Global

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report on China from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt will discuss whether China’s President Xi Jinping is losing his political mandate. Best regards, Peter Berezin, Chief Global Strategist Highlights The pandemic is likely to have a more severe impact on Main Street than Wall Street, which helps explain why stocks have rallied off their lows even as bond yields have remained depressed. Equity investors are hoping that central banks will keep rates lower for longer, while fiscal easing will revive demand. The end result could be lower bond yields within the context of a full employment economy – a win-win for stocks.  In the near term, these hopes could be dashed, given bleak economic data, falling earnings estimates, and rising worries about a second wave of the pandemic. Longer term, an elevated equity risk premium and the likelihood that the pandemic will not have a significantly negative effect on the supply side of the economy argue for overweighting stocks over bonds. Negative real rates will continue to support gold prices. A weaker dollar later this year will also help. Divergent Signals Chart 1Conflicting Signals Conflicting Signals Conflicting Signals Global equities have rallied 24% off their March lows. The S&P 500 is down only 12% year-to-date and is trading close to where it was last August. In contrast, bond yields have barely risen since March. The US 10-year note currently yields 0.63%, down from 1.92% at the start of the year. The yield on the 30-year bond stands at a mere 1.3%. While crude oil and industrial metal prices have generally tracked bond yields, gold prices have rallied alongside equities (Chart 1). It would be easy to throw up one’s hands and exclaim that markets are behaving schizophrenically. Yet, we think it is possible to reconcile these seemingly divergent price patterns in a way that sheds light on where the major asset classes are likely to go in the months ahead. Two important points should be kept in mind: Bonds and industrial commodities tend to reflect the outlook for the real economy (i.e., Main Street) whereas stocks reflect the outlook for corporate earnings (i.e., Wall Street). The two often move together but can occasionally diverge in important ways. Stock prices and bond yields will tend to move in tandem when deflationary pressures are intensifying; however, the two often move in opposite directions when monetary policy is becoming more accommodative. The former prevailed in early March whereas the latter has been the dominant force since central banks have opened up the monetary spigots. The Real Economy Is Suffering The current economic downturn will go down as the deepest since the Great Depression. The IMF expects global GDP to contract by 3% this year, compared with a flat reading in 2009. GDP in advanced economies is projected to fall by 6%, twice as bad as in 2009 (Chart 2). Chart 2Severe Damage To The Global Economy This Year Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Unemployment rates are also likely to reach the highest levels since the 1930s. The US unemployment rate spiked to 14.7% in April. Even that understates the true increase in joblessness. The labor force has shrunk by 8 million workers since February. If everyone who had left the labor force had been considered unemployed, the unemployment rate would have jumped to nearly 19% (Chart 3). Unemployment among less-skilled workers rose more than among the skilled. Joblessness also increased more among women than men (Chart 4). Chart 3Increase In Joblessness Is Understated Increase In Joblessness Is Understated Increase In Joblessness Is Understated Chart 4Unemployment Has Risen More For Less Skilled Workers And Women Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? The one silver lining is that unlike in past recessions, temporary layoffs have accounted for the vast majority of job losses (Chart 5). This suggests that the links between firms and workers have yet to be severed. As businesses reopen, the hope is that most of these workers will be able to return to their jobs, fueling a rebound in spending. Chart 5Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Risks Of A Second Wave Will that hope be realized? As we discussed last week, the virus that causes COVID-19 is highly contagious – probably twice as contagious as the one that caused the Spanish flu.1 While some social distancing measures will persist even if governments relax lockdown orders, the risk is high that we will see a second wave of infections. Even if a second wave ensues, we do not expect stocks to take out their March lows. In many places, the second wave could come on top of a first wave that has barely abated. This is precisely what happened during the Spanish flu pandemic (Chart 6). Stock prices and credit spreads have closely tracked the number of Google queries about the coronavirus (Chart 7). If the number of new infections begins to trend higher, concern about the pandemic will deepen. This makes us somewhat wary about the near-term direction of risk assets. Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Chart 7Joined At The Hip Joined At The Hip Joined At The Hip   March Was The Bottom In Equities Nevertheless, even if a second wave ensues, we do not expect stocks to take out their March lows. This is partly because the cone of uncertainty around the virus has narrowed. We now know that the fatality rate from the virus is around 1%-to-1.5%, which makes COVID-19 ten times more deadly than the common flu, but still less lethal than SARS or MERS, let alone some avian flu strains which have mortality rates upwards of 50%. A few treatments for the virus are on the horizon. Gilead’s remdesivir appears to be effective in treating COVID-19. Blood plasma injections also look promising. A vaccine developed by researchers at the University of Oxford has been shown to be safe on humans and effective against COVID-19 on rhesus monkeys. Production of the vaccine has already begun, and if it works well on humans, the Oxford scientists expect it to be widely available by September.2 The Stock Market Is Not The Economy Then there is the issue of Main Street versus Wall Street. US equities account for over half of global stock market capitalization. Tech and health care are the two largest sectors in the S&P 500. The former has benefited from the shift towards digital commerce in the wake of the pandemic, while the latter is a highly defensive sector that has gained from the flurry of interest in new treatments for the disease (Chart 8). Chart 8AUS Equity Sectors: Winners And Losers From The Pandemic (I) US Equity Sectors: Winners And Losers From The Pandemic US Equity Sectors: Winners And Losers From The Pandemic Chart 8BUS Equity Sectors: Winners And Losers From The Pandemic (II) US Equity Sectors: Winners And Losers From The Pandemic US Equity Sectors: Winners And Losers From The Pandemic Even within individual sectors, the impact on Wall Street has been more muted than on Main Street. For example, spending on consumer discretionary goods and services has plummeted across the real economy over the past few months. Yet, this has not hurt equity investors as much as one might have expected. Amazon accounts for 55% of the retail sector’s market capitalization. Home Depot is in second place by market cap. Home Depot’s stock is trading near an all-time high, buoyed by increased spending on home improvement projects by people stuck at home. McDonald's, which is benefiting from the shift to take-out ordering, is the largest stock in the consumer services sector (followed by Starbucks). Contrary to the claim that the stock market is blissfully ignorant of the mounting economic damage, those sectors that one would expect to suffer from a pandemic-induced downturn have, in fact, suffered. Airline stocks, which account for less than 2% of the industrials sector, have plunged. The same is true for cruise ship stocks. Bank stocks have also been beaten down, reflecting fears of heightened loan losses. Likewise, lower oil prices have undercut the stocks of energy exploration and production companies (Chart 9). At the regional level, non-US stocks, with their heavy weighting in deep cyclicals and financials, have underperformed their US peers. Small caps have also lagged their large cap brethren, while value stocks have trailed growth stocks (Chart 10). Chart 9Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Chart 10Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Tech stocks are overrepresented in growth indices, which helps explain why growth has outperformed value. Tech companies also tend to carry little debt while sporting large cash holdings. Companies with strong balance sheets have greatly outperformed companies with weak ones since the start of the year (Chart 11). Chart 11Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Chart 12Real Rates Have Come Down This Year Real Rates Have Come Down This Year Real Rates Have Come Down This Year In addition, growth companies have disproportionately benefited from the dramatic decline in real interest rates (Chart 12). A drop in the discount rate raises the present value of a stream of cash flows more the further out in time those cash flows are expected to be realized.   What Low Bond Yields Are Telling Us Doesn’t the decline in real long-term interest rates signal that future economic growth will be considerably weaker? If so, doesn’t this nullify the benefit to growth companies in particular, and the stock market in general, from a lower discount rate? Not necessarily! While lockdowns have led to a temporary drop in aggregate supply, they have not severely undermined the long-term productive capacity of the economy. Unlike during a war, no factories have been destroyed. And while heightened unemployment could lead to some atrophying of skills, the human capital base has remained largely intact. Chart 13 shows that output-per-worker eventually returned to its long-term trend following the Great Depression. Chart 13No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth What the pandemic has done is made some forms of capital obsolete. We probably will not need as many cruise ships or airplanes as we once thought. But these items are not a huge part of the capital stock. And while some brick and mortar stores will disappear, this was part of a long-term shift toward a digital economy – a shift that has been raising productivity levels, rather than lowering them. Demand Is The Bigger Issue So why have long-term real interest rates fallen so much? The answer has more to do with demand than supply. Investors are betting that the pandemic will force central banks to keep interest rates at ultra-low levels for a very long period of time. All things equal, such an extended period of low rates might be necessary if the pandemic causes households to increase precautionary savings and prompts businesses to cut back on investment spending for an extended period of time. All things are not equal, however. As discussed in greater detail in Box 1, if real interest rates fall by enough, aggregate demand could still return to levels consistent with full employment since lower interest rates would discourage savings while encouraging capital expenditures. What if interest rates cannot fall by enough because of the zero-lower bound? In that case, fiscal policy would have to pick up the slack. Either taxes would need to be cut so that the private sector becomes more eager to spend, or the government would need to undertake more spending directly on goods and services. When interest rates are close to zero, worries about debt sustainability diminish since debt can be rolled over at little cost. In the end, the economy could end up in a new post-pandemic equilibrium where real interest rates are lower and fiscal deficits are larger. Applying Theory To Practice Framed in this light, we can make sense of what has happened over the past few months. The drop in long-term bond yields in February and early March was driven by falling inflationary expectations and rising financial stress. Yields then briefly jumped in mid-March as panicky investors dumped bonds in a mad scramble to raise cash. Not surprisingly, stocks suffered during this period. The Federal Reserve reacted to this turmoil by cutting rates to zero. It also initiated large-scale asset purchases, which injected much needed cash into the markets. In addition, the Fed dusted off the alphabet soup of programs created during the financial crisis, while launching a few new ones in an effort to increase the availability of credit and reduce funding costs. Other central banks also eased aggressively. As Chart 14 illustrates with a set of simple examples, even a modest decline in long-term interest rates has the power to significantly raise the present value of future cash flows. To compliment the easing in monetary policy, governments loosened fiscal policy (Chart 15). The point of the stimulus was not to raise GDP. After all, governments wanted most non-essential workers to remain at home. What fiscal easing did do was allow many struggling households and businesses to meet their financial obligations, while hopefully having enough income left over to generate some pent-up demand for when businesses did reopen their doors. Chart 14What Happens To Earnings During A Recessionary Shock? Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Chart 15Will It Be Enough? Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Ultimately, equity investors are hoping for an outcome where fiscal policy is eased by enough to eventually restore full employment while interest rates stay low well beyond that point in order to induce the private sector to keep spending: A win-win combination for stocks. Chart 16Gold Prices Move In The Opposite Direction To Real Rates Gold Prices Move In The Opposite Direction To Real Rates Gold Prices Move In The Opposite Direction To Real Rates The discussion above can also explain the divergent moves in commodity prices. Most industrial metals are consumed not long after they are produced. This makes industrial metal prices highly sensitive to the state of the global business cycle. In contrast, almost all of the gold that has ever been unearthed is still around. This makes gold an anticipatory asset whose price reflects expectations about future demand. Since owning gold does not generate any income, the opportunity cost of holding gold is simply the interest rate (Chart 16). When real interest rates rise, as they did briefly in early March when deflationary fears intensified, gold prices tend to fall. When real interest rates decline, as they did after central banks slashed rates and restarted large-scale QE programs, gold prices tend to rise. Investment Conclusions The current environment bears a passing resemblance to the one that prevailed in late 2008. Following the stock market crash in the wake of Lehman’s bankruptcy, the S&P 500 rallied by 24% between November 20, 2008 and January 6, 2009 to reach a level of 935. Had you bought stocks on that day in January, you still would have made good money over a 12-month horizon. However, you would have lost money over a 3-month horizon since the S&P 500 ultimately dropped to as low as 667 on March 6. During that painful first quarter of 2009, the economic surprise index remained firmly below zero, while earnings estimates continued to drift lower, just like today (Chart 17). As noted above, we do not expect stocks to take out their March 2020 lows, but a temporary sell-off would not surprise us, especially against a backdrop where a second wave of the pandemic looks increasingly likely. Chart 17Is Today A Replay Of Late 2008/Early 2009? Is Today A Replay Of Late 2008/Early 2009? Is Today A Replay Of Late 2008/Early 2009? Chart 18Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Despite our near-term concerns, we continue to think that stocks will outperform bonds over a 12-month horizon. The equity risk premium remains elevated, particularly outside the US (Chart 18). While non-US stocks do not have as much exposure to tech and health care, they do benefit from very cheap valuations. European banks are trading at washed out levels (Chart 19). The cyclically-adjusted PE ratio for EM stocks is near record lows (Chart 20). Investors should consider increasing exposure to non-US equities if global growth begins to reaccelerate this summer. Chart 19European Banks Are Trading At Washed Out Levels European Banks Are Trading At Washed Out Levels European Banks Are Trading At Washed Out Levels Chart 20EM Stocks Are Very Cheap Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Given our view that central banks want real rates to stay low and will refrain from tightening monetary policy even if inflation eventually begins to rise, investors should maintain above-average exposure to gold. A weaker US dollar later this year will also help bullion. Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2  Charlie D’Agata, “Oxford scientists say a vaccine may be widely available by September,” cbsnews (April 30, 2020). Global Investment Strategy View Matrix Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Current MacroQuant Model Scores Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages?

Highlights Fear of deflation – especially at current debt levels – will keep central-bank policy looser for longer. As a result, monetary authorities will do whatever it takes to revive inflation and inflation expectations to move policy rates away from the zero lower bound. EM income growth will rebound, and the US dollar will weaken as monetary and fiscal stimulus reach the real economy. This will be bullish for commodities, including gold. Over the medium to long term, the reversal in globalization and the atrophy of working-age populations will be inflationary: Labor markets will tighten as economic growth recovers and baby-boomers continue to retire, pushing wages higher and savings lower. Over the short term, we are neutral gold from a pricing standpoint, and believe $1,700/oz is close to fair value. When gold pushes through $1,800/oz, longer-term demographic and economic trends will become apparent and will catalyze gold’s rally. We continue to favor gold as a portfolio hedge, as it has held value throughout the COVID-19 pandemic and the re-emergence of geopolitical tensions, particularly the return of Sino-US trade acrimony. Feature Gold will remain at ~ $1,700/oz after rallying 15% from its mid-March bottom, as markets consolidate over the short term. This new equilibrium has been fueled by North American retail investors and is slightly above our model’s fair value (Chart of the Week). While gold’s short-term price drivers appear to have stabilized over the past few weeks – i.e. real rates, US dollar, and equity uncertainty are holding fairly steady – a temporary pullback is likely. Strategically, however, the balance of risks is skewed to the upside. Chart of the WeekRetail Investment Demand Supports Gold Above Our Fair-Value Estimates Retail Investment Demand Supports Gold Above Our Fair-Value Estimates Retail Investment Demand Supports Gold Above Our Fair-Value Estimates Our usual framework classifies gold’s drivers into three broad categories: Demand for inflation hedges; Monetary and financial aggregates; and Demand for portfolio-diversification assets. In this report, we are narrowing our focus to concentrate on the tactical vs. strategic drivers of gold prices, to assess the metal’s upside potential over the short- and long-term horizons (Table 1). Table 1Short- vs. Long-Term Drivers Of Gold Prices Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Over the short-term, gold prices fluctuate mostly with changes in risk aversion, opportunity costs and relative prices vis-à-vis other assets. Longer term, gold prices trend with income and inflation cycles, along with structural changes in households’ savings rates. Short- and Medium-term Drivers Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. Western Buyers To The Rescue The COVID-19 pandemic greatly altered the composition of gold demand in 1Q20. Jewellery and bar-and-coin demand dropped 42% and 11% y/y in the wake of a collapse of Chinese and Indian demand (Chart 2, panel 1). This was offset by sharp inflows to ETF products – mainly from DM investors. ETF inflows increased by ~ 300 tons in 1Q20, and by 170 tons in April 2020 (Chart 2, panel 3). Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. However, the short-term outlook for gold could be volatile as investment and jewellery demand normalize. As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand. Chart 2Weak EM Consumer Demand Offset By Strong North America ETF Inflows Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Chart 3Investment Demand Overtakes Jewellery's Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Since 2010, investment and jewellery demand represented ~ 33% and ~ 58%, respectively, of total gold demand – excluding central bank net purchases (Chart 3). As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand – albeit at a slower pace (Chart 4). NB: A large mismatch in the speed of these adjustments could lead to an undershoot in prices – especially at current elevated positioning. Chart 4Elevated Interests In Gold From Retail Investors Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Chart 5Investors Allocation To Gold Is Close To 2012 Levels Investors Allocation To Gold Is Close To 2012 Levels Investors Allocation To Gold Is Close To 2012 Levels We’ve argued in February there was still an opportunity for investment-led growth to support prices based on the low value of investors’ total holdings of gold compared to global equities on a market-cap basis. This measure is now approaching its 2012 peak and moving toward unknown territory in terms of portfolio and wealth allocation to gold (Chart 5). This is flagging up a risk that short-term traders will want to take profits on their speculative positions, if virus-related uncertainty diminishes. On the other hand, retail buyers could hold on to their hedges. Historically, profound economic dislocations and persistent uncertainty have been complemented by shifts in investors’ behavior, leading to higher average saving rates – e.g. 1929, WWII, 2008’s GFC – (Chart 6). Additionally, downside risks to the reopening of economies worldwide remain significant, particularly given the uncertainty of the COVID-19 pandemic’s evolution: A second wave of contagion would trigger a massive flight to safety and further central bank actions to keep rates depressed. Chart 6Precautionary Savings Rise In Highly Uncertain Periods Precautionary Savings Rise In Highly Uncertain Periods Precautionary Savings Rise In Highly Uncertain Periods Awaiting A Setback To The USD The Fed and other systemically important central banks have taken decisive action to keep money markets functioning and to prevent a solvency crisis (Chart 7, panel 1). Ample liquidity, low economic growth, and collapsing inflation expectations pushed bond yields lower globally, which, in large measure, powered the rally in gold prices (Chart 7, panel 2). The protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year. In recent weeks, US yields have stabilized, meaning this factor will not provide much support to gold at current levels – assuming, again, no major second wave in COVID-19 contagion. The upside to rates is also limited over the short term as the increase in Treasury supply will be offset by the Fed’s dovish forward rate guidance. Still, the protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year (e.g., ahead of the US elections). Moreover, the Fed appears to be willing to risk remaining behind the curve for the foreseeable future. Bonds' protection would suffer if the Fed allows inflation overshoot (more on this below). In 2H20, we expect the USD to weaken as virus-related safe-haven demand – which fueled its 14% rally ytd vs. EM currencies – abates and the Fed’s and the US government’s responses to the crisis floods markets globally with USD liquidity.1 Relative balance-sheet and interest-rate dynamics will reassert themselves as important drivers of currency movements (Chart 8). Chart 7QE Infinity Will Keep Bond Yields Depressed QE Infinity Will Keep Bond Yields Depressed QE Infinity Will Keep Bond Yields Depressed Chart 8USD Deviating From Interest Rate Differentials USD Deviating From Interest Rate Differentials USD Deviating From Interest Rate Differentials The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Bottom Line: The sum of gold’s short-term drivers are neutral at the current $1,700/oz equilibrium. The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Long-term Drivers The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. Stimulative Policies To Boost EM Income Growth Global income growth is one of the core drivers of gold prices over long horizons (Chart 9, panel 1). As countries get wealthier, the pool of savings rises, which benefits gold, along with most financial assets. Because gold-mining production growth is relatively stable and inelastic to prices in the short-term, changes in income growth above production growth have a crucial influence on gold’s trajectory over the long run. EM countries – chiefly China and India – are the largest buyers of jewellery, bars and coins, and remain among the fastest-growing economies on the planet. Hence, since 2000, gold’s annual price change correlates strongly with their income growth (Chart 9, panel 2). In addition, central banks’ net gold purchases – which have been increasingly positive since 2009 – effectively reduce available supply to consumers. We include net purchases in our measure of total supply to separate it from consumer and investor demand – which respond to entirely different incentives (Chart 9, panel 3). We expect EM central banks will continue diversifying part of their US dollar reserves to gold.2 Chart 9Global Income Growth Drives Long Term Gold Returns Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Chart 10China's Economic Activity Close To Pre-COVID-19 Levels Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. China’s economic activity appears to have partly recovered from the COVID-19 shock (Chart 10). Going forward, the country’s surging fiscal and monetary stimulus, in addition to a weakening US dollar, will revive growth in neighboring Asian economies this year. Structural Deflationary Pressures Are Easing We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system. As we’ve argued in previous reports, gold acts as a good inflation hedge when there is an increase in perceived risks of significant overshoots.3 In normal times, inflation expectations move slowly and trend more or less with past inflation prints (Chart 11). However, the unprecedented global fiscal and monetary stimulus deployed to combat the COVID-19-induced recession could shift expectations rapidly and profoundly. We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system (Chart 12). Moreover, a combination of deflationary structural factors – i.e. trade globalization, expanding global value chains, and demographics – are reversing, and will gradually become inflationary.4 This is a stark difference to the post-GFC quantitative easing. Chart 11Inflation Expectations Trend Along Past Realized Inflation Rates Inflation Expectations Trend Along Past Realized Inflation Rates Inflation Expectations Trend Along Past Realized Inflation Rates Chart 12Surging US Broad Money Supply Surging US Broad Money Supply Surging US Broad Money Supply Firstly, globalization’s deflationary impulse – thru increasing trade and expanding global value chains – stalled a few years ago (Chart 13). Recently, ramping anti-globalization policies amidst the Sino-US trade tensions exposed vulnerabilities in the current trade infrastructure. The COVID-19 pandemic risks accelerating these trends. Following widespread quarantine measures in China, US imports from China fell sharply in February and March, and firms without pre-established supply chain relationships with other Asian countries that could backstop supply disruptions were left unable to find alternative suppliers (Table 2). Firms will likely continue diversifying their supply sources and insource critical activities to the US, post-COVID-19.5 Additionally, our Geopolitical strategists see increasing risks of renewed US pressures on China ahead of the election.6 An acceleration in de-globalization trends post-COVID-19 will disrupt international supply chains and amplify inflationary pressures. Chart 13The Structural Reversal In Globalization Trends Will Be Inflationary The Structural Reversal In Globalization Trends Will Be Inflationary The Structural Reversal In Globalization Trends Will Be Inflationary   Table 2Vulnerability In US Supply Chains Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking. Secondly, structural demographic trends are reversing. The world’s support ratio – i.e. the number of workers per dependent – has been trending downward since 2015 (Chart 14, panel 1). As more people around the world reach retirement age, this trend is expected to continue. This trend is especially powerful in China, whose workforce was one of the great deflationary demographic factors in previous decades. Effectively, this implies aggregate demand is likely to exceed aggregate supply as more workers become consumers. In theory, this also implies lower global savings and a higher neutral rate of interest. Consequently, a rising neutral rate, combined with our belief central bankers will be behind the curve in raising rates, increases the risks of inflation moving sharply above target. Chart 14Demographic Trends Will Become Inflationary Demographic Trends Will Become Inflationary Demographic Trends Will Become Inflationary China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking – the country could lose ~ 400 million workers over the remainder of the century (Chart 14, panel 2). The integration of the Chinese – and other EM countries – workforce during the 2000s led to a doubling of the global pool of labor supply and reduced the average labor cost. Investment Conclusion Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges. Investors need to assess the long-term consequences of these trends and policies vs. the short-term deflationary COVID-19 shock. Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges (Chart 15). While we expect higher US inflation expectations and headline rates in 2H20 – driven by the decline in the USD and the increase in oil and base-metals’ prices – we do not expect meaningful inflation-overshoot risks until late 2021. Core inflation rates will remain depressed until the large labor-supply overhang clears – in the US and globally – and the effect of the lower USD pass-through to higher prices emerges (Chart 16). Chart 15Gold Is Not Relatively Expansive, Except Vs. Commodities Gold Is Not Relatively Expansive, Except Vs. Commodities Gold Is Not Relatively Expansive, Except Vs. Commodities Chart 16The COVID-19-Induced Deflationary Effects Will Last Until Next Year The COVID-19-Induced Deflationary Effects Will Last Until Next Year The COVID-19-Induced Deflationary Effects Will Last Until Next Year Re-anchoring expectations will necessitate periods of above-target inflation rates. The short-term drivers of gold are neutral at the current $1,700/oz equilibrium, as inflation pressure won’t surface until 2H21. Moreover, there is a non-negligible risk of a short-term pullback if DM economies are successfully reopened without significant increases in COVID-19 infection rates. This should serve as a buying opportunity, as the medium- and long-term outlook remains bullish for the yellow metal. EM income growth is poised to rebound as global monetary and fiscal stimulus reach the real economy and the USD depreciates. The reversal in globalization and demographic trends will become inflationary. Policymakers will do whatever it takes to revive inflation and inflation expectations to move away from the zero lower bound. Re-anchoring expectations will necessitate periods of above-target inflation rates. Thus, real rates should be contained as QE continues to depress the term premium and inflation starts to move higher. Fear of deflation – especially at current debt levels – will keep central banks too easy for too long.   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Oil production globally is falling faster than expected, based on anecdotal press reports showing the Kingdom of Saudi Arabia (KSA) took an additional 1mm b/d of production off the market, bringing its total shut-in level to 7.5mm b/d for next month. The Saudi government urged OPEC 2.0 member states to follow its lead and reduce production further. The US EIA this week reported it expects Russia’s production to fall more than 800k b/d, while in the US production is expected to decline by a similar amount this year, and another 600k b/d in 2021. Canada’s production is expected to fall 400k b/d. Non-OPEC production overall is expected to fall 2.4mm b/d this year. We will be updating our supply-demand balances and prices forecasts in next week’s report. Base Metals: Neutral Steel markets are becoming concerned COVID-19-induced production declines will reduce iron-ore shipments. Earlier this month, 10 cities in the Brazilian state of Para, an ore-producing region, were placed under lockdown, according to FastMarkets MB, a sister publication of BCA Research. Even though ore mining and shipping have been exempted, concern that COVID-19 could reach the producing regions and affect output is growing. Benchmark 62% Fe ore is down 6.2% from its January highs (Chart 17). Precious Metals: Neutral A forecast by Australia’s Department of Industry, Science, Energy and Resources (ISER) that Australia would become the world’s largest gold producer in 2021 was seconded this week by a private forecaster, Resources Monitor. The ISER forecast Australia would overtake China as the top gold producer in its March 2020 forecast, with output reaching 383 tons next year. Australia produced 326 tons last year, vs. China’s 380 tons. Ags/Softs:  Underweight The USDA released its first estimate for the 2020/2021 marketing year, projecting corn ending stocks at 3.318 Bn bushels for the season, the largest stockpile since 1987/1998 (Chart 18). Huge planting projections will outweigh increases in exports demand of 35 Mn bushels and in usage for ethanol biofuel of 5.2 Bn bushels compared to the current season. Nonetheless corn futures hedged higher on Tuesday, rising 5.25 cents/bu, as the weak outlook was offset by downward revisions to old crop inventories. Finally wheat’s ending stocks were moderately revised up for the current season, but futures still fell to the lowest in a week due to better than expected weather in the US and higher global stocks expectations. Chart 17Supply Constraints Could Boost Prices Supply Constraints Could Boost Prices Supply Constraints Could Boost Prices Chart 18USDA Expects Large US Corn Stocks Increase USDA Expects Large US Corn Stocks Increase USDA Expects Large US Corn Stocks Increase       Footnotes 1     We’ve outlined our view on the dollar for 2020 in our April 23, 2020 Weekly Report. Please see USD Strength Restrains Commodity Recovery, available at ces.bcaresearch.com 2     The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is fading. 3    Please see our Weekly Report titled "All That Glitters ... And Then Some," published July 25, 2019. It is available at ces.bcaresearch.com 4    For more details on these structural factors please see The Bank Credit Analyst Special Reports titled "Troubling Implications Of Global Demographic Trends," and "Three Demographic Megatrends," published 28 February, 2019 and October 26, 2017.  5    Please see Sebastian Heise, “How Did China’s COVID-19 Shutdown Affect U.S. Supply Chains?,” Federal Reserve Bank of New York Liberty Street Economics, May 12, 2020. 6    Please see BCA's Geopolitical Strategy Special Alert titled "#WWIII," published May 1, 2020. It is available at gps.bcaresearch.com.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound Raising Gold To A Strategic Holding, In Preparation For An Inflation Rebound

Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy Quantitative Easing Puts Germans On Hook For Italy Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Chart 9Merkel's CDU Revives Amid Global Crisis Merkel's CDU Revives Amid Global Crisis Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.

Highlights Our baseline view foresees a U-shaped recovery, as economies slowly relax lockdown measures. There are significant risks to this forecast, however. On the upside, a vaccine or effective treatment could hasten the reopening of economies and recovery in spending. On the downside, containment measures could end up being eased too quickly, leading to a surge in new cases. A persistent spell of high unemployment could also permanently damage economies, especially if fiscal and monetary stimulus is withdrawn too quickly. In addition, geopolitical risks loom large, with the US election likely to be fought on who sounds tougher on China. Earnings estimates have yet to fall as much as we think they will, making global equities vulnerable to a near-term correction. Nevertheless, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon. Is It Safe To Come Down? We published a report two weeks ago entitled Still Stuck In The Tree where we likened the current situation to one where an angry bear has chased a hiker up a tree.1 Having reached a high enough branch to escape immediate danger, the hiker breathes a sigh of relief. As time goes by, however, the hiker starts to get nervous. Rather than disappearing back into the forest, the bear remains at the base of the tree licking its chops. Meanwhile, the hiker is cold, hungry, and late for work. Like the hiker, the investment community breathed a collective sigh of relief when the number of cases in Italy and Spain, the first two major European economies to be hit by the coronavirus, began to trend lower. In New York City, which quickly emerged as the epicentre of the crisis in the United States, more COVID patients have been discharged from hospitals than admitted for the past three weeks (Chart 1). Chart 1Discharges From New York Hospitals Have Exceeded Admissions For The Past Three Weeks Risks To The U Risks To The U Deepest Recession Since The 1930s Yet, this progress has come at a very heavy economic cost. The IMF expects the global economy to shrink by 3% this year (Chart 2). In 2009, global GDP barely contracted. Chart 2Severe Damage To The Global Economy This Year Risks To The U Risks To The U The sudden stop in economic activity has led to a surge in unemployment. According to the Bloomberg consensus estimate, the US unemployment rate rose to 16% in April. The true unemployment rate is probably higher since to be considered unemployed one has to be looking for work, which is difficult if not impossible in the presence of widespread lockdowns. Regardless, even the official unemployment rate is the worst since the Great Depression (Chart 3). Chart 3Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression   Unshackling The Economy A key difference from the 1930s is that today’s recession has been self-induced. Policymakers want workers to stay home as much as possible. The hope is that once businesses reopen, most of these workers will return to their jobs. How long will that take? Our baseline scenario envisions a slow but steady reopening of the global economy starting later this month, which should engender a U-shaped economic recovery. Since mid-March, much of the world has been trying to compensate for lost time by taking measures that would not have been necessary if policymakers had acted sooner. As Box 1 explains, some loosening of lockdown measures could be achieved without triggering a second wave of cases once the infection rate has been brought down to a sufficiently low level. To the extent that economic activity tends to move in tandem with the number of interactions that people have, a relaxation of social distancing measures should produce a modest rebound in growth. New technologies and a better understanding of how the virus is transmitted should also allow some of the more economically burdensome measures to be lifted. As we have discussed before, mass testing can go a long way towards reducing the spread of the disease (Chart 4).2 Right now, high-quality tests are in short supply, but that should change over the coming months.  Chart 4Mass Testing Will Help Risks To The U Risks To The U Increased mask production should also help. Early in the pandemic, officials in western nations promulgated the view that masks do not work. At best, this was a noble lie designed to ensure that anxious consumers did not deprive frontline workers of necessary safety equipment. At worst, it needlessly led many people astray. As East Asia’s experience shows, mask wearing saves lives. A recent paper estimated that the virus could be vanquished if 80% of people wore masks that were at least 60% effective, a very low bar that even cloth masks would pass (Chart 5).3  Chart 5Masks On! Risks To The U Risks To The U Recent research has also cast doubt on the merits of closing schools. The China/WHO joint commission could not find a single instance during contact tracing where a child transmitted the virus to an adult. A study by the UK Royal College of Paediatrics provides further support to the claim that children are unlikely to be important vectors of transmission. The evidence includes a case study of a nine year-old boy who contracted the virus in the French Alps but fortunately failed to transmit it to any of the more than 170 people he had contact with in three separate schools.4  Along the same lines, there is evidence that the odds of adults catching the virus indoors is at least one order of magnitude higher than outdoors.5 This calls into question the strategy of states such as California of clearing out prisons of dangerous felons in order to make room for beachgoers.6 Upside Risks To The U: Medical Breakthroughs While a U-shaped economic recovery remains our base case, we see both significant upside and downside risks to this outcome. The best hope for an upside surprise is that a vaccine or effective treatment becomes available soon. There are already eight human vaccine trials underway, with another 100 in the planning stages. In the race to develop a vaccine, Oxford is arguably in the lead. Scientists at the university’s Jenner Institute have developed a genetically modified virus that is harmless to people, but which still prompts the immune system to produce antibodies that may be able to fight off COVID. The vaccine has already worked well on rhesus monkeys. If it proves effective on humans, researchers hope to have several million doses available by September. On the treatment side, Gilead’s remdesivir gained FDA approval for emergency use after early results showed that it helps hasten the recovery of coronavirus patients. Hydroxychloroquine, which President Trump has touted on numerous occasions, is the subject of dozens of clinical trials internationally. While evidence that hydroxychloroquine can treat the virus post-infection is thin, there is some data to suggest that it can work well as a prophylactic.7 Research is also being conducted on nearly 200 other treatments, including an improbable contender: famotidine, the compound found in the heartburn remedy Pepcid.8  Downside Risk: Too Open, Too Soon Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Risks To The U Risks To The U As noted above, once the number of new cases drops to sufficiently low levels, some relaxation of containment measures can be achieved without reigniting the pandemic. That said, there is a clear danger that measures will end up being relaxed too aggressively and too soon. This is precisely what happened during the Spanish Flu (Chart 6). It has become customary to talk about the risk of a second wave of infections; however, the reality is that we have not even concluded the first wave. While the number of cases in New York has been falling, it has been rising in many other US states. As a result, the total number of new coronavirus cases nationwide has remained steady for the past five weeks (Chart 7). It is the same story globally: Falling caseloads in western Europe and East Asia have been offset by rising cases in countries such as Russia, India, and Brazil (Chart 8). Chart 7The Spread Of COVID-19 Has Not Been Contained Everywhere (I) Risks To The U Risks To The U Chart 8The Spread Of Covid-19 Has Not Been Contained Everywhere (II) Risks To The U Risks To The U   Chart 9Widespread Social Distancing Has Dampened The Spread Of All Flus And Colds Risks To The U Risks To The U At the heart of the problem is that COVID-19 remains a highly contagious disease. Most studies assign a Reproduction Number, R, of 3-to-4 to the virus. As a point of comparison, the Spanish flu is estimated to have had an R of 1.8. An R of 3.5 would require about 70% of the population to acquire herd immunity to keep the virus at bay.9 As discussed in Box 2, the “true” level of herd immunity may be substantially greater than that. At this point, if you come down with a cough and fever, you should assume you have COVID. As Chart 9 shows, social distancing measures have brought the number of viral respiratory illnesses down to almost zero in the United States. Up to 30% of common cold cases stem from the coronavirus family. Just like it would be foolhardy to assume that the common cold has been banished from the face of the earth, it would be unwise to assume that COVID will not return if containment measures are quickly lifted.   Downside Risk: Permanent Economic Damage Chart 10No Spike In Bankruptcies For Now Risks To The U Risks To The U There are a lot of asymmetries in economics: It is easier to lose a job than to find one; starting a new business is also more difficult than going bankrupt.  The good news so far is that bankruptcies have been limited and most unemployed workers have not been permanently laid off (Chart 10 and Chart 11). Thus, for the most part, the links that bind firms to workers have not been severed.   Chart 11Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment   Unfortunately, there is a risk that the economy will suffer permanent damage if unemployment remains high and economic activity stays depressed. For some sectors, such as airlines, long-term damage is nearly assured. It took a decade for real household spending on airlines to return to pre 9/11 levels (Chart 12). It could take even longer for the physiological scars of the pandemic to fade. While businesses outside the travel and hospitality sectors will see a quicker rebound, they could still experience subdued demand for as long as social distancing measures persist. Chart 129/11 Was A Big Shock For US Air Travel 9/11 Was A Big Shock For US Air Travel 9/11 Was A Big Shock For US Air Travel There is not much that fiscal policy can do to reverse the immediate hit to GDP from the pandemic. If people cannot work, they cannot produce. What fiscal stimulus can do is push enough money into the hands of households and firms to enable them to meet their financial obligations, while hopefully creating some pent-up demand that can be unleashed when businesses reopen. For now and for the foreseeable future, there is no need to tighten fiscal policy. The private sector in the major economies is generating plenty of savings with which governments can finance budget deficits. Indeed, standard economic theory suggests that if governments tried to “save more” by reducing budget deficits, total national savings would actually decline.10   Nevertheless, just as fiscal policy was prematurely tightened in many countries following the Great Recession, there is a risk that austerity measures will be reintroduced too quickly again. Likewise, calls to tighten monetary policy could grow louder. Just this week, Germany’s constitutional court ruled that the EU Court of Justice had overstepped its powers by failing to require the ECB to conduct an assessment of the “proportionality” of its controversial asset purchase policy. The German high court ordered the Bundesbank to suspend QE in three months unless the ECB Governing Council provides “documentation” showing it meets the criteria of proportionality. Among other things, the ruling could undermine the ECB’s newly launched €750 billion Pandemic Emergency Purchase Programme (PEPP). Downside Risk: Geopolitical Tensions Had the virus originated anywhere else but China, President Trump could have made a political case for further deescalating the Sino-US trade war in an effort to shore up the US economy and stock market. Not only did that not happen, but the likelihood of a new clash between China and the US has gone up dramatically. Antipathy towards China is rising (Chart 13). As our geopolitical team has stressed, the US election is likely to be fought on who can sound tougher on China. With the economy on the ropes, Trump will try to paint Joe Biden as too passive and conflicted to stand up to China. Indeed, running as a “war president” may be Trump’s only chance of getting re-elected. Chart 13US Nationalism Is On The Rise Amid Broad-Based Anti-China Sentiment Risks To The U Risks To The U At the domestic political level, the pandemic has exacerbated already glaringly wide inequalities. While well-paid white-collar workers have been able to work from the comfort of their own homes, poorer blue-collar workers have either been furloughed or asked to continue working in a dangerous environment (in nursing homes or meat-packing plants, for example). It is not clear what the blowback from all this will be, but it is unlikely to be benign. Investment Implications Global equities and credit spreads have tracked the frequency of Google search queries for “coronavirus” remarkably well (Chart 14). As coronavirus queries rose, stocks plunged; as the number of queries subsided, stocks rallied. If there is a second wave of infections, anxiety about the virus is likely to grow again, leading to another sell-off in risk assets. Chart 14Joined At The Hip 9/11 Was A Big Shock For US Air Travel Joined At The Hip 9/11 Was A Big Shock For US Air Travel Joined At The Hip Chart 15Negative Earnings Revisions Will Weigh On Stocks In The Near Term Risks To The U Risks To The U   Earnings estimates have come down, but are still above where we think they ought to be. This makes global equities vulnerable to a correction (Chart 15). Meanwhile, retail investors have been active buyers, eagerly gobblingup stocks such as American Airlines and Norwegian Cruise Lines that have fallen on hard times recently (Chart 16). They have also been active buyers of the USO oil ETF, which is down 80% year-to-date. When retail investors are trying to catch a falling knife, that is usually an indication that stocks have yet to reach a bottom. As such, we recommend that investors maintain a somewhat cautious stance on the near-term direction of stocks. Chart 16Retail Investors Keen To Buy The Dip Risks To The U Risks To The U   Chart 17Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon   Chart 18USD Is A Countercyclical Currency USD Is A Countercyclical Currency USD Is A Countercyclical Currency Looking further out, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon (Chart 17). If global growth does end up rebounding, cyclicals should outperform defensives. As a countercyclical currency, the dollar will probably weaken (Chart 18). A weaker greenback, in turn, will boost commodity prices (Chart 19). Historically, stronger global growth and a softer dollar have translated into outperformance of non-US stocks relative to their US peers (Chart 20). Thus, investors should prepare to add international equity exposure to their portfolios later this year.   Chart 19Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 20Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening   Box 1The Dynamics Of R Risks To The U Risks To The U Box 2Why Herd Immunity Is Not Enough Risks To The U Risks To The U Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 2 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 3 Philip Anfinrud, Valentyn Stadnytskyi, et al., “Visualizing Speech-Generated Oral Fluid Droplets with Laser Light Scattering,” nejm.org (April 15, 2020); Jeremy Howard, Austin Huang, Li Zhiyuan, Zeynep Tufekci, Vladmir Zdimal, Helene-mari van der Westhuizen, et al., “Face Masks Against COVID-19: An Evidence Review,” Preprints.org, (April 12, 2020); and Liang Tian, Xuefei Li, Fei Qi, Qian-Yuan Tang, Viola Tang, Jiang Liu, Zhiyuan Li, Xingye Cheng, Xuanxuan Li, Yingchen Shi, Haiguang Liu, and Lei-Han Tang, “Calibrated Intervention and Containment of the COVID-19 Pandemic,” arxiv.org (April 2, 2020). 4 “COVID-19 – Research Evidence Summaries,” Royal College of Paediatrics and Child Health; and Alison Boast, Alasdair Munro, and Henry Goldstein, “An evidence summary of Paediatric COVID-19 literature,” Don’t Forget The Bubbles (2020). 5 Hiroshi Nishiura, Hitoshi Oshitani, Tetsuro Kobayashi, Tomoya Saito, Tomimasa Sunagawa, Tamano Matsui, Takaji Wakita, MHLW COVID-19 Response Team, and Motoi Suzuki, “Closed environments facilitate secondary transmission of coronavirus disease 2019 (COVID-19),” medRxiv (April 16, 2020). 6 “Coronavirus: Arrests as California beachgoers defy lockdown,” Skynews (April 26, 2020); and “High-risk sex offender rearrested days after controversial release from OC Jail,” abc7.com (May 1, 2020). 7 Sun Hee Lee, Hyunjin Son, and Kyong Ran Peck, “Can post-exposure prophylaxis for COVID-19 be considered as an outbreak response strategy in long-term care hospitals?” International Journal of Antimicrobial Agents (April 25, 2020). 8 Brendan Borrell, “New York clinical trial quietly tests heartburn remedy against coronavirus,” Science (April 26, 2020). 9 In the simplest models, the herd immunity threshold is reached when P = 1-1/Ro, where P is the proportion of the population which has acquired immunity and Ro is the basic reproductive number. Assuming an Ro of 3.5, heard immunity will be achieved once more than 71.4% of the population has been infected (1-1/3.5). For further discussion on this, please refer to Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. 10 It is easiest to understand this point by considering a closed economy where savings, by definition, equals investment. Savings is the sum of private and public savings. Suppose the economy is depressed and the government increases public savings by either raising taxes or cutting spending. Since this action will further depress the economy, private investment will fall even more. But, since investment must equal total savings, private savings must decline more than proportionately with any increase in public savings. This happens because tighter fiscal policy leads to lower GDP. It is difficult to save if one does not have a job. To the extent that lower GDP reduces employment, it also tends to reduce private-sector savings. Global Investment Strategy View Matrix Risks To The U Risks To The U Current MacroQuant Model Scores Risks To The U Risks To The U