collapse of new export orders to 33.5. Moreover, the new orders subcomponent of the non-manufacturing PMI survey increased from 49.2 to 52.1, with the construction subcomponent reverting to its pre-pandemic level. The construction employment subcomponent also confirms that the industry has shown the strongest rebound among sectors in the Chinese economy (Chart 1, middle and bottom panels). Chart 2Home Sales Are Likely To Accelerate Home Sales Are Likely To Accelerate Home Sales Are Likely To Accelerate China’s housing market also continued to improve in April. Chart 2 (top panel) shows that the demand for both residential housing and floor space started rebounding in March. The high frequency data indicate the year-over-year growth rate in home sales in China’s 30 large- and medium-sized cities turned positive in April (Chart 2, middle panel). The rapid expansion in home sales in the past weeks may be due to recent discount promotions, but we anticipate housing prices to remain stable this year in line with the Chinese leadership’s policy direction (“houses are for living, not for speculation”). We also expect that the number of home sales will accelerate.  Local governments will significantly ramp up land sales this year to make up for their large revenue shortfalls.  The central government will continue to gradually relax real estate purchase restrictions. The more property market-friendly policies, coupled with extremely accommodative monetary conditions, will encourage a healthy rally in property market investment and housing demand in H2 (Chart 2, bottom panel). So far most improvement in China’s domestic demand seems to be concentrated in the construction sector.  The slow pace of manufacturers’ capacity utilization suggests that China’s industrial output growth is unlikely to return to its pre-pandemic rate in Q2. As of April 25, among the official PMI surveyed enterprises, the resumption rate of large- and medium-sized enterprises was 98.5%. However, only 77.3% of them reported that they were operating at 80% or higher of their usual capacity utilization rates.1 Chart 3Pressure On Inventory Should Start To Ease In H2 Pressure On Inventory Should Start To Ease In H2 Pressure On Inventory Should Start To Ease In H2 The imbalance in the recoveries of China’s supply and demand has led to a pileup in inventory, the highest level in five years (Chart 3).  The combination of excessive inventory and low demand has weakened China’s factory pricing power and profit growth. However, in our view, the inventory overhang will be temporary, and the factory price contraction is unlikely to turn into a deep deflation such as the one in 2009 or the long-lasting deflationary cycle from 2012-2015. The level of industrial inventory has been much lower than it was during the four years leading to the 2008/2009 global financial crisis (GFC) and the 2015/2016 deep deflationary cycle. The deflation in factory prices also has been relatively mild compared with the two previous phases. Moreover, an extremely tight monetary policy and protracted inventory destocking period that contributed to the collapse in global raw material prices in 2012 are not present. Declines in China’s manufacturing, raw material and mining prices are synchronized, echoing the GFC when global demands nose-dived and pushed international oil and raw material prices into deep contractions. Our baseline scenario of an incremental re-opening of the global economy, a peak in the US dollar, and a recovery in the oil market in H2, all support our view that the deflation in China’s producer prices should not last beyond Q3. Given that exports’ share to China’s GDP is currently half of what it was in 2008, the weakness in global demand will be much less of a drag on China’s domestic manufacturing sector than during the GFC. Chart 4Logistics Bottleneck Still In Place Logistics Bottleneck Still In Place Logistics Bottleneck Still In Place Additionally, the drawdown in April’s raw material inventory and an increase in the official PMI’s supplier delivery subcomponents suggest that some lingering logistical bottlenecks may be at play, preventing China’s domestic business operations from recuperating at full speed (Chart 4). We expect a further relaxation of intra- and inter-provincial travel restrictions following the National People’s Congress (NPC) on May 22 in Beijing. This easing should help to accelerate the normalization in both manufacturing activities and inventory levels. The outperformance of Chinese equity prices versus global stocks has eased significantly in the past month (Table 3 and Chart 5). The moderation suggests that investors may be starting to factor in a slower-than-expected economic recovery in China. Near-term risks are still high for further selloffs in both Chinese and global stocks. Nevertheless, we think the rapid advancement in global stock prices in the past month, particularly the SPX, means that Chinese stocks are not as overbought as in February and March. The widening gap between US equity prices and economic fundamentals makes the SPX more vulnerable to near-term uncertainties surrounding global economic recovery. We maintain our view that a combination of massive Chinese stimulus and the momentum in China’s economic recovery in H2 should support an outperformance in Chinese stocks in the next 6 to 12 months. Table 3Chinese Stocks Advanced Much Less Than SPX In April China Macro And Market Review China Macro And Market Review Chart 5Chinese Stocks Less Overbought Now Chinese Stocks Are Less Overbought Now Chinese Stocks Are Less Overbought Now The bull steepening in the government bond yield curve since March 23 flattened a bit in the last week of April, but it remains heightened with the short end of the yield curve falling much faster than the long end (Chart 6). This suggests that domestic investors expect China’s ultra-easy monetary policy to remain in place in the near term due to uncertainties surrounding the global pandemic and a slow economic upturn. At the same time, investors do not believe the weakness in the Chinese economy will persist long enough to warrant a sustained easy monetary policy regime. In addition, China’s 10-year government bond yield fell by 60bps so far this year, about half of the drop in the 10-year US Treasury bond yield (Chart 6, bottom panel). Even though we think the long end of the government bond yield curve has yet to bottom,2 the relatively stable return and RMB exchange rate make Chinese government bonds a safe bet for global investors seeking less risky assets. Chart 6Chinese 10-Year Government Bond Yield Has Not Capitulated Chinese 10-Year Government Bond Yield Has Not Capitulated Chinese 10-Year Government Bond Yield Has Not Capitulated Chart 7Chinese Onshore Corporate Bonds Still Offer Solid Returns Chinese Onshore Corporate Bonds Still Offer Solid Returns Chinese Onshore Corporate Bonds Still Offer Solid Returns Chart 7 highlights that the ChinaBond Corporate Bond total return index remains in a solid uptrend in both local currency and USD terms, despite the incredible strength in the USD since March. We continue to recommend onshore corporate bond positions in the coming 6-12 months.For domestic investors, we favor a diversified portfolio of SOE corporate bonds. Even though bond defaults will likely rise in the next 6-12 months, they will probably remain lower than what the market is  currently pricing in.     Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1NBS’s interpretation of China April PMI.  http://www.stats.gov.cn/tjsj/sjjd/202004/t20200430_1742576.html  2Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Low-Rated Junk Returns Are Lagging Low-Rated Junk Returns Are Lagging Low-Rated Junk Returns Are Lagging The story of bond markets in April is a story about the Federal Reserve. Traditional relationships have broken down and clear divisions have formed between sectors that are receiving Fed support and those that are not. For example, we would usually expect the riskiest (i.e. lowest-rated) pockets of the corporate bond market to perform worst in down markets and best in up markets. However, Fed intervention has disrupted this dynamic since the central bank announced a slew of emergency lending facilities on March 23. Since then, Baa and Ba rated corporates – sectors that benefit from Fed support – have behaved as usual, but lower-rated junk bonds – sectors that remain cut off from Fed support – have lagged (Chart 1). To take advantage of this disruption, we continue to advocate a strategy of favoring sectors that have attractive spreads and that benefit from Fed support. Appendix A of this report presents returns across a range of fixed income sectors since the Fed’s intervention began on March 23. We will update this table regularly going forward to keep tabs on the policy-driven disruptions to typical bond market behavior. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 455 basis points in April, bringing year-to-date excess returns up to -871 bps. The average index spread tightened 70 bps on the month, and 171 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, even after all that tightening, the index spread remains 113 bps wider than it was at the end of last year (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support through the SMCCF and PMCCF.1 The sector therefore meets both of our criteria for purchase and we recommend an overweight allocation. One note of caution is that, as Chair Powell emphasized at last week’s FOMC press conference, the Fed has lending powers but not spending powers. That is, it can forestall bankruptcy for eligible firms by offering loans, but many firms will still see their credit ratings downgraded if they become saddled with debt. Already, Moody’s downgraded 219 issuers in March and upgraded only 19 (panel 4). Downgrades surely continued through April and will persist in the months ahead. With that in mind, there is value in favoring sectors and firms that are unlikely to face downgrade during the recession. As we explained in last week’s report, subordinate bank bonds are attractive in this regard.2 Banks remain very well capitalized and subordinate bonds offer greater expected returns than higher-rated senior bank debt.  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Policy-Driven Bond Market The Policy-Driven Bond Market Table 3B The Policy-Driven Bond Market The Policy-Driven Bond Market High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 420 basis points in April, bringing year-to-date excess returns up to -1308 bps. The average index spread tightened 136 bps on the month, and 356 bps since the Fed unveiled its corporate bond purchase programs on March 23 (Chart 3A). As noted on page 1, the junk bond market is experiencing unusually large return differentiation between credit tiers. This is because the Fed is offering support to the higher-rated segments of the market (Ba and some B), while the lower-rated tiers have been left out in the cold.3 We recommend that investors overweight Ba-rated junk bonds because that sector meets our criteria of offering elevated spreads compared to history and benefitting from Fed support. However, we will only recommend owning bonds rated B and lower if those sectors offer adequate compensation for expected default losses. On that note, Chart 3B shows the relationship between 12-month B-rated excess returns and the Default-Adjusted Spread. We define three scenarios for default losses: The mild scenario is a 6% default rate and 25% recovery rate, the moderate scenario is a 9% default rate and 25% recovery rate, the severe scenario is a 12% default rate and 25% recovery rate. Our base case expectation lies somewhere between the moderate and severe scenarios. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios The Policy-Driven Bond Market The Policy-Driven Bond Market As Chart 3B makes plain, B-rated spreads don’t offer adequate compensation for our base case default loss scenario. The same hold true for credits rated Caa & lower.4 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 48 basis points in April, bringing year-to-date excess returns up to -34 bps. The conventional 30-year zero-volatility spread tightened 24 bps on the month, split between 18 bps of option-adjusted spread (OAS) tightening and a 6 bps reduction in expected prepayment losses (aka option cost). Agency MBS benefit a great deal from Fed intervention. In fact, the Fed is aggressively purchasing the securities in the secondary market. However, we see better opportunities elsewhere in US fixed income. MBS spreads have already completely recovered from March’s sell off and spreads are low compared to other sectors. The conventional 30-year MBS OAS is 70 bps below the Aa-rated corporate OAS (Chart 4), 82 bps below the Aaa-rated consumer ABS OAS, 135 bps below the Aaa-rated non-agency CMBS OAS and 48 bps below the Agency CMBS OAS. Moreover, the primary mortgage rate has still not declined very much despite this year’s huge fall in Treasury yields. This leaves open the possibility that the mortgage rate could come down in the coming months, leading to a renewed spike in refinancing activity. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 44 basis points in April, bringing year-to-date excess returns up to -626 bps. Sovereign debt underperformed duration-equivalent Treasuries by 69 bps on the month, dragging year-to-date excess returns down to -1434 bps. Foreign Agencies outperformed the Treasury benchmark by 151 bps in April, bringing year-to-date excess returns up to -888 bps. Local Authority debt outperformed Treasuries by 98 bps in April, bringing year-to-date excess returns up to -859 bps. Domestic Agency bonds outperformed by 16 bps, bringing year-to-date excess returns up to -87 bps. Supranationals outperformed by 24 bps, bringing year-to-date excess returns up to -39 bps. USD-denominated Sovereign bonds didn’t rally alongside US corporate credit in April. Rather, spreads widened on the month since the sector only benefits modestly from Fed intervention via currency swap lines for a select few countries.5 The result of April’s underperformance is that Sovereign spreads are no longer very expensive compared to US corporate credit (Chart 5). A buying opportunity could emerge in USD-denominated Sovereign debt during the next few months, but we would want to see signs of emerging market currencies forming a bottom versus the dollar before making that call. As of now, EM currencies continue to weaken (bottom panel). Municipal Bonds: Overweight Chart 6State & Local Governments Need Support State & Local Governments Need Support State & Local Governments Need Support Municipal bonds underperformed the duration-equivalent Treasury index by 167 basis points in April, dragging year-to-date excess returns down to -909 bps (before adjusting for the tax advantage). The spreads between Aaa-rated municipal yields and Treasury yields tightened at the short end of the curve but widened significantly at the long end (Chart 6). Specifically, the 2-year spread tightened 18 bps on the month and the 5-year spread tightened 7 bps on the month. However, the 10-year, 20-year and 30-year spreads widened 6 bps, 32 bps and 34 bps, respectively. The divergence between spread changes at the short and long ends of the curve is once again the result of Fed intervention. The Fed’s Municipal Liquidity Facility initially promised to extend credit to state & local governments for a maximum maturity of 2 years. This was later extended to three years and several other changes were made to allow more municipalities to access the facility.6 We see a buying opportunity in municipal bonds at both long and short maturities. First and foremost, the Fed has already shown that it is willing to modify the scope of its lending facilities if some segments of the market are in distress, and the moral hazard argument against lending to state and local governments is weak when the Fed is already active in the corporate sector. Second, despite Senate Majority Leader Mitch McConnell’s posturing, Congress will likely authorize more direct aid to distressed state & local governments in the coming weeks.7 All in all, elevated spreads offer a compelling buying opportunity in municipal debt.   Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in April. The 2-year/10-year Treasury slope flattened 3 bps on the month to 44 bps. The 5-year/30-year slope flattened 6 bps on the month to 92 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.8 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.9 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 198 basis points in April, bringing year-to-date excess returns up to -552 bps. The 10-year TIPS breakeven inflation rate rose 21 bps to 1.08%. The 5-year/5-year forward TIPS breakeven inflation rate rose 17 bps to 1.43%. As we noted in a recent report, March’s market crash created an extraordinary amount of long-run value in TIPS.10 For example, the 10-year and 5-year TIPS breakeven inflation rates are down to 1.08% and 0.68%, respectively. This means that a buy & hold position long TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.68% for the next five years, or greater than 1.08% for the next ten (Chart 8). This seems like a slam dunk. On a shorter time horizon, investors should also consider entering real yield curve steepeners.11 The recent collapse in oil prices drove down short-dated inflation expectations. This, in turn, caused short-maturity real yields to rise because the Fed’s zero-lower-bound policy has killed nominal yield volatility at the short-end of the curve (panels 4 & 5). During the last recession, the real yield curve steepened sharply once oil prices troughed in 2008. We think now is a good time to position for a similar outcome.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed securities outperformed the duration-equivalent Treasury index by 117 basis points in April, bringing year-to-date excess returns up to -203 bps. The index option-adjusted spread for Aaa-rated ABS tightened 51 bps on the month to 140 bps. It remains 100 bps above where it was at the beginning of the year. Aaa-rated consumer ABS meet both our criteria to own. Index spreads are elevated compared to typical historical levels and the sector benefits from Fed support through the TALF program.12 Specifically, TALF allows investors to borrow against Aaa ABS collateral at a rate of OIS + 125 bps. The current index yield remains above that level (Chart 9).13 The combination of attractive valuations and strong Fed support makes this sector a buy. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -789 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 19 bps on the month to 190 bps. Aaa-rated CMBS actually outperformed duration-matched Treasuries by 100 bps in April, in contrast to the lower credit tiers, which lagged. Once again, the divergence between Aaa and lower credit tier performance is driven by the Fed. Aaa-rated CMBS benefit from TALF, while lower-rated securities do not.14 In fact, TALF borrowers can access the facility at a rate of OIS + 125 bps. The index yield remains well above this level (Chart 10).   The combination of attractive valuation and strong Fed support makes Aaa-rated non-agency CMBS a buy. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 144 basis points in April, bringing year-to-date excess returns up to -221 bps. The average index spread tightened 27 bps on the month to 103 bps, still well above typical historical levels (panel 4). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities The Policy-Driven Bond Market The Policy-Driven Bond Market Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 30 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 30 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Policy-Driven Bond Market The Policy-Driven Bond Market Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market ​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For a more detailed description of the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 4 For a more detailed analysis of Default-Adjusted Spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 The complete list of countries, and more detailed analysis of the swap lines, is found in US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For more details on the MLF 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 7 Please see Geopolitical Strategy Weekly Report, “Drowning In Oil (GeoRisk Update)”, dated April 24, 2020, available at gps.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 9 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 11 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 12 For details of TALF 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 13 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights ECB: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. Euro Area High-Yield: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios. Feature Chart 1Will Growth Trump Liquidity For Euro Area Junk Bonds? Will Growth Trump Liquidity For Euro Area Junk Bonds? Will Growth Trump Liquidity For Euro Area Junk Bonds? Over the past week, investors heard from the three major developed market central banks – the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BoJ). The Fed and BoJ did little to seriously impact financial markets, offering only strengthened forward guidance on already hyper-easy policy settings along with some expansion of existing asset purchase programs (involving municipal bonds for the Fed, JGBs and Japanese corporate bonds for the BoJ). The ECB was the most interesting of the three, because of what was NOT done – namely, an increase in the amount of asset purchases – and what it implies about the policy debate within the central bank on how to deal with Italy. The hit to the euro area economy from the COVID-19 lockdowns has been sharp and brutal, pushing the entire region quickly into deep recession (Chart 1). Given such a severe hit to growth, and with policy interest rates already at zero (or even negative), the only avenue for the ECB to deliver more stimulus is through expanding its balance sheet through asset purchases and liquidity provision to banks. This makes the ECB’s next moves on its balance sheet critical for determining the future path of European risk assets like equities and high-yield corporate bonds – the latter of which we discuss later in this report. A Cautious Next Step From The ECB Chart 2An Unprecedented Economic Collapse An Unprecedented Economic Collapse An Unprecedented Economic Collapse The need for the ECB to do something at last week’s monetary policy meeting was obvious. Real GDP for the entire region is estimated to have contracted -3.8% on a year-over-year basis in the first quarter of the year. At the country level, large declines occurred in France (-5.8%), Italy (-4.7%) and Spain (-5.2%) that were far greater than seen during the 2009 recession. The decline was broad-based across industries as well, with the European Commission’s (EC) business confidence indices collapsing in April for manufacturing, services, retail and construction (Chart 2). The bottom has also fallen out on the EC price expectations indices, suggesting that outright deflation across the euro area is just around the corner. The ECB last week provided what were called “alternative scenarios” for the impact of COVID-19 on euro area growth. We presume these are meant to be an alternative to the most recent set of ECB economic projections that were published in March that now look wildly optimistic given the COVID-19 lockdowns. The revised scenarios now call for a real GDP contraction in 2020 of anywhere from -5% to -12%, with only a partial recovery of those losses in 2021.1 The central bank also provided an estimate of the output loss by industry from COVID-19 related lockdowns (Table 1) – a staggering -60% for retail, transportation, accommodation and food services and -40% for manufacturing and construction. Table 1The Lockdown Has Been Painful For Europe The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually Against this horrendous growth and inflation backdrop, with forecasts being slashed, the expectation was that the ECB would ramp up the size of its bond buying programs to try and ease financial conditions further. That would help cushion the growth downturn and attempt to put a floor under collapsing inflation expectations (Chart 3). Yet at last week’s monetary policy meeting, the ECB announced the following: No changes in policy interest rates No increase in the size of the Asset Purchase Program (APP) from the existing €120bn or Pandemic Emergency Purchase Program (PEPP) from the existing €750bn For existing targeted long-term refinancing operations (TLTROs) between June 2020 and June 2021, interest rates were lowered by -25bps A new long-term refinancing operation for euro area banks was introduced called the Pandemic Emergency Long Term Refinancing Operation (PELTRO), which would offer liquidity to euro area banks on a monthly basis until December, at an interest rate of -0.25%. The increased use of LTROs was an easier way for the ECB Governing Council to avoid a potential credit crunch if euro area banks become more risk averse. The ECB clearly wants to take no chances on banks reining in loan activity. The latest ECB Bank Lending Survey, released just two days before last week’s policy meeting, showed a modest tightening of standards for bank loans to businesses in the first quarter of 2020. This was most visible in Germany and Italy, with France actually showing a slight decline in the net percentage of banks tightening lending standards (Chart 4). The survey also showed that euro area banks expected a significant net easing of lending standards in response to the loan guarantees and liquidity support measures announced by European governments to mitigate the impact of COVID-19 lockdowns. Chart 3Expanding The Balance Sheet Is The Only Tool The ECB Has Left Expanding The Balance Sheet Is The Only Tool The ECB Has Left Expanding The Balance Sheet Is The Only Tool The ECB Has Left Chart 4The ECB Wants To Avoid A Credit Crunch The ECB Wants To Avoid A Credit Crunch The ECB Wants To Avoid A Credit Crunch With bank lending growth across the entire euro area having already increased to 4.9% on a year-over-year basis in March, the fastest pace in two years, the ECB clearly wants to take no chances on banks reining in loan activity - even if those loans are merely for stressed companies tapping existing credit lines, or taking advantage of government loan guarantees to minimize layoffs in a deep recession. Another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP. However, there was likely an additional reason why the ECB chose the LTRO route over ramping up asset purchases – internal political divisions over Italy. Chart 5Italian Financial Stability Remains Critical For The ECB Italian Financial Stability Remains Critical For The ECB Italian Financial Stability Remains Critical For The ECB There remain some on the ECB Governing Council that do not wish to keep buying more BTPs, thus giving Italy a blank check to run even larger budget deficits. The unique nature of the COVID-19 outbreak has somewhat loosened those biases against the highly indebted countries of southern Europe, as evidenced by the inclusion of Greek bonds in the PEPP shopping list. Yet there are still many within the ECB, and within the governments of the “hard money” countries of the euro area, who would prefer to see Italy get monetary support for greater deficit spending through ECB vehicles with conditionality like Outright Monetary Transactions (OMT). Given these internal divisions over Italy, an increase in the size of the existing asset purchase schemes will only take place if there is a major increase in Italian risk premiums that threatens the financial stability of the entire euro area. On that front, risk indicators like the BTP-Bund spread and credit default spreads on Italian banks have risen over the past month, but remain well below the stressed levels witnessed during the Global Financial Crisis and the European Debt Crisis (Chart 5). Additionally, Italian bank stocks have actually been outperforming their euro area peers since early 2019, while the Italy-Germany spread curve is not inverted (2-year spreads higher than 10yr spreads) as occurred in 2011 when investors feared Italy would crash out of the euro. With Italian government yields still at relatively low and manageable levels, even as the highly-indebted Italian government has stated that its budget deficit will surge to -10% of GDP to provide stimulus to a virus-ravaged economy, there is no pressure on the ECB to increase the size of the PEPP that was just announced less than two months ago. Yet even with all the internal divisions, another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP to prevent a broader tightening of euro area financial conditions. For this reason, we continue to recommend a strategic (6-12 months) overweight stance on Italian government bonds within global fixed income portfolios. Bottom Line: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. A Quick Look At Euro Area High-Yield Valuation We recently upgraded our recommended investment stance on euro area investment grade corporate bonds to neutral.2 This shift was based on the ECB increasing the amount of its corporate bond purchases as part of its COVID-19 monetary easing measures, coming after the Fed announced its own new programs to buy US investment grade corporates. With the major central banks providing direct support to higher quality corporates, the left side of the return distribution for those bonds eligible for these purchase programs has effectively been reduced. This warrants a higher weighting for those bonds in investor portfolios. For high-yield corporates, the story is more nuanced. Both the Fed and ECB have announced that investment grade bonds purchased in their bond buying programs, which are then subsequently downgraded to below investment grade, can stay on the balance sheet of those programs. This makes Ba-rated junk bonds – the highest credit tier below investment grade – a relatively more attractive bet within the overall high-yield universe, both in the US and Europe. Although the lack of a direct central bank bid still makes high-yield corporates a riskier bet in a recessionary environment where default losses will surely increase. This means rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. To evaluate the attractiveness of euro area high-yield corporates, we use three different approaches that use relative value to other credit markets, or more intrinsic value based on potential credit losses. Relative spreads vs. euro area investment grade One way to assess the value of euro area high-yield is to compare its credit spread to that of higher-rated euro area investment grade corporate bonds. Since movements in both spreads are highly correlated, as they both benefit from accelerating euro area economic growth (and vice versa), any change in spreads between the two could represent a relative value opportunity. Currently, the option-adjusted spread (OAS) of the euro area high-yield benchmark index (635bps) is 449bps over that of the investment grade index (186bps), using Bloomberg Barclays index data (Chart 6). While this is a relatively wide spread differential for the years since the 2008 financial crisis, it is not a particularly large gap during a recession that is likely to be deeper than the 2009 downturn. The same argument holds when looking at the ratio of the euro area high-yield OAS to the investment grade OAS, which is only at average levels for the post crisis period (3rd panel). 12-month breakeven spreads One of our favorite credit valuation tools is the 12-month breakeven spread, which measures the amount of spread widening over a one-year horizon that would make the total return of a corporate bond equal to that of a duration-matched government bond. We apply that calculation to data for an entire spread product sector, like investment grade or high-yield, to determine a breakeven spread for that sector. We then look at the percentile ranks of the breakeven spread versus its own history to determine if that particular fixed income sector looks relatively attractive. Rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. On that basis, euro area high-yield corporates, across all credit tiers, offer somewhat attractive spreads, with 12-month breakevens in the upper half of the historical distribution (Chart 7). US high-yield, by comparison, offers far more attractive spreads with 12-month breakevens in the upper quartile of their historical distribution across all credit tiers. Only the riskiest Caa-rated bonds are in the top 25% of the distribution in the euro area (Chart 8). Chart 6In The Euro Area, HY Is Not That Cheap Versus IG In The Euro Area, HY Is Not That Cheap Versus IG In The Euro Area, HY Is Not That Cheap Versus IG Chart 712-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... 12-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... 12-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... Chart 8… But Not Versus US High-Yield The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually The overall attractiveness of US high-yield versus euro area equivalents can also be seen when comparing the benchmark index yields in common currency terms. For the overall indices, euro area junk bond yields, hedged into USD dollars, offer a yield of 7.8%, virtually equal to the 8.0% yield in the US (Chart 9), although more material differences do exist within credit tiers. Chart 9A Comparison Of Junk Bond Yields In The Euro Area & The US The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually Default-adjusted spreads The other metric that we use to assess the value of high-yield corporate bonds is default-adjusted spreads. This measure takes the high-yield index OAS and subtracts credit losses to determine an “excess” spread. We look at the current default-adjusted spread versus its long-run average to determine if high-yield spreads offer an attractive valuation cushion relative to expected credit losses. To determine the credit losses, we need the default rate, and the recovery rate given default, for the overall high-yield market. For defaults, we will use the output of our euro area default rate model (Chart 10). The model uses four variables: lending standards for businesses from the ECB bank lending survey, high-yield ratings downgrades as a share of all rating actions, euro area real GDP growth, and the median debt-to-equity ratio for a sample of issuers in the euro area high-yield space. All the variables are advanced such that the model produces a one-year-ahead forecast of expected high-yield defaults.3 Our high-yield model is projecting that the euro area default rate will climb to 11% by the end of 2020, before declining to 8% mid-2021 as the euro area economy recovers from the 2020 recession. For the euro recovery rate, we are using a range based on the historical experience during recessions (30%) and recoveries (45%). Using our default rate model projection, and that range of recovery rates, we can produce a range of euro area default-adjusted spreads. Euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. In Chart 11, we show the history of the euro area default adjusted spread. We have added the long run average (358bps) and the +/1 standard deviation of the spread. Spreads at or lower than -1 standard deviation are considered expensive (i.e. the high-yield index spread is too low relative to credit losses), and vice versa. The shaded box in the bottom right corner of the chart represents our forecasted default-adjusted spread for the next year. Chart 10Our Model Says The Euro Area Default Rate Will Surpass 10% Our Model Says The Euro Area Default Rate Will Surpass 10% Our Model Says The Euro Area Default Rate Will Surpass 10% Chart 11Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Chart 12An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted Our projected spread range over the next twelve months is 218bps to -112bps, well below the long-run average and at the low end of the historical distribution. We conclude from this analysis that current euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. Given the lack of a compelling valuation argument under all our metrics, we are leaving our recommended investment stance on euro area high-yield bonds at underweight. We continue to focus our recommended global spread product allocations on overweights in markets where there is direct and explicit support from policymaker purchase programs: US investment grade bonds with maturity of less than five years, US Ba-rated high-yield bonds, and UK investment grade corporates. This selectively overweight investment stance on global credit is warranted from a risk management perspective, as well. Our “Pro-Risk Checklist” of indicators that would lead us to recommend a more aggressive stance on risk assets in general, and spread product in particular, is still flashing a cautious message (Chart 12). The US dollar continues to strengthen (exacerbating global deflation and dollar funding pressures); the VIX index of US equity volatility has fallen below our threshold of 40, but not by much; and the number of new global (ex-China) COVID-19 cases is showing mixed results, falling in the US and Italy but increasing elsewhere. Bottom Line: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The alternative ECB growth forecasts can be found here: https://www.ecb.europa.eu/pub/economic-bulletin/focus/2020/html/ecb.ebbox202003_01~767f86ae95.en.html 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 3 For real GDP growth, we use Bloomberg consensus forecasts for the next four quarters in the model. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The ECB Will Do Whatever It Takes … Eventually The ECB Will Do Whatever It Takes … Eventually Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Global equities have seen an astonishing rally since mid-March, rising by 28%. This leaves them only 13% below their level at the beginning of the year. This is particularly remarkable given the unprecedented decline in economic activity with, for example, US GDP shrinking by an annualized 4.8% quarter-on-quarter in Q1, and the consensus forecasting it to fall by as much as 30% in Q2. Given this, risk assets are pricing in a highly optimistic trajectory over the coming months: a rapid return to normalcy, a V-shaped economic recovery, and minimal side-effects from the sudden stop to the world economy. In our Q2 Quarterly, we wrote we would turn more cautious if the S&P 500 moved quickly above 2,750.1 With it now at 2910, we are therefore lowering our recommendation on global equities on a 12-month horizon from Overweight to Neutral. The balance of probabilities – and the possibility of a second wave of the pandemic, rising corporate defaults, and problems among EM borrowers – simply does not justify an outright risk-on stance. Bear markets typically end 3-4 months before the economy bottoms (Table 1). If March was the low for stocks, therefore, this implies that the recession will end in June or July. BCA Research’s view is that the recovery is more likely to be U-shaped than V-shaped. Table 1Stocks Bottom On Average 3-4 Months Before The Recession Ends Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Chart 1New COVID-19 Cases Have Peaked New COVID-19 Cases Have Peaked New COVID-19 Cases Have Peaked What triggered the rally? Most notably, it anticipated a peaking of new COVID-19 cases in the world outside China (Chart 1). Several countries, notably Spain and Italy, have already felt able to ease quarantine rules, and others will do so during May. This raises the possibility that the pandemic will largely be over by July (except perhaps in a few developing countries, such as Brazil, where strict containment was shunned). The rally was fueled by unprecedented fiscal and monetary measures taken by the authorities everywhere. In the US, for example, the various new Federal Reserve liquidity programs add up to $4.2 trillion (20% of GDP) (Chart 2). The balance-sheets of major global central banks, particularly the Fed's, have ballooned in just a few weeks (Chart 3). As a result, US money supply and dollar liquidity have soared (Chart 4). Normally, when there is a flood of liquidity over and above what is needed to fund the real economy, that excess liquidity flows into asset markets, weakens the dollar, and boosts commodities and Emerging Markets. But these are not normal times. Liquidity injections amid deteriorating economic conditions cushion the downside but do not necessarily improve the outlook immediately – as we witnessed in 2007-2008.   Chart 2Multiple New Stimulus Programs… Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Chart 3...Made Central Bank Balance-Sheets Balloon... ...Made Central Bank Balance-Sheets Balloon... ...Made Central Bank Balance-Sheets Balloon... Chart 4...And Dollar Liquidity Soar ...And Dollar Liquidity Soar ...And Dollar Liquidity Soar Chart 5Pandemics Usually Have Several Waves Pandemics Usually Have Several Waves Pandemics Usually Have Several Waves The biggest risk is that the pandemic lingers. Epidemiologists agree that COVID-19 will not disappear until (1) a vaccine is available, likely to be 12-18 months (if one is possible at all – there is still no vaccine for HIV or SARS), or (2) 65-80% of the population has had the disease, creating “herd immunity”. Maybe a vaccine will be ready sooner, or a therapeutic treatment will drastically lower the mortality rate – but investors should not bet on it. It is worth remembering that the last big pandemic, the Spanish ‘flu of 1918-1919, had several waves, with the second the deadliest (Chart 5). It is possible that each time governments ease containment measures, the number of new cases will rise again. And even if they don’t, how likely is it that consumers will go back to shopping, eating in restaurants, or travelling as before? Big data from China show a general return to work but not to going out for entertainment (Chart 6). This is likely to remain a drag on the economy for a considerable period.   Chart 6Chinese Remain Reluctant To Go Out Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Moreover, the fiscal and stimulus packages will help to tide over households and companies in advanced economies during the toughest times – replacing lost wages, and providing bridging loans – but they do not solve the fundamental problem for firms that have lost most of their revenues. US corporate debt is at its highest percentage of GDP in recent history – and the ratio is even higher in parts of Europe, Japan, and China (Chart 7). Bankruptcies are likely to rise, which will make banks more cautious about lending, further tightening credit conditions. Moreover, stimulus packages won’t help Emerging Market borrowers, which have around $4 trillion of outstanding foreign-currency-denominated debt. With the sharp rise in EM credit spreads and fall in currencies over the past three months, many will struggle to service and repay this debt (Chart 8). Chart 7Corporate Debt Is At A Worrying Level Corporate Debt Is At A Worrying Level Corporate Debt Is At A Worrying Level Chart 8EM Dollar Borrowers Will Struggle EM Dollar Borrowers Will Struggle EM Dollar Borrowers Will Struggle     Portfolio construction is about probabilities. The scenario priced into risk assets currently – a rapid return to the status quo ante – could turn out to be correct. But there is a significant probability that it does not. We therefore recommend taking some risk off the table. We would not switch into quality government bonds as a hedge, since current yields would give little return even in a disastrous economic scenario – and could produce very negative returns if inflation picks up. We, rather, recommend Overweights in cash and gold, and a relatively low-beta tilt within equities.  Equities: Valuations, especially in the US, have not hit typical market-bottom levels. The price/book ratio for US equities, for example, troughed only at 2.9 in March, compared to a bear-market low of 1.5 in 2009 (Chart 9). Earnings will probably be revised down further: the consensus still expects only a 12% decline in S&P 500 EPS in 2020 (and a 21% jump next year); earnings revisions are usually closely correlated to stock prices (Chart 10). We, therefore, remain cautious in our regional equity positioning, with an Overweight on US stocks, and a somewhat defensive sector tilt (Overweights in IT and Healthcare, along with Industrials as a play on Chinese stimulus). One factor to watch: any sustained pickup in value and small-cap stocks, which showed some signs of appearing in late April (Chart 11). This has historically signaled the beginning of a bull market. Chart 9US Valuations Are Not At Usual Bottom Lows US Valuations Are Not At Usual Bottom Lows US Valuations Are Not At Usual Bottom Lows Chart 10Weak Earnings Can Drag Markets Down Further Weak Earnings Can Drag Markets Down Further Weak Earnings Can Drag Markets Down Further     Chart 11When Will Value And Small Caps Pick Up? When Will Value And Small Caps Pick Up? When Will Value And Small Caps Pick Up? Fixed Income: Quality government bonds look highly unattractive at current yields. Our calculations suggest only an 6.7% return from 10-year US Treasuries and 4.6% from Bunds even if their yields fall to the lowest possible level, 0% and -1% respectively. Inflation-linked bonds, especially in the US, the UK, Australia and Canada, look very undervalued, however.2 US 10-year breakevens have fallen to as low as 1.1% (Chart 12). In spread product, the best strategy at the moment is to buy what central banks are buying. That means investment-grade bonds in the US and Europe, Fallen Angels3  (since both the Fed and ECB will backstop bonds that were downgraded to junk in the past month), US Aaa CMBS and ABS, Agency CMBS, and munis. But the riskier end of the junk-bond universe looks unattractive. Even a moderate default cycle (with a 9% default rate for junk bonds – compared to 15% in the last recession – and a 25% recovery rate) would point to an excess return from B-rated corporate bonds of -20% over the next 12 months (Chart 13). Chart 12TIPS Look Very Cheap TIPS Look Very Cheap TIPS Look Very Cheap Chart 13Avoid The Lower End Of Junk Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Currencies: The dollar has moved sideways on a trade-weighted basis over the past two months. We remain Neutral, since in the short term the dollar could face upward pressure as a safe-haven play, especially versus Emerging Market currencies, if investors start to worry again about growth. In the longer run, however, the dollar looks expensive relative to purchasing power parity (Chart 14), and interest-rate differentials no longer favor it as they have done over much of the past decade (Chart 15). BCA Research’s FX strategists recommend a barbell strategy in currencies, with Overweights in cheap cyclical currencies such as the Canadian dollar and Norwegian krone, as well as safe havens such as the yen.4 Chart 14Dollar Is Expensive... Dollar Is Expensive... Dollar Is Expensive... Chart 15...And No Longer Benefits From Higher Rates ...And No Longer Benefits From Higher Rates ...And No Longer Benefits From Higher Rates     Commodities: After the extraordinary behavior of near-month WTI futures in April, the crude price should settle down. BCA Research’s energy strategists argue that renewed production cuts from Saudi Arabia and Russia, combined with a near-normalization in demand in H2, should push crude-oil balances back into a supply deficit by Q3 (Chart 16). Chart 16Oil Price Should Rise In H2 Oil Price Should Rise in H2 Oil Price Should Rise in H2 They forecast Brent to rise to $42 a barrel by the end of 2020, compared to $24 now. Industrial metals prices have generally remained depressed, despite the recovery in risk assets (Chart 17). But the effects of Chinese stimulus, combined with a weaker dollar, should cause them to recover later in the year (Chart 18). Gold remains a good hedge against further economic shocks or an eventual resurgence in inflation. Chart 17Metal Prices Haven't Recovered... Metal Prices Haven't Recovered... Metal Prices Haven't Recovered... Chart 18...But Should Soon Benefit From Chinese Stimulus ...But Should Soon Benefit From Chinese Stimulus ...But Should Soon Benefit From Chinese Stimulus   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 2  Please see Global Fixed Income Strategy, "Global Inflation Expectations Are Now Too Low," dated April 28, 2020. 3  Bonds that have recently been downgraded from investment grade to sub-investment grade. 4  Please see Foreign Exchange Strategy, "QE And Currencies," dated April 17, 2020. GAA Asset Allocation  

Highlights The global economy will contract at its fastest pace since the early 1930s, but will not slump into a depression. Easy monetary conditions, an extremely expansive fiscal policy, and solid bank and household balance sheets are crucial to the economic outlook. Risk assets remain attractive. The dollar and bonds will soon move from bull to bear markets. The credit market offers some attractive opportunities. Stocks are vulnerable to short-term profit-taking, but the cyclical outlook remains bright. Favor energy and consumer discretionary equities. Feature What a difference a month makes. US and global equities have rallied by 31.4% and 28.3% from their March lows, respectively. Last month we recommended investors shift the weighting of their portfolios to stocks over bonds. April’s dramatic turnaround has not altered our positive view of equities on a 12- to 24-month basis, especially relative to government bonds. However, the probability of near-term profit taking is significant. The spectacular dislocation in the oil market also has grabbed headlines. This was a capitulation event. Hence, assets linked to oil are now cyclically attractive, even if they remain volatile in the coming weeks. It is time to buy energy equities, especially firms with solid balance sheets and proven dividend records. Under the IMF’s base case, the resulting output loss will total $9 trillion. Finally, the Federal Reserve’s large liquidity injections have dulled the dollar’s strength. While the USD still has some upside risk in the near term, investors should continue to transfer capital into foreign currencies. A weaker dollar will be the catalyst to lift Treasury yields and will contribute to the outperformance of energy stocks. Dismal Growth Versus Vigorous Policy Responses Chart I-1Consumer Spending Is In Freefall Consumer Spending Is In Freefall Consumer Spending Is In Freefall The economic lockdowns and the collapse in consumer confidence continue to take their toll on the US and global economies (Chart I-1). The eventual end of the shelter-at-home orders and the progressive re-opening of the economy will halt this trend. The rapid monetary and fiscal easing worldwide will allow growth to recover smartly in the second half of the year, but only after authorities loosen extreme social distancing measures. The Economy Is In Freefall… First-quarter US growth is already as weak as it was at the depth of the recession that followed the Great Financial Crisis. The second quarter will be even more anemic. Our Live-Trackers for both the US and global economies either continue to collapse or have flat-lined at rock-bottom levels (Chart I-2). US industrial production is falling at a 21% quarterly annualized rate and the weakness in the PMI manufacturing survey warns that the worst is yet to come. In March, retail sales contracted by 8.7% compared with February, which was the poorest reading on record, and year-on-year comparisons will only deteriorate further. Annual GDP growth could fall below -11% next quarter with both the industrial and consumer sectors in shock, according to the New York Fed Weekly Economic Index (Chart I-3). Chart I-2No Hope From The Live Trackers May 2020 May 2020 Chart I-3Real GDP Growth Is Melting Real GDP Growth Is Melting Real GDP Growth Is Melting The IMF expects the recession to eclipse the post GFC-slump, in both advanced and emerging economies. Its most recent World Economic Outlook describes base-case 2020 growth of -5.9%, -7.5%, and -1.0% in the US, Eurozone and emerging markets, respectively. This compares with -2.5%, -4.5% and 2.8% each in 2009. If a second wave of infections forces renewed lockdowns in the fall, then 2020 growth could be 5.12% and 4.49% lower than baseline in developed markets and emerging markets, respectively. Under the IMF’s base case, the resulting output loss will total $9 trillion in the coming 3 years (Chart I-4). Chart I-4An Enormous Output Gap Is Forming May 2020 May 2020 Chart I-5Disinflation Build-Up Disinflation Build-Up Disinflation Build-Up An output gap of the magnitude depicted by the IMF will dampen inflation for the next 12 to 24 months. In addition to the shortfall in aggregate demand, imploding economic confidence and the lag effect of the Fed’s monetary tightening in 2018 will pull down the velocity of money even further. This combination will reduce US inflation to 1.5% or lower (Chart I-5, top panel). The Price Paid component of both the Philly Fed and Empire State Manufacturing Surveys already captures this impact. The return of producer price deflation in China guarantees that weak US import prices will add to domestic deflationary pressures (Chart I-5 third panel). The recent strength in the dollar will only amplify imported deflation (Chart I-5, bottom panel). A deflationary shock is an immediate problem for businesses and creates a huge risk for household incomes because it exacerbates the already violent contraction in aggregate demand. In the coming months, the weakest nominal GDP growth since the Great Depression will depress profits. BCA Research’s US Equity Strategy team expects S&P 500 operating earnings per share to drop from $162 in 2019 to no further than $104 in 2020.1 The profits of small businesses will suffer even more. Cash flow shortfalls will also cause corporate defaults to spike because many firms will not be able to service their debt (Chart I-6). Currently, 86% of the job losses since the onset of the COVID-19 crisis are temporary. However, if corporate bankruptcies spike too fast and too high, then these job losses will become permanent and household incomes will not recover quickly. A sharp but brief recession would turn into a long depression. Chart I-6Defaults Can Only Rise Defaults Can Only Rise Defaults Can Only Rise …But The Liquidity Crisis Will Not Morph Into A Solvency Crisis… In response to the aggregate demand shock caused by COVID-19, global central banks are supporting lending. These policies are an essential ingredient to flatten the default curve and minimize the permanent hit to employment and household income. The US Fed is acting as the central banker to the world. The US Fed is acting as the central banker to the world. Its new quantitative easing program has already added $1.36 trillion in excess reserves this quarter. Moreover, the Fed’s decision to loosen supplementary liquidity ratios and capital adequacy ratios allows the interbank and offshore markets to normalize. Meanwhile, the Fed’s swap lines with global central banks have surged by $432 billion since the crisis began. Its FIMA facility also permits central banks to pledge Treasurys as collateral to receive US dollars. These two programs let global central banks provide dollar funding to the private sector outside the US. Chart I-7Easing Liquidity Stress Easing Liquidity Stress Easing Liquidity Stress The Fed is also supporting the credit market directly. The $250 billion Secondary Market Corporate Facility, the $500 billion Primary Market Corporate Facility and the $600 billion Main Street New Loan and Expanded Loan Facilities, all mean that firms with a credit rating above Baa or a debt-to-EBITDA ratio below 4x can still get funding. Together with the $100 billion Term-Asset-backed Securities Loan Facility, these measures will prevent a liquidity crisis from morphing into a solvency crisis in which healthier borrowers cannot roll over their debt. Such a crisis would magnify the inevitable increase in defaults manyfold.  The market is already reflecting the impact of the Fed’s programs. Corporate spreads for credit tiers affected by the Fed’s support are narrowing (Chart I-7). Spreads reflective of liquidity conditions, such as the FRA-OIS gap, the Commercial paper-OIS spread and cross-currency basis-swap spreads, have also begun to normalize. The narrowing of bank CDS spreads demonstrates that unlike the GFC, the current crisis does not threaten the viability of major commercial banks (Chart I-7, bottom panel). Other central banks are doing their share. The Bank of Canada is buying provincial debt to ensure that the authorities directly tasked with managing the pandemic have the ability to do so. The European Central Bank has enacted a QE program of at least EUR1.1 trillion and enlarged the TLTRO facility while decreasing its interest rate, which cheapens the cost of financing for commercial banks. Moreover, the ECB has also eased liquidity and capital adequacy ratios for commercial banks. Last week, it announced that it would also accept junk bonds as collateral, as long as these bonds were rated as investment grade prior to April 7, 2020. …And Governments Are Pulling Levers… Chart I-8Record Fiscal Easing May 2020 May 2020 Governments, too, are ensuring that private-sector default rates do not spike uncontrollably and doom the economy to a repeat of the 1930s. Policymakers in the G-10 and China have announced larger stimulus packages than the programs implemented in the wake of the GFC (Chart I-8). The US’s programs already total $2.89 trillion or 13% of 2020 GDP. Germany is abandoning fiscal discipline and has declared stimulus measures totaling 12% of GDP. Italy’s package is more modest at 3% of GDP. Even powerhouse China is not taking chances. In addition to a larger fiscal package than in 2008, the reserve requirement ratio stands at 9.5%, the lowest level in 13 years, and the People’s Bank of China cut the rate of interest on excess reserves by 37 basis points to 0.35% (Chart I-9). The last cut to the IOER was in November 2008 and was of 27 basis points. This interest rate easing preceded a CNY4 trillion increase in the stock of credit, which played a major role in the global recovery that began in 2009. Hence, the recent IOER reduction, in light of the decline in loan prime rates and MLF rates, suggests that China is getting ready to boost its economy by as much as in 2008. Chart I-9China Is Pressing On The Gas Pedal China Is Pressing On The Gas Pedal China Is Pressing On The Gas Pedal Among the advanced economies, loan guarantees supplement growing deficits. So far, this protection totals at least $1.3 trillion. While guarantees do not directly boost the income and spending of the private sector, they address the risk of an uncontrolled spike in defaults. Therefore, they minimize the odds that rocketing temporary layoffs will morph into permanent unemployment. Section II, written by BCA’s Jonathan Laberge, addresses the question of fiscal policy and whether the packages announced so far are large enough to fill the hole created by COVID-19. While a deep recession is unavoidable, governments will provide more stimulus if activity does not soon stabilize. … While Banks And Household Balance Sheets Compare Favorably To 2008 Banks and the household sector, the largest agent in the private sector, entered 2020 on stronger footing than prior to the GFC. Otherwise, all the fiscal and monetary easing in the world would do little to support the global economy. If banks were as weak as when they entered the GFC, then monetary stimulus would have remained trapped in the banking system in the form of excess reserves. Both in the US and in the euro area, banks now possess higher capital adequacy ratios than in 2008 (Chart I-10). Moreover, as BCA Research’s US Investment Strategy service has demonstrated, the large cash holdings and low loan-to-deposit ratio of the US banking system reinforces its strength (Chart I-11).2  Thus, banks are unlikely to tighten credit standards for as long as they did after the GFC. Broad money expansion should outpace the post-GFC experience, as the surge in US M2 growth to a post-war record of 16% indicates. Chart I-10Banks Have More Capital Than In 2008… May 2020 May 2020 Chart I-11...And Have More Cash And Secure Funding ...And Have More Cash And Secure Funding ...And Have More Cash And Secure Funding     Consumers are also in better shape than in 2008. Last December, US household debt stood at 99.7% of disposable income compared with a peak of 136% in 2008. More importantly, financial obligations represented only 15.1% of disposable income, a near-record low. Limited financial obligations suggest that consumer bankruptcies should remain manageable as long as governments help households weather the current period of temporary unemployment (Chart I-12). Meanwhile, household indebtedness in Spain and Ireland has collapsed from 137% to 94% and from 183% to 85% of disposable income, respectively. Italy, despite its structural economic weakness, always sported a low private-sector debt load. A precautionary rise in the savings rate is unavoidable, but it will not match the magnitude of the increase that followed the GFC. The economy will recover quicker than it did following the GFC. The deep recession engulfing the world should not evolve into a prolonged depression because banks and household balance sheets are in a better state than in 2008. While the recovery will be chaotic, the velocity of money will not remain as depressed for as long as it stayed after 2008, which will allow nominal GDP to recover faster than after the GFC. Banks and households will be quicker to lend and borrow from each other than they were after the GFC. Consequently, the collapse in the consumption of durable goods (e.g. cars) has created pent-up demand, but not a permanent downshift in the demand curve (Chart I-13). Chart I-12Robust Household Finances Robust Household Finances Robust Household Finances Chart I-13Households' Pent-Up Demand Households' Pent-Up Demand Households' Pent-Up Demand   Bottom Line: The global economy is on track to suffer its worst contraction since the 1930s. However, the combination of aggressive monetary and fiscal stimulus will prevent a rising wave of defaults from swelling to a crippling tsunami that permanently curtails household income. Given that banks and households have stronger balance sheets than in 2008, when governments ease lockdowns, the economy will recover quicker than it did following the GFC. The evolution of any second wave of infection is the crucial risk to this view. The IMF’s forecast indicates that growth will suffer substantial downside relative to its baseline scenario if the second wave is strong and forces renewed lockdowns. In this scenario, the current package of stimulus must be augmented to avoid a depression-like outcome. A big problem for forecasters, is that we do not have a good sense of how the second wave of infections will evolve. Moreover, the ability to test the population and engage in contact tracing will determine how aggressive lockdowns will be. Therefore, we currently have very little visibility to handicap the odds of each path. Investment Implications Low inflation for the next 18 months will allow monetary conditions to stay extremely accommodative. Growth will recover in the second half of 2020, so the window to own risk assets remains fully open as long as we can avoid a second wave of complete lockdowns. The Dollar’s Last Hurrah The US dollar has become dangerously expensive. According to a simple model, the dollar trades at a premium to its purchasing-parity equilibrium against major currencies, which is comparable to 1985 or 2002 when it attained its most recent cyclical tops (Chart I-14). The dollar may not trade as richly against our Behavioral Effective Exchange Rate model, but this fair value estimate has rolled over (Chart I-14, bottom panel). A peak in global policy uncertainty may be the key to timing the start of the dollar’s decline. Policy will prompt downside risk created by the dollar’s overvaluation. The US twin deficit, which is the sum of the fiscal and current account deficits, is set to explode because Washington will expand the fiscal gap by 15~20% of GDP while the private sector will not increase its savings rate at the same pace. If US real interest rates are high and rising, then foreign investors will snap up US liabilities and finance the twin deficit. If real rates are low and falling, then foreigners will demand a much cheapened dollar (which would embed higher long-term expected returns) to buy US liabilities (Chart I-15). Chart I-14The Dollar Is Pricey The Dollar Is Pricey The Dollar Is Pricey Chart I-15Bulging Twin Deficits Are A Worry Bulging Twin Deficits Are A Worry Bulging Twin Deficits Are A Worry   Real interest rates probably will not climb, hence the twin deficit will become an insurmountable burden for the dollar. The Fed has not hit its symmetric 2% inflation target since the GFC and will not do so in the next one to two years. As a result, the Fed will not lift nominal interest rates until inflation expectations, currently at 1.14%, return to the 2.3% to 2.5% zone consistent with investors believing that the Fed is achieving its mandate. Thus, real interest rates will decline, which will drag down the USD. Relative money supply trends also point to a weaker dollar in the coming 12 months (Chart I-16). The Fed is easing policy more aggressively than other central banks and US banks are better capitalized than European or Japanese ones. Therefore, US money supply growth should continue to outpace foreign money supply. The inevitable slippage of dollars out of the US economy, especially if the current account deficit widens, will boost the supply of dollars globally relative to other currencies. Without any real interest rate advantage, the USD will lose value against other currencies. China’s policy easing is also negative for the dollar. China’s large-scale stimulus will allow the global industrial cycle to recover smartly in the second half of 2020, especially if the increase in pent-up demand fuels realized demand in the fall. The US economy’s closed nature and low exposure to both trade and manufacturing will weigh on US internal rates of return relative to the rest of the world, and invite outflows (Chart I-17). This selling will accentuate downward pressure created by the aforementioned balance of payments and policy dynamics.  Chart I-16Money Supply Trends Will Hurt The Dollar Money Supply Trends Will Hurt The Dollar Money Supply Trends Will Hurt The Dollar Chart I-17The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency   The dollar is also vulnerable from a technical perspective. A record share of currencies is more than one-standard deviation oversold against the USD (Chart I-18). According to the Institute of International Finance (IIF), outflows from EM economies have already eclipsed their 2008 records, and the underperformance of DM assets suggests that portfolio managers have aggressively abandoned non-USD assets. These developments imply that investors who wanted to move money back into the US have already done so. Chart I-18The Dollar Is Becoming Overbought The Dollar Is Becoming Overbought The Dollar Is Becoming Overbought Chart I-19The Dollar Is A Momentum Currency May 2020 May 2020 Investors should move funds out of the dollar, but not aggressively. The outlook for the dollar in the next year or two is poor, but the USD’s most important tailwind is intact: the global economy will recover, but for the time being, it remains in freefall. Moreover, among the G-10 currencies, the dollar responds most positively to the momentum factor (Chart I-19), which remains another tailwind. The greenback will remain volatile in the coming weeks. EM currencies offer a particularly tricky dilemma. They have cheapened to levels where historically they offer very compelling long-term returns (Chart I-20). However, EM firms have large amounts of dollar-denominated debt. The fall in EM FX and collapse in domestic cash flows will likely cause some large-scale bankruptcies. If a large, famous EM company defaults, then the headline risk would probably trigger a broad-based selling of EM currencies. For now, our Emerging Market Strategy service recommends that, within the EM FX space, investors favor the currencies with the lowest funding needs, such as the RUB, KRW and THB.3 Chart I-20EM FX Is Decisively Cheap EM FX Is Decisively Cheap EM FX Is Decisively Cheap For tactical investors, a peak in global policy uncertainty may be the key to timing the start of the dollar’s decline (Chart I-21). This implies that if a second wave of infections force severe lockdowns, the dollar rally may not be done. Chart I-21Uncertainty Must Recede For The Dollar To Weaken Uncertainty Must Recede For The Dollar To Weaken Uncertainty Must Recede For The Dollar To Weaken Fixed Income Government bonds have not yet depreciated and the exact timing of a price decline remains uncertain. However, Treasurys and Bunds offer an increasingly poor cyclical risk-reward ratio. Bond valuations continue to deteriorate. Our time-tested BCA Bond Valuation model shows that G-10 bonds, in general, and US Treasurys, in particular, are at their most expensive levels since December 2008 and March 1985, two periods that preceded major increases in yields (Chart I-22). Buy inflation-protected securities at the expense of nominal bonds. Liquidity conditions also represent a threat for safe-haven bonds. The wave of liquidity unleashed by global central banks is meeting record fiscal thrust. Thus, not only is the supply of government bonds increasing, but a larger proportion of the money injected by central banks will actually make its way into the real economy than after 2008. Record-low yields are vulnerable because the increase in the global money supply should prevent nominal GDP growth from slumping permanently as in the 1930s and after the GFC. Additionally, the sharp escalation in liquid assets on the balance sheets of commercial banks also creates an additional risk for bond prices (Chart I-23). Chart I-22Bonds Are Furiously Expensive Bonds Are Furiously Expensive Bonds Are Furiously Expensive Chart I-23Liquidity Injections Point To Higher Yields Liquidity Injections Point To Higher Yields Liquidity Injections Point To Higher Yields   QE also threatens government fixed income. After the GFC, real interest rates fell because investors understood that US short rates would remain at zero for a long time. Yet, 10-year Treasury yields rose sharply in 2009 as inflation breakevens increased more than the decline in TIPS yields. This pattern repeated itself following each QE wave (Chart I-24). In essence, if the Fed provides enough liquidity to allow markets to function well, then the chance of cyclical deflation decreases, which warrants higher inflation expectations. A lower dollar will be fundamental to the rise in inflation breakeven and yields. A soft dollar will confirm that the Fed is providing enough liquidity to satiate dollar demand and it will favor risk-taking around the world. Moreover, it will boost commodity prices and help realize inflation increases down the line. Chart I-24QE Lifts Breakevens And Yields QE Lifts Breakevens And Yields QE Lifts Breakevens And Yields Technical considerations also point to the end of the bond bull market, at least for the next 12 to 18 months. Investors remain bullish toward bonds, which is a contrarian signal. Our Composite Momentum Indicator has reached levels last achieved at the end of 2008, which suggested at that time that bond-buying was long in the tooth. Chart I-25Inflation Will Drive US/German Spreads Inflation Will Drive US/German Spreads Inflation Will Drive US/German Spreads In this context, investors with a cyclical investment horizon should consider bringing duration below benchmark. In the short term, this position still carries significant risks because the outlook for yields depends on the dollar. Another dollar spike caused by renewed lockdowns would also pin yields near current levels for longer. A lower-risk version of this bet would be to buy inflation-protected securities at the expense of nominal bonds, a position recommended by our US Bond Strategy service.4  Investors should be careful when betting that US yields will further converge toward German ones. The 10-year yield spread between US Treasurys and German Bunds has quickly narrowed, falling by 170 basis points from a high of 279 basis points in November 2018. Despite this sharp contraction, the spread remains elevated by historical standards. So far, the declining yield gap reflects the fall in policy rates in the US relative to Europe. Given that both the Fed and the ECB are at the lower bounds of their policy rates, short-rate differentials are unlikely to compress further. Instead, inflation differentials between the US and Europe must decline (Chart I-25). The inflation gap between the US and Europe probably will not narrow significantly this year. The IMF forecasts that Europe’s economy will underperform the US. Therefore, slack in Europe will expand faster than in the US. Moreover, monetary and fiscal support in the US is more aggressive than in Europe. Consequently, a weaker dollar, which will increase US inflation expectations relative to Europe, will put upward pressure on the US/German 10-year spread. However, if the European fiscal policy response starts to match the size of the US stimulus, then the spread between the US and Germany would narrow further. Ample liquidity also continues to underpin equity prices. Finally, for credit investors, our US Bond Strategy service recommends buying securities with abnormally large spreads and which the various Fed programs target. These include agency CMBS, consumer ABS, municipal bonds, and corporates rated Ba and above.5 Equities Chart I-26Investors Are Not Exuberant About Stocks Investors Are Not Exuberant About Stocks Investors Are Not Exuberant About Stocks Despite some short-term risks, we continue to favor equities on a 12- to 18-month investment horizon in an environment where a second wave of lockdowns can be avoided. Stock valuations have deteriorated, but they remain broadly attractive (see page 2 of Section III). While multiples are not particularly cheap, the equity risk premium remains very high. Alternatively, the expected growth rate of long-term earnings embedded in stock prices continues to hover at the bottom of its post-war distribution (Chart I-26). In other words, stocks are attractive because bond yields are low. Ample liquidity also continues to underpin equity prices. Our US Financial Liquidity Index points to rising S&P 500 returns in the coming months (Chart I-27). The Fed’s surging liquidity injections, which foreign central banks are mimicking, will only accentuate this backdrop. Moreover, in times of crisis, inflation expectations correlate positively with stock prices because “bad deflation” represents an existential threat to profitability.6 QE lifts inflation expectations, therefore, its bearish impact on bond prices should not translate into a fall in stock prices. Chart I-27Ample Liquidity For The S&P 500 Ample Liquidity For The S&P 500 Ample Liquidity For The S&P 500 Chart I-28Valuation And Monetary Condition Offset COVID-19 Valuation And Monetary Condition Offset COVID-19 Valuation And Monetary Condition Offset COVID-19 The combined valuation and liquidity backdrop are accommodative enough for stocks to persevere higher, despite the immense economic shock generated by COVID-19. The readings of our BCA Valuation and Monetary Indicator are even more accommodative for stocks than they were in Q1 2009, which marked the beginning of a 340% bull market (Chart I-28). Moreover, trend growth may have been less negatively affected by COVID-19 than it was by the GFC. Consequently, our US Equity Strategy service uses the historical pattern of profit rebounds subsequent to recessions to anticipate 2021 S&P 500 earnings per share of $162.1 Technicals remain supportive for stocks on a cyclical basis. Sentiment and momentum continue to be depressed, which could explain the resilience of stocks. Indeed, our Composite Momentum Indicator based on both the 13-week rate of change of the S&P 500 and traders’ sentiment lingers at the bottom of its historical distribution (Chart I-29). Moreover, the percentage of stocks above their 30-week moving average or at 52-week highs suggests that the average stock is still oversold (Chart I-30). Chart I-29Cyclical Momentum Is Not A Risk Yet Cyclical Momentum Is Not A Risk Yet Cyclical Momentum Is Not A Risk Yet Chart I-30The Median Stock Remains Oversold The Median Stock Remains Oversold The Median Stock Remains Oversold The problem for equity indices is that some sectors, such as tech, are very overbought on a near-term basis, which could invite profit-taking among the names that account for a disproportionate share of the index. If these sectors correct meaningfully, then the whole index would fall even if the median stocks barely vacillate. Nonetheless, all the forces listed in Section I suggest that the correction will not develop into a new down leg for the market. Energy stocks offer an attractive opportunity for investors, a view shared by our US Equity Strategy colleagues.1 The energy sector trades at its largest discount to the broad market on record and a weaker dollar normally lifts its relative performance (Chart I-31). Moreover, energy stocks have modestly outperformed the market since its March 23 bottom, despite the abyss into which oil prices tumbled. A pair trade is also available to investors. Healthcare and tech stocks have rallied in parabolic fashion relative to energy stocks. Oil may have capitulated on April 20 when the WTI May contract hit $-40/bbl. Storage capacity is essentially maxed out, but the Kingdom of Saudi Arabia is set to restrict production from 12.3 million b/d to 8.5 million b/d, which will contribute generously to the 10 million bpd cut agreed by OPEC+. Countries such as Canada are also curtailing output, a move repeated among many oil producers. US shale firms, which have become marginal producers of oil, are also paring down their production. Shale producers are not done cutting, judging by both the decline in horizontal rig counts and WTI trading below most marginal costs (Chart I-32). The oil market will move away from its surplus position when the global economy restarts. Chart I-31An Opportunity In Energy An Opportunity In Energy An Opportunity In Energy Chart I-32Shale Production Will Fall Much Further Shale Production Will Fall Much Further Shale Production Will Fall Much Further   The slope of the oil curve confirms that the outlook for energy stocks is improving. On April 20, Brent and WTI hit their deepest contango on record, a development accentuated by the reflexive relationship between major oil ETFs and the price of the commodity itself. The structure of those ETFs was amended on April 21st, allowing a break in this reflexive relationship. The oil curve is again steepening, which after such a large contango often results in higher crude prices (Chart I-33). Meanwhile, net earnings revisions for the energy sector have become very depressed. Relative to the broad market, revisions are also weak but turning up. In this context, rising oil prices can easily lift energy stocks relative to the broad market. Chart I-33A Decreasing Contango Would Boost Oil Stocks A Decreasing Contango Would Boost Oil Stocks A Decreasing Contango Would Boost Oil Stocks Chart I-34Parabolic Moves Are Rarely Durable Parabolic Moves Are Rarely Durable Parabolic Moves Are Rarely Durable   A pair trade is also available to investors. Healthcare and tech stocks have rallied in parabolic fashion relative to energy stocks (Chart I-34). We constructed a global sector ranking based on the bottom-up valuation scores from BCA Research’s Equity Trading Strategy service. Based on this metric, energy stocks are attractively valued, while tech and healthcare are not (Chart I-35). A rebound in oil prices should prompt some portfolio rebalancing in favor of the energy sector.   Chart I-35A Bottom-Up Ranking For Sectors Valuations May 2020 May 2020 Finally, our US Equity Sector Strategy service also recommends investors overweight consumer discretionary stocks. This sector will benefit because robust household balance sheets will allow consumers to take advantage of low interest rates when the global economy recovers.7 Mathieu Savary Vice President The Bank Credit Analyst April 30, 2020 Next Report: May 28, 2020   II. The Global COVID-19 Fiscal Response: Is It Enough? In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession. The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. Even when narrowly-defined, the announced (or likely) fiscal response of the US, China, and Germany is quite large and appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. This is not the case, however, in other euro area economies (France, Italy, and Spain), or in emerging markets. Our analysis also suggests that the global fiscal response will need to increase if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year. This underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. The global economic expansion that began in 2009 has come to an abrupt end due to the COVID-19 pandemic. Aggressive containment measures necessary to control the spread of the disease and prevent the collapse in health care systems around the world have caused a large and sudden stop in global economic activity, which has prompted unprecedented responses from governments around the world. In this Special Report we explore in detail the fiscal response amongst advanced economies, with the goal of judging whether the response is large enough to prevent an “L-shaped” recession (characterized by a very prolonged return to trend growth). The crisis remains in its early days and new information about the size and character of the response, as well as the magnitude of the economic shock, continues to emerge on a near-daily basis. As such, our conclusions may change over the coming weeks in line with incoming data. But for now, we (tentatively) conclude that the fiscal response appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event. However, there are two important caveats. First, while Germany has provided among the strongest fiscal responses globally, measures in France, Italy, and Spain are still lacking and must be stepped up. Second, the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year – more will have to be done. For policymakers, this underscores the importance of ensuring that the “Great Lockdown” succeeds at reducing the spread of the disease to a point that does not necessitate widespread renewed restrictions on economic activity. In this regard, the gradual re-opening of several US states by early-May, while positive for economic activity in the short-run, is a non-trivial risk to the US and global economic outlooks over the coming 6-12 months. This risk must be closely watched by investors. The Global Fiscal Response: Comparing Across Countries And Across Measures The flurry of policy announcements from national governments over the past six weeks has led to a great degree of confusion about the size and disposition of the global COVID-19 fiscal response. Our analysis is based heavily on the IMF’s tracking of these measures, albeit with a few adjustments. We also rely on analysis from Bruegel, a prominent European macroeconomic think-tank, as well as our own Geopolitical Strategy team and a variety of news reports. Chart II-1 presents the IMF’s estimate of the total fiscal response to the crisis across major countries, as of April 23rd, broken down into “above-the-line” and “below-the-line” measures. Above-the-line measures are those that directly impact government budget balances (direct fiscal spending and revenue measures, usually tax deferrals), whereas below-the-line measures typically involve balance sheet measures to backstop businesses through capital injections and loan guarantees. Chart II-1The Global Fiscal Response Is Huge When Including All Measures May 2020 May 2020 Chart II-1 makes it clear that the fiscal response of advanced economies is enormous when including both above- and below-the-line measures. By this metric, the response of most developed economies is on the order of 10% of GDP, and well above 30% in the case of Italy and Germany. However, using the sum of above- and below-the-line measures to gauge the fiscal response of any country may not be the ideal approach, given that below-the-line measures are contingent either on the triggering of certain conditions or on the provision of credit to households and firms from the financial system. Below-the-line measures also likely increase the liability position of the private sector, thus raising the odds of negative second-round effects. Instead, Chart II-2 compares the countries shown in Chart 1 based only on the IMF’s estimate of above-the-line measures, and with a 4% downward adjustment to Japan’s reported spending to account for previously announced measures.8 The chart shows that countries fall into roughly three categories in terms of the magnitude of their above-the-line response: in excess of 4% of GDP (Australia, the US, Japan, Canada, and Germany), 2-3% (the UK, Brazil, and China), and sub-2% (all other countries shown in the chart, including Spain, Italy, and France). Chart II-2The Picture Changes When Excluding Below-The-Line Measures May 2020 May 2020 Analysis by Bruegel provides somewhat different estimates of the global COVID-19 fiscal response for select European countries as well as the US (Table II-1). Bruegel breaks down discretionary fiscal measures that have been announced into three categories: those involving an immediate fiscal impulse (new spending and foregone revenues), those related to deferred payments, and other liquidity provisions and guarantees. Bruegel distinguishes between the first and second categories because of their differing impact on government budget balances. Deferrals improve the liquidity positions of individuals and companies but do not cancel their obligations, meaning that they result only in a temporary deterioration in budget balances. Table II-1The Type Of Fiscal Response Varies Significantly Across Countries May 2020 May 2020 Table II-1 highlights that Bruegel’s estimates of the sum of above- and below-the-line measures are similar to the IMF’s estimates for the US, the UK, and Spain, but are smaller for Italy and larger for France and Germany (particularly the latter). These differences underscore the extreme uncertainty facing investors, who have to contend not only with varying estimates of the magnitude of government policies but also a torrent of news concerning the evolution of the pandemic itself. Chart II-3 presents our best current estimate of the above-the-line fiscal response of several countries (the measure we deem to be most likely to result in an immediate fiscal impulse), by excluding loans, guarantees, and non-specified revenue deferrals to the best of our ability.9 Chart II-3 is based on a combination of data from the IMF, Bruegel analysis, and BCA estimates and news analysis. Chart II-3When Narrowly Defined, Several Countries Are Responding Forcefully, But Many Countries Are Not May 2020 May 2020 Overall, investors can draw the following conclusions from Charts II-1 – II-3 and Table II-1: When measured as the total of above- and below-the-line measures, nearly all large developed market countries have responded with sizeable measures. Emerging market economies are the clear laggards. Excluding below-the-line measures and using our approach, Australia, the US, China, Germany, Japan, and Canada appear to be spending the most relative to the size of their economies. While Japan’s “headline” fiscal number was inflated by including previously-announced spending, it is still decently-sized after adjustment. Outside of Germany, the rest of Europe appears to be providing a middling or poor above-the-line fiscal response. The UK appears to be providing between 4-5% of GDP as a fiscal impulse, whereas the fiscal response in Italy, Spain, and France looks more like that of emerging markets than of advanced economies. Measuring The Stimulus Against The Shock Despite the substantial amount of new information over the past six weeks concerning the evolution of the pandemic and the attendant policy response, it remains extremely difficult to judge what the balance between shock and stimulus will be and what that means for the profile of growth. Nonetheless, below we present a framework that investors can use to approach the question, and that can be updated as new information emerges concerning the impact of the shutdowns and the extent of the response. Our approach involves analyzing four specific questions: What is the size of the initial shock? What are the likely second-round effects on growth? What is the likely multiplier on fiscal spending? Will the composition of fiscal spending alter its effectiveness? The Size Of The Initial Shock Chart II-4 presents the OECD’s estimates of the initial impact of partial or complete shutdowns on economic activity in several countries. The OECD first used a sectoral approach to estimating the impact on activity while lockdowns are in effect, assuming a 100% shutdown for manufacturing of transportation equipment and other personal services, a 50% decline in activity for construction and professional services, and a 75% decline for retail trade, wholesale trade, hotels, restaurants, and air travel. Chart II-4 illustrates the total impact of this approach for key developed and emerging economies. Chart II-4Annual GDP Will Be 1.5%-2.5% Lower For Each Month Lockdowns Are In Effect May 2020 May 2020 The OECD’s approach provides a credible estimate of the impact of aggressive containment policies, and implies that annual real GDP is likely to be 1.5-2.5% lower for major countries for each month that lockdown policies are in effect. This implies that output in major economies is likely to fall 3.5% - 6% for the year from the initial shock alone, assuming an aggressive 10-week lockdown followed by a complete return to normal. Estimating Potential Second Round Effects Chart II-5 presents projections from the Bank for International Settlements on the spillover and spillback potential of a 5% initial shock to the level of global GDP from the COVID-19 pandemic (equivalent to a 20% impact on an annualized basis). Chart II-5Additional Lockdown Events Are A Greater Risk Than First Wave After-Effects May 2020 May 2020 The chart shows that the cumulative impact of the initial shock rises to 7-8% by the end of this year for the US, euro area, and emerging markets, and 6% for other advanced economies. These estimates account for both domestic second round effects of the initial shock, as well as the reverberating impact of the shock on global trade. Chart II-5 also shows the devastating effect that a second wave of COVID-19 emerging in the second half of the year would have after including spillover and spillback effects, assuming that only partial lockdowns would be required. In this scenario, the level of GDP would be 10-12% lower at the end of the year depending on the region, suggesting that investors should be more concerned about the possibility of additional lockdown events than they should be about the after-effects of the first wave of infections (more on this below). Will Fiscal Multipliers Be High Or Low? When examining the academic literature on fiscal multipliers, the first impression is that multipliers are likely to be extremely large in the current environment. Tables II-2 and II-3 present a range of academic multiplier estimates aggregated by the IMF, categorized by the stage of the business cycle and whether the zero lower bound is in effect. Table II-2Fiscal Multipliers Are Much Larger During Recessions Than Expansions May 2020 May 2020 Table II-3Models Suggest The Multiplier Is Quite High At The Zero Lower Bound May 2020 May 2020 The tables tell a clear story: multipliers are typically meaningfully larger during recessions than during expansions, and extremely large when the zero lower bound (ZLB) is in effect. However, there are at least two reasons to expect that the fiscal multiplier during this crisis will not be as large as Tables II-2 and II-3 suggest. First, it is obviously the case that the multiplier will be low while full or even partial lockdowns are in effect, as consumers will not have the ability to fully act in response to stimulative measures. This will be partially offset by a burst of spending once lockdowns are removed, but the empirical multiplier estimates during recessions shown in Table II-2 have not been measured during a period when constraints to spending have been in effect, and we suspect that this will have at least somewhat of a dampening effect on the efficacy of fiscal spending relative to previous recessions (even once regulations concerning store closures are removed). Second, Table II-3 likely overestimates the multiplier at the ZLB. These estimates have been based on models rather than empirical analysis, and appear to be in reference to the prevention of large subsequent declines in output following an initial shock. The modeled finding of a large multiplier at the ZLB occurs because increased deficit spending will not lead to higher policy rates in a scenario where the neutral rate has fallen below zero. But it seems difficult to believe that the fiscal multiplier during ZLB episodes, defined as the impact of fiscal spending on the path of output relative to the initial shock (not relative to a counterfactual additional shock), is larger than the highest empirical estimates of the multiplier during recessions. The only circumstance in which we can envision this being the case is an environment where long-term bond yields are capped and remain at zero, alongside short-term interest rates, as the economy improves. The IMF has provided a simple rule of thumb approach to estimating the fiscal multiplier for a given country. The IMF’s approach involves first estimating the multiplier under normal circumstances based on a series of key structural characteristics that have been shown to influence the economy’s response to fiscal shocks. Then, the “normal” multiplier is adjusted higher or lower depending on the stage of the business cycle, and whether monetary policy is constrained by the ZLB. For the US, the IMF’s approach suggests that a multiplier range of 1.1 – 1.6 is reasonable, assuming the highest cyclical adjustment but no ZLB adjustment (see Box II-1 for a description of the calculation). Given the unprecedented nature of this crisis, we are inclined to use the low end of this range (1.1) as a conservative assumption when judging whether fiscal responses to the crisis are sufficient. For investors, this means that governments should be aiming, at a minimum, for fiscal packages that are roughly 90% of the size of the expected shock of their economies, using our US fiscal multiplier assumption as a guide. Box II-1 The “Bucket” Approach To Estimating Fiscal Multipliers The IMF “bucket” approach to estimating fiscal multiplier involves determining the multiplier that is likely to apply to a given country during “normal” circumstances, based on a set of structural characteristics associated with larger multipliers. This “normal” multiplier is then adjusted based on the following formula: M = MNT * (1+Cycle) * (1+Mon) Where M is the final multiplier estimate, MNT is the “normal times” multiplier derived from structural characteristics, Cycle is the cyclical factor ranging from −0.4 to +0.6, and Mon is the monetary policy stance factor ranging from 0 to 0.3. The Cycle factor is higher the more a country’s output gap is negative, and the Mon factor is higher the closer the economy is to the zero lower bound. Table II-B1 applies the IMF’s approach to the US, using the same structural score as the IMF presented in the note that described the approach. The table highlights that the approach suggests a US fiscal multiplier range of 1.1 – 1.6 given the maximum cycle adjustment proscribed by the rule, which we feel is reasonable given the unprecedented rise in US unemployment. We make no adjustment to the range for the zero lower bound. Table II-B1A Multiplier Estimate Of 1.1 – 1.6 Seems Reasonable For The US May 2020 May 2020 The Composition Of The Response: Helping Or Hurting? The last of our four questions deals with the issue of composition and whether the form of a country’s fiscal response is likely to alter its effectiveness. We implicitly addressed the first element of composition, whether measures are above-the-line or below-the-line, by comparing Charts II-1 - II-3 on pages 28-31. Our view is that above-the-line measures are far more important than below-the-line measures, as the former provides direct income and liquidity support. Below-the-line measures are also important, as they are likely to help reduce business failure and household bankruptcies. The fiscal multiplier on these measures has to be above zero, but it is likely to be much lower than that of an above-the-line response. The second element of composition concerns the appropriate distribution of aid among households, businesses, and local governments. On this particular question, it remains extremely challenging to analyze the issue on a global basis, owing to a frequent lack of an explicit breakdown of fiscal measures by recipient. Chart II-6Much Of The US Fiscal Response Is Going To Households And Small Businesses May 2020 May 2020 For now, we limit our distributional analysis to the US, and hope to expand our approach to other countries in future research. Chart II-6 presents a breakdown of the US fiscal response by recipient, which informs the following observations. Households: Chart II-6 highlights that US households will receive approximately $600 billion as part of the CARES Act, roughly half of which will occur through direct payments (i.e. “stimulus checks”) and another 40% from expanded unemployment benefits. In cases where the federal household response has been criticized by members of the public as inadequate, it has often been compared to income support programs of other countries. The Canada Emergency Response Benefit (“CERB”) is a good example of a program that seems, at first blush, to be superior: it provides $2,000 CAD in direct payments to individuals for a 4 week period, for up to 16 weeks (i.e. a maximum of $8,000 CAD), which seems better than a $1,200 USD stimulus check. However, Table II-4 highlights that this comparison is mostly spurious. First, the CERB is not universal, in that it is only available to those who have stopped or will stop working due to COVID-19. At a projected cost of $35 billion CAD, the CERB program represents 1.5% of Canadian GDP. By comparison, $600 billion USD in overall household support represents 2.75% of US GDP; this number drops to 1.75% when only considering support to those who have lost their jobs, but this is still higher as a share of the economy than in Canada. Moreover, there is little question that Congress is prepared to pass more stimulus for additional weeks of required assistance. The discrepancy between the perception and reality of US household sector support appears to be rooted in the speed of payments. Speed is the one area where Canada’s household sector response appears to have legitimately outperformed the US; CERB payments are received by applicants within three business days for those registered for electronic payment, and in some cases they are received the following day. By contrast, it has taken some time for US States to start paying out the additional $600 USD per week in expanded unemployment benefits, but as of the middle of last week nearly all states had started making these payments. Table II-4US Household Relief Is Just As Generous As Seemingly Better Programs May 2020 May 2020 Firms: On April 16th the Small Business Administration announced that the Paycheck Protection Program (“PPP”) had expended its initial budget of $350 billion. While additional funds of $320 billion have subsequently been approved (plus $60 billion in small business emergency loans and grants), the run on PPP funds was, to some investors, an implicit sign that the CARES Act was inadequately structured. However, the fact that the initial funds ran out in mid-April simply reflects the reality that social distancing measures had been in place for 3-4 weeks by the time that the program began taking applications. Table II-5 highlights that $350 billion was large enough to replace nearly 90% of lost small business income for one month, assuming that overall small business revenue has fallen by 50% and that small businesses account for 44% of total GDP. The Table also shows that a combined total of $730 billion is enough to replace almost 80% of lost small business income for 10 weeks, given these assumptions. With loan forgiveness at least partially tied to small businesses retaining employees on payroll for an 8-week period, the PPP is also essentially an indirect form of household income support. Table II-5Help For Small Businesses Will Replace A Significant Amount Of Lost Income May 2020 May 2020 Chart II-7Persistent State & Local Austerity Must Be Avoided This Time Persistent State & Local Austerity Must Be Avoided This Time Persistent State & Local Austerity Must Be Avoided This Time State & Local Governments: The magnitude of support for state & local (S&L) governments appears to be the least-well designed element of the US fiscal response. The CARES Act provides for $170 billion in support to S&L, which at first blush seems large as it is approximately 25% of S&L current receipts in Q4 2019 (i.e. it stands to cover a 25% loss in revenue for one quarter). However, this does not account for the significant reported increase in S&L costs to combat the pandemic, nor does it provide S&L governments with any revenue certainty beyond June 30th when most of the assistance from CARES must be spent. Unlike households or firms, who also face significant uncertainty, nearly all US states are subject to balanced budget requirements, which prevent them from spending more than they collect in revenue. When faced even with projected revenue losses in the second half of this year and into 2021, states are likely to aggressively and immediately cut costs in order to avoid budgetary shortfalls. Chart II-7 highlights that S&L austerity was a significant element of the persistent drag on real GDP growth from overall government expenditure and investment in the first 3-4 years of the post-GFC economic expansion. A repeat of this episode would significantly raise the odds of an “L-type” recession (and thus should certainly be avoided). This is why Congress is moving to pass larger state and local aid. Our Geopolitical Strategy team argues that neither President Trump nor Senate Majority Leader Mitch McConnell will prevent the additional financial assistance that US states will require, despite their rhetoric about states going bankrupt.10 A near-term, temporary standoff may occur, but Washington will almost certainly act to provide at least additional short-term funding if state employment starts to fall due to budget pressure. So while we recognize that the state & local component of the US fiscal response is currently lacking, it does not seem likely to represent a serious threat to an eventual economic recovery in the US. Putting It All Together: Will It Be Enough? Chart II-8 reproduces Chart II-3 with an assumed fiscal multiplier of 1.1, and with shaded regions denoting the likely initial and total impact on GDP from aggressive containment measures (based on the OECD and BIS’ estimates). Based on our analysis of the US fiscal response, we make no adjustments for the composition of the measures beyond defining the fiscal response on a narrow basis (i.e. excluding loans, guarantees, and non-specified revenue deferrals). The chart highlights that the narrowly-defined fiscal response of three key economies driving global demand, the US, China, and Germany, is either at the upper end or above the total impact range. Thus, for now, we tentatively conclude that the fiscal response that has or will happen appears to be adequate to prevent the direct and indirect effects of the lockdowns from causing an “L-shaped” event, especially since Chart II-8 explicitly excludes below-the-line measures. However, there are two important caveats to this conclusion. First, Chart II-8 makes it clear that measures in France, Italy, and Spain are still lacking and must be stepped up. Italy and France have provided a substantial below-the-line response, but it is far from clear that a debt-based response or one that only temporarily improves access to cash for households and businesses will be enough to prevent a prolonged fallout from the sudden stop in economic activity and income. Chart II-8Several Important Countries Seem To Be Doing Enough, But More Is Needed In Europe Ex-Germany May 2020 May 2020 Second, our analysis suggests that the announced fiscal measures will not be sufficient if the global economy faces a W-shaped shock caused by another round of aggressive containment measures later this year or if these measures remain in place at half-strength for many months. This underscores how sensitive the adequacy of announced fiscal measures are to the amount of time economies remain under full or partial lockdown. As such, it is crucial for investors to have some sense of when advanced economies may be able to sustainably end aggressive containment measures. When Can The Lockdowns Sustainably End? Several countries and US states have already announced some reductions in their restrictions, but the question of how comprehensive these measures can be without risking a second period of prolonged stay-at-home orders looms large. Table II-6 presents two different methods of estimating sustainable lockdown end dates for several advanced economies. First, we use the “70-day rule” that appears to have succeeded in ending the outbreak in Wuhan, calculated from the first day that either school or work closures took effect in each country.11 Second, using a linear trend from the peak 5-day moving average of confirmed cases and fatalities, we calculate when confirmed cases and fatalities may reach zero. Table II-6By Re-Opening Soon, The US May Be Risking A Damaging Second Wave May 2020 May 2020 The table highlights that these methods generally prescribe a reopening date of May 31st or earlier, with a few exceptions. The UK’s confirmed case count and fatality trends are still too shallow to suggest an end of May re-opening, as is the case in Canada. In the case of Sweden, no projections can truly be made based on the 70-day rule because closures never formally occurred. But the most problematic point highlighted in Table II-6 is that US newly confirmed cases are only currently projected to fall to zero as of February 2021. Chart II-9 highlights that while new cases per capita in New York state are much higher than in the rest of the country, they are declining whereas they have yet to clearly peak elsewhere. Cross-country case comparisons can be problematic due to differences in testing, but with several US states having already begun the gradual re-opening process, this underscores that US policymakers may be allowing a dangerous rise in the odds of a secondary infection wave. Chart II-9No Clear Downtrend Yet Outside Of New York State May 2020 May 2020 Investment Conclusions Our core conclusion that an “L-shaped” global recession is likely to be avoided is generally bullish for equities on a 12-month horizon. However, uncertainty remains extremely elevated, and the recent rise in stock prices in the US (and globally) has been at least partially based on the expectation that lockdowns will sustainably end soon, which at least in the case of the US appears to be a premature conclusion given the current lack of large-scale virus testing capacity. As such, we are less optimistic towards risky assets tactically, and would recommend a neutral stance over a 0-3 month horizon. As noted above, our cross-country comparison of narrowly-defined fiscal measures suggested that euro area countries (excluding Germany) will likely have to do more in order to prevent a long period of below-trend growth. In the case of highly-indebted countries like Italy, this raises the additional question of whether a significantly increased debt-to-GDP ratio stemming from an aggressive fiscal impulse will cause another euro area sovereign debt crisis similar to what occurred from 2010-2014. Chart II-10Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Italy's Debt Sustainability Hurdle Is Lower Than It Used To Be Government debts are sustainable as long as interest rates remain below economic growth, and from this vantage point Italy should spend as much as needed in order to ensure that nominal growth remains above current long-term government bond yields. Chart II-10 highlights that, despite a widening spread versus German bunds, Italian 10-year yields are much lower today than they were during the worst of the euro area crisis, meaning that the debt sustainability hurdle is technically lower. However, we have also noted in previous reports that high-debt countries often face multiple government debt equilibria; if global investors become fearful that that high-debt countries may not be able to repay their obligations without defaulting or devaluing, then a self-fulfilling prophecy will occur via sharply higher interest rates (Chart II-11). Chart II-11Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort May 2020 May 2020 Chart II-12Italy's Structural Budget Balance Has Improved Italy's Structural Budget Balance Has Improved Italy's Structural Budget Balance Has Improved For now, we view the risk of a renewed Italian debt crisis from significantly increased spending related to COVID-19 as minimal, and it is certainly lower than the status quo as the latter risks causing a sharp gap between nominal growth and bond yields like what occurred from 2010 – 2014. First, Chart II-12 highlights that Italy has succeeded in somewhat reducing its structural balance, which averaged -4% for many years prior to the euro area crisis. Assuming an adequate global response to the crisis and that economic recovery ensues, it is not clear why global bond investors would be concerned that Italian structural deficits would persistently widen. Second, the ECB is purchasing Italian government bonds as part of its new Pandemic Emergency Purchase Program, which will help cap the level of Italian yields. Chart II-13Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Italy's Debt Service Ratio Won't Go Up Much, If Yields Are Unchanged Third, Chart II-13 shows what will occur to Italy’s government debt service ratio (general government net interest payments as a percent of GDP) in a scenario where Italy’s gross debt to GDP rises a full 20 percentage points and the ratio of net interest payments to debt remains unchanged. The chart shows that while debt service will rise, it will still be lower than at any point prior to 2015. So not only should Italy spend significantly more to combat the severely damaging nature of the pandemic, we would expect that Italian spreads would fall, not rise, in such an outcome. Jonathan LaBerge, CFA Vice President Special Reports III. Indicators And Reference Charts Last month, we took a more positive stance on equities as both our valuation and monetary indicators had moved decisively into accommodative territory. While the global economy was set to weaken violently, the easing in our indicators suggested that stocks offered an adequate risk/reward ratio to take some risk. This judgment was correct. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further. Moreover, we are starting to get more clarity as to the re-opening of most Western economies because new reported cases of COVID-19 are peaking. Finally, the VIX has declined substantially but is nowhere near levels warning of an imminent risk to stocks and sentiment is still subdued. Tactically, equities are becoming somewhat overbought. However, this impression is mostly driven by the rebound in tech stocks and the strong performance posted by the healthcare sector. The median stock remains quite oversold. In this context, if the S&P 500 were to correct, we would not anticipate this correction to morph into a new down leg in the bear market that would result in new lows below the levels reached on March 23. For now, the most attractive strategy to take advantage of the supportive backdrop for stocks is to buy equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. Real yields will likely remain at very low levels for an extended period of time as short rates are unlikely to rise anytime soon. The yield curve is therefore slated to steepen further. The dollar has stabilized since we last published but it has not meaningfully depreciated. On the one hand, the threat of an exploding twin deficit and a Fed working hard to address the dollar shortage and keep real rates in negative territory are very bearish for the dollar. But on the other hand, free-falling global growth and spiking policy uncertainty are highly bullish for the Greenback. A stalemate was thus the most likely outcome. However, we are getting closer to a rebound in growth in Q3, which means that the balance of forces will become an increasingly potent headwind for the expensive dollar. Thus, it remains appropriate to use rallies in the dollar to offload this currency. Finally, commodities continue to linger near their lows, creating a mirror image to the dollar. They are still very oversold and sentiment has greatly deteriorated, except for gold. Thus, if as we expect, the dollar will soon begin to soften, then commodities will appreciate in tandem. The move in oil prices was particularly dramatic this month. The oil curve is in deep contango and oil producers from Saudi Arabia to the US shale patch have begun cutting output. Therefore, oil is set to rally meaningfully as the global economy re-opens for business. The large balance sheet expansion by the Fed and other global central banks will only fuel that fire. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see US Equity Strategy Weekly Report "Gauging Fair Value," dated April 27, 2020, available at uses.bcaresearch.com 2  Please see US Investment Strategy Special Report "How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study," dated March 30, 2020 and US Investment Strategy Special Report "How Vulnerable Are US Banks? Part 2: It’s Complicated," dated April 6, 2020 available at usis.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report "EM Domestic Bonds And Currencies," dated April 23, 2020, available at ems.bcaresearch.com 4  Please see US Bond Strategy Weekly Report "Buying Opportunities & Worst-Case Scenarios," dated March 17, 2020 and US Bond Strategy Weekly Report "Life At The Zero Bound," dated March 24, 2020 available at usbs.bcaresearch.com 5  Please see US Bond Strategy Weekly Report "Is The Bottom Already In?" dated April 21, 2020 and US Bond Strategy Special Report "Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures," dated April 14, 2020 available at usbs.bcaresearch.com 6 “Bad deflation” reflects poor demand, which constrains corporate pricing power. “Good deflation” reflects productivity growth. Good deflation?? does not automatically extend to declining real profits and it is not linked with falling stock prices. The Roaring Twenties are an example of when “good deflation” resulted in a surging stock market. 7  Please see US Equity Strategy Weekly Report "Fight Central Banks At Your Own Peril," dated April 14, 2020, available at uses.bcaresearch.com 8  Skeptical economists call Japan’s largest-ever stimulus package ‘puffed-up’, Keita Nakamura, The Japan Times, April 8, 2020. 9  Please note that Chart II-3 differs somewhat from a chart that has been frequently shown by our Geopolitical Strategy service. Both charts are accurate; they simply employ different definitions of the fiscal response to the pandemic. 10 Indeed, McConnell has already walked back his comments that states should consider bankruptcy. President Trump is constrained by the election, as are Senate Republicans, and the House Democrats control the purse strings. Hence more state and local funding is forthcoming. At best for the Republicans, there may be provisions to ensure it goes to the COVID-19 crisis rather than states’ unfunded pension obligations. See Geopolitical Strategy, “Drowning In Oil (GeoRisk Update),” April 24, 2020, www.bcaresearch.com. 11 School and work closure dates have been sources from the Oxford COVID-19 Government Response Tracker.

Highlights The six-month increase in European bank credit flows amounts to an underwhelming $70 billion, compared to a record high $660 billion in the US and $550 billion in China. Underweight European domestic cyclicals versus their peers in the US and China. Specifically, underweight euro area banks versus US banks. Overweight equities on a long-term (2 years plus) horizon. The mid-single digit return that equities are offering makes them attractive versus ultra-low yielding bonds. But remain neutral equities on a 1-year horizon, until it becomes clear that we can prevent a second wave of the pandemic. Fractal trade: long bitcoin cash, short ethereum. Feature Chart I-1Bank Credit 6-Month Flow Up $70 Bn ##br##In The Euro Area… Bank Credit 6-Month Flow Up $70 Bn In The Euro Area... Bank Credit 6-Month Flow Up $70 Bn In The Euro Area... Chart I-2…But Up $700 Bn ##br##In The US ...But Up $700 Bn In The US ...But Up $700 Bn In The US Governments and central banks are dishing out an alphabet soup of stimulus. The question is: how much is reaching those that need it? Our preferred approach to assessing monetary stimulus is to focus on the evolution of bank credit flows and bond yields over a six-month period. Bank Credit Flows Have Surged In The US And China, Not In Europe On our preferred assessment, Europe’s monetary stimulus is underwhelming compared with that in the US and China. The six-month increase in US bank credit flows, at $660 billion, is the highest in a decade and not far from the highest ever. In China, the equivalent six-month increase is $550 billion. But in the euro area, the six-month increase in bank credit flows amounts to an underwhelming $70 billion (Charts I-1 - Chart I-4). Chart I-3Bank Credit 6-Month Flow Up $550 Bn In China… Bank Credit 6-Month Flow Up $550 Bn In China... Bank Credit 6-Month Flow Up $550 Bn In China... Chart I-4...And Up ##br##Globally ...And Up Globally ...And Up Globally Admittedly, US firms are drawing on pre-arranged bank credit lines rather than taking out new loans. Furthermore, the link between bank credit flows and final demand might be compromised during the current economic shutdown. For example, if firms are borrowing to pay workers who are not producing any output, then the transmission of a credit flow acceleration to a GDP acceleration would be weakened. Europe’s monetary stimulus is underwhelming compared with that in the US and China. Nevertheless, some bank credit flows will still reach the real economy. And the US and China are creating more bank credit flows than Europe. Focus On The Deceleration Of The Bond Yield Turning to the bond yield, it is important to focus not on its level, and not on its decline. Instead, it is important to focus on its deceleration. The focus on the deceleration of the bond yield sounds counterintuitive, but it results from a fundamental accounting identity. The next two paragraphs may seem somewhat technical but read them carefully, as they are important for understanding the transmission of stimulus. GDP is a flow. It measures the flow of goods and services produced in a quarter. Hence, GDP receives a contribution from the flow of credit. The flow of credit, in turn, is established by the level of bond yields. When we talk about stimulating the economy, we mean boosting the GDP growth rate from, say, -1 percent to +1 percent, which is an acceleration of GDP. This acceleration in the GDP flow must come from an acceleration in the flow of credit. This acceleration in the flow of credit, in turn, must come from a deceleration of bond yields. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Banks tend to perform better after bond yields have decelerated. The good news is that in the US and China, bond yields have decelerated; the bad news is that in Europe, they have not. Over the past six months, the 10-year bond yield has decelerated by 40 bps in the US and by 65 bps in China. Yet in France, despite the coronavirus crisis, the 10-year bond yield has accelerated by 60 bps (Charts I-5 - Chart I-8).1 Chart I-5The Bond Yield Has Accelerated ##br##In The Euro Area... The Bond Yield Has Accelerated In The Euro Area... CHART B The Bond Yield Has Accelerated In The Euro Area... CHART B Chart I-6...Decelerated ##br##In The US... ...Decelerated In The US... ...Decelerated In The US... Chart I-7...Decelerated In China... ...Decelerated In China... ...Decelerated In China... Chart I-8...And Decelerated Globally ...And Decelerated Globally ...And Decelerated Globally European bond yields are struggling to decelerate because of their proximity to the lower bound to bond yields, at around -1 percent. The inability to decelerate the bond yield constrains the monetary stimulus that Europe can apply compared to the US and China, whose bond yields are much further from the lower bound constraint. Compared to Europe, the US and China have much stronger decelerations in their bond yields and much stronger accelerations in their bank credit flows. This suggests underweighting European domestic cyclicals versus their peers in the US and China. Specifically, banks tend to perform better after bond yields have decelerated; and they tend to perform worse after bond yields have accelerated. On this basis, underweight euro area banks versus US banks (Chart I-9). Chart I-9Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Banks Perform Better After Bond Yields Have Decelerated, Worse After Bond Yields Have Accelerated Long-Term Asset Allocation Is Straightforward, Shorter-Term Is Not The level of the bond yield, or of so-called ‘financial conditions’, does not drive the short-term oscillations in credit flows. To repeat, it is the acceleration and deceleration of the bond yield that matters. Yet when it comes to the long-term valuation of assets, the level of the bond yield does matter, and when the bond yield is ultra-low it matters enormously. An ultra-low bond yield justifies a much lower prospective return on competing long-duration assets, like equities. The reason is that when bond yields approach their lower bound, bond prices can no longer rise, they can only fall. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on equities. In this world of ultra-low numbers – for both bond yields and equity risk premiums – the low to mid-single digit long-term return that equities are offering makes them attractive versus bonds (Chart I-10). Chart I-10Equities Are Offering Mid-Single Digit Long-Term Returns Equities Are Offering Mid-Single Digit Long-Term Returns Equities Are Offering Mid-Single Digit Long-Term Returns But this long-term valuation argument only works for those with long-term investment horizons. What does long-term mean? There is no clear dividing line, but we would define long-term as two years at the very minimum. For a one-year investment horizon, the much more important question is: what will happen to 12-month forward earnings (profits)?  In the stock market recessions of 2008-09 and 2015-16, the stock market reached its low just before forward earnings reached their low. Assuming the same holds true in 2020-21, we must establish whether forward earnings are close to their low or not. In 2008-09, world forward earnings collapsed by 45 percent. In the current recession, which is putatively worse, world forward earnings are down by less than 20 percent to date. To have already reached the cycle low in forward earnings with only half the decline of 2008, the current recession needs to be much shorter than the 2008-09 episode (Chart I-11 and Chart I-12). Chart I-11In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent In The Global Financial Crisis, Forward Earnings Collapsed By 45 Percent Chart I-12In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? In The Current Crisis, Forward Earnings Are Down 20 Percent. Is That Enough? Whether this turns out to be the case or not hinges on the pandemic and our response to it. A controlled easing of lockdowns will boost growth as more of the economy comes back to life. But too rapid an easing of lockdowns will unleash a second wave of the pandemic, requiring a second wave of economic shutdowns, a double dip recession and a new low in the stock market. Hence, if you have a long-term (2-year plus) investment horizon, the choice between equities and bonds is very straightforward: overweight equities. On this long-term horizon, German and Swedish equities are especially attractive versus negative-yielding bonds. On a 1-year investment horizon, the key question is: can we avoid a second wave of the pandemic? But if you have a 1-year investment horizon, the choice is less straightforward, because it hinges on whether we can avoid a second wave of the pandemic or not. Until it becomes clear that governments will not reopen economies too quickly, remain neutral equities on the 1-year horizon. Fractal Trading System* This week’s recommended trade is a pair-trade within the cryptocurrency asset-class. Long bitcoin cash / short ethereum. Set the profit target at 21 percent with a symmetrical stop-loss. The 12-month rolling win ratio now stands at 61 percent. Chart I-13Bitcoin Cash Vs. Ethereum Bitcoin Cash Vs. Ethereum Bitcoin Cash Vs. Ethereum When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In the US, the 10-year bond yield has declined by 120 bps in the past six months compared with 80 bps in the preceding six months, which equals a deceleration of 40 bps; in China, the 10-year bond yield has declined by 73 bps in the past six months compared with 18 bps in the preceding six months, which equals a deceleration of 65 bps; but in France, the 10-year bond yield has increased by 12 bps in the past six months compared with a 48 bps decline in the preceding six months, which equals an acceleration of 60 bps. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

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

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