Inflation/Deflation
Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1 Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a) Offer attractive yields/spreads b) Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - 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 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. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other 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 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf 7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners 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 Fixed Income Sector Performance Recommended Portfolio Specification
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 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 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 Chart 3Investment Demand Overtakes Jewellery's 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 Chart 5Investors 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 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 Chart 8USD 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 Chart 10China's Economic Activity Close To Pre-COVID-19 Levels 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 Chart 12Surging 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 Table 2Vulnerability In US Supply Chains 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 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 Chart 16The 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 Chart 18USDA 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 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades
Highlights Real Yield Curve: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). High-Yield: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Bank Bonds: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. Feature Oil was the big mover in financial markets last week, with the WTI price dropping briefly into negative territory on the day before expiry of the May futures contract.1 Bond markets didn’t react much to the negative oil price (Chart 1), but this doesn’t mean that the energy market is unimportant for yields. On the contrary, the oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Chart 1Negative Oil Didn't Shock The Bond Market A Bond Market Trade Inspired By Negative Oil The Fisher Equation is the formula that relates nominal yields, real yields and inflation expectations. In its simplest form the Fisher equation is: Nominal Yield = Real Yield + Inflation Expectations When applying this equation to the act of bond yield forecasting we find it helpful to note that both the nominal yield and inflation expectations have specific valuation anchors. The Federal Reserve sets the valuation anchor for nominal yields because it controls the overnight nominal interest rate. If you enter a long position in a nominal Treasury security and hold to maturity you will make money versus a position in cash if the average overnight nominal interest rate turns out to be lower than the nominal bond yield at the time of purchase. The oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Similarly, inflation expectations are anchored by the actual inflation rate. If you enter a long position in inflation protection and hold to maturity you will make money if actual inflation turns out to be higher than the rate that was embedded in bond prices at the time of purchase.2 Turning to real yields, we see why the Fisher Equation is important. Real yields have no obvious valuation anchor. This means that the best forecasting technique is often to: (1) Use our known valuation anchors (the fed funds rate and inflation) to forecast the nominal yield and inflation expectations. (2) Use the Fisher Equation to back-out a fair value for real yields. With all that said, let’s apply this framework to today’s bond market in light of last week’s dramatic oil price moves. Inflation Compensation The cost of inflation protection tracks the oil price, more so at the front end of the curve than at the long end. This makes sense given that recent oil price trends tell us a fair amount about the outlook for inflation over the next year but very little about the outlook for inflation over the next 10 or 30 years. The inflation market didn’t react much to oil’s dip into negative territory last week, but this year’s broader drop in the WTI price from above $50 to below $20 had a big impact on TIPS breakeven inflation rates and CPI swap rates, particularly at short maturities (Chart 2). In fact, consistent with expectations for a very low oil price, the bond market is now pricing-in deflation over the next two years. Chart 2Bond Market Priced For Deflation Nominal Yields The Fed’s zero interest rate policy is having a profound effect on nominal bond yield volatility. Because the consensus investor expectation is that the Fed will keep rates pinned near zero for a long time, almost irrespective of economic outcomes, even a significant market event like a plunge in the oil price will do very little to move nominal bond yields. During the last zero-lower-bound period, nominal bond yield volatility fell across the entire yield curve but fell much more at the short end of the curve than at the long end (Chart 3). The same phenomenon will re-occur during the current zero-lower-bound episode. Chart 3The Zero Lower Bound Crushes Nominal Bond Yield Volatility Real Yields Using the Fisher Equation, we can deduce how real yields must move given changes in inflation expectations and nominal bond yields. With the Fed ensuring that short-maturity nominal yields remain stable, the recent decline in oil and inflation expectations caused short-dated real yields to jump (Chart 4). Long-maturity real yields remain low because (a) the shock to inflation expectations was smaller at the long-end of the curve and (b) the Fed’s forward rate guidance doesn’t suppress nominal bond yield volatility as much for long maturities. Chart 4There's Value In Short-Maturity Real Yields Investment Implications If we assume that last week’s -$37.60 WTI print will mark the cyclical trough in oil prices, US bond investors can profit by implementing real yield curve steepeners.3 Short-dated real yields will fall as oil and short-dated inflation expectations recover and nominal yields remain stable. In this scenario, real yields are more likely to rise at the long-end of the curve, given the greater volatility in long-dated nominal yields and the fact that long-maturity inflation expectations are not as depressed. Looking at the 2008 episode as a comparable, we see that the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI (Chart 5). After that trough, with the Fed keeping short-dated nominal rates pinned near zero, the inflation compensation curve flattened and the real yield curve steepened. Chart 5Initiate Real Yield Curve Steepeners Bottom Line: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). Poor Junk Bond Valuations Illustrated In recent reports we have been advising investors to own spread products that offer attractive spreads and that benefit from Fed support.4 This includes investment grade corporate bonds and Ba-rated high-yield bonds, but not junk bonds rated B or below. In past reports we also showed that B-rated and below junk spreads don’t adequately compensate investors for likely default losses. But this week, we want to quickly illustrate that junk spreads are trading too tight even compared to other common coincident indicators. Specifically, we zero in on the VIX and ratings migration. In 2008, the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI. Charts 6A, 7A and 8A show the historical relationship between the VIX and Ba, B and Caa junk spreads. In all three cases, spreads are well below levels that have been historically consistent with the current reading from the VIX. Charts 6B, 7B and 8B show the historical relationship between the monthly Moody’s rating downgrade/upgrade ratio and Ba, B and Caa spreads. These charts tell a similar story. In fact, March saw nearly 12 times as many ratings downgrades as upgrades, the third highest monthly ratio since 1986. With more downgrades coming in the months ahead, it is apparent that junk spreads are stretched. Chart 6ABa Spreads & VIX Chart 6BBa Spreads & Ratings Chart 7AB Spreads & VIX Chart 7BB Spreads & Ratings Chart 8ACaa Spreads & VIX Chart 8BCaa Spreads & Ratings Relatively tight spreads are probably justified in the Ba space where firms will benefit from the Federal Reserve’s Main Street Lending facilities.5 However, B-rated and below securities have mostly been left out in the cold. We see high odds of spread widening for those credit tiers. Bottom Line: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Subordinate Bank Debt Is A Good Bet The Fed’s decision to exclude bank bonds from its primary and secondary market corporate bond purchases complicates our investment strategy. We want to focus on sectors that offer attractive spreads and that benefit from Fed support, but should we carve out an exception for bank bonds? Bank Bonds Are A Defensive Sector First, we note that banks are a defensive corporate bond sector. This is due to bank debt’s relatively high credit rating and low duration. Notice that banks outperformed the rest of the corporate index when spreads widened in March, but have lagged the index by 131 bps since spreads peaked on March 23 (Chart 9). Bank equities don’t exhibit the same behavior and have in fact steadily underperformed the S&P 500 since the start of the year (Chart 9, bottom 2 panels). Chart 9Bank Bonds Are Defensive... However, if we consider senior and subordinate bank debt separately, a different picture emerges (Chart 10). Senior bank bonds behave defensively, as described above, but the lower-rated/higher duration subordinate bank bond index is more cyclical. It has outperformed the corporate benchmark by 316 bps since March 23 (Chart 10, bottom panel). Chart 10...Except Subordinate Debt The Value In Bank Bonds Despite being a defensive sector, senior bank bonds offer attractive risk-adjusted value. The average spread of the senior bank index is 18 bps above the spread offered by the equivalently-rated (A) corporate bond benchmark. Further, the senior bank index has lower average duration than the A-rated benchmark, making the sector very attractive on a per-unit-of-duration basis (Chart 11A). Chart 11ASenior Bank Bond Valuation Chart 11BSubordinate Bank Bond Valuation Turning to subordinate bank bonds, risk-adjusted value looks only fair compared to other equivalently-rated (Baa) corporate bonds (Chart 11B). However, in absolute terms the subordinate bank index offers a spread of 246 bps, compared to a spread of 178 bps on the senior bank index. Downgrade Risk Is Minimal We think investors should overweight subordinate bank bonds for two reasons. First, we think the Fed’s aggressive policy response means that investment grade corporate bond spreads, in general, have already peaked. We would expect defensive senior bank bonds to underperform in this environment of spread tightening, even though they offer attractive risk-adjusted value. Subordinate bank bonds should outperform the index in this environment, even if other Baa-rated sectors offer better value. Second, other Baa-rated corporate bond sectors offer elevated spreads because downgrade risk remains high. The Fed’s facilities will prevent default for investment grade firms, but many Baa-rated issuers will end up taking on a lot of debt to avoid bankruptcy and will get downgraded. We think banks are insulated from this downgrade risk. Even in the Fed's "Severely Adverse Scenario", three of banks' four main capital ratios remain above pre-GFC levels. Chart 12 shows the four main capital ratios calculated for US banks, and the dashed line shows the minimum value the Fed estimates that those ratios will hit under the “Severely Adverse Scenario” from the 2019 Stress Test. Three of the four ratios would remain above pre-crisis levels, and the Tier 1 Leverage Ratio would be only a touch lower. Chart 12Banks Have Huge Capital Buffers Further, our US Investment Strategy service observes that the large banks had sufficient earnings in the first quarter to significantly ramp up loan loss provisions without taking any capital hit at all.6 Our US Investment Strategy team believes that, as long as the shutdown doesn’t last more than six months, the big banks will have sufficient earnings power to absorb loan losses this year, without having to mark down their capital ratios, which in any case are extremely high. Bottom Line: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. In short, subordinate bank debt looks like a reasonably safe way to capture high-beta exposure to the investment grade corporate bond market. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed explanation of the WTI price’s shocking move please see Commodity & Energy Strategy Special Alert, “WTI In Free Fall”, dated April 20, 2020, available at ces.bcaresearch.com 2 An example of a long position in inflation protection would be buying the 5-year TIPS and shorting the equivalent-maturity nominal Treasury security. 3 Our Commodity & Energy Strategy service’s view is that the WTI oil price will average ~$60 to $65 in 2021. For further details please see Commodity & Energy Strategy Weekly Report, “US Storage Tightens, Pushing WTI Lower”, dated April 16, 2020, available at ces.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 For more details on the Fed’s different emergency facilities please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, April 2020”, dated April 20, 2020, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Inflation-Linked Bonds: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy awakens from the COVID-19 slumber, depressed market-derived inflation expectations can move higher across the developed markets – most notably in the US, the UK, Australia and Canada. Favor inflation-linked government bonds versus nominals in those countries on a strategic (6-12 months) basis. UK Corporates: The Bank of England (BoE) is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases, with credit spreads at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from BoE buying. Feature Chart of the WeekThe Link Between Oil & Bond Yields Remains Strong The shocking, albeit brief, journey of the West Texas Intermediate (WTI) oil price benchmark below zero last week was another in a long line of stunning market moves seen during the COVID-19 pandemic. Those negative oil prices were technical in nature and lasted all of one day, but the ramifications for global bond markets of the falling cost of oil in 2020 have been more enduring. Government bond yields have largely followed the ebbs and flows in energy markets for most of the past decade, and this year has been no exception (Chart of the Week). That link from oil has been through the inflation expectations component of yields, which have been (and remain) highly correlated to oil prices in virtually every developed market country. This is likely due to the persistent low global inflation backdrop since the 2008 financial crisis, which has made cyclical swings in energy prices the marginal driver of both realized and expected inflation. Chart 2BCA's Commodity Strategists Expect Oil Prices To Recover Our colleagues at BCA Research Commodity & Energy Strategy now anticipate higher oil prices over the next 12-18 months.1 Global growth is expected to recover from the COVID-19 recession sooner (and faster) than global oil production, helping to improve the demand/supply balance in energy markets and boost oil prices (Chart 2). Our energy strategists expect the benchmark Brent oil price to rise to $42/bbl by the end of 2020 and $78/bbl by the end of 2021. Those are big moves compared to the current spot price around $20/bbl, and would impart significant upward pressure on inflation expectations if the history of the past decade is any guide. That kind of move in oil prices should also help lift overall nominal government bond yields. Although the real (inflation-adjusted) component of yields is likely to remain low as major central banks like the Fed and ECB will remain highly accommodative, even when growth and inflation begin to recover, given the severity of the COVID-19 global recession. With market-based inflation expectations now at such beaten-up levels, and with the disinflationary effect of falling energy prices set to fade, we see an opportunity to play for a cyclical rebound in inflation breakevens across the developed markets by favoring inflation-linked government bonds versus nominal yielding equivalents. A Simple Framework For Finding Value In Inflation Breakevens Given the remarkably tight correlation between oil prices and market-determined inflation expectations in so many countries, it should be fairly straightforward to model the latter using the former as the main input. We have developed a series of fair value regressions for breakevens in the major developed countries which do exactly that. In this simple approach, we attempt to model the 10-year breakeven from inflation-linked bonds for eight countries – the US, the UK, Germany, Japan, France, Italy, Canada and Australia - as a function of a short-run variable (oil prices) and a long-run variable (the trend in realized inflation). Specifically, we are using the annual percentage change in the Brent oil price benchmark in local currency terms (i.e. converted from US dollars at spot exchange rates) as the short-run variable and a five-year moving average of realized headline CPI inflation as the long-run variable. The latter is included to provide an “anchor” for breakevens based on the actual performance of inflation in each country. In other words, expectations about what inflation will look like in the future are informed by what it has done in the past – what economists refer to as “adaptive” expectations. The generic regression equation used for each country is: 10-year inflation breakeven = α + β1 * (annual % change of Brent oil price in local currency terms) + β2 * (60-month moving average of headline CPI inflation) In Table 1, we present the results of the regressions of each of the eight countries, which use weekly data dating back to the start of 2012 to capture the period when oil prices have most heavily influenced inflation expectations. The coefficients, R-squareds and standard errors of the regressions are all shown, as well as the most recent model residual (i.e. the deviation of 10-year inflation expectations from model-determined fair value). All the coefficients for each model are significant. The R-squareds of the models vary, with the models for France and Australia doing the best job of explaining changes in inflation expectations in those two countries. Table 1Details Of Our New 10-Year Inflation Breakeven Models For the UK and Japan, we added an additional “dummy” variable to control for the unique situations that we believe have influenced inflation breakevens in those countries. For the UK, the period since the June 2016 Brexit vote has seen the path of inflation expectations stay nearly 50bps higher than implied by moves in GBP-denominated oil prices and the trend in actual UK inflation. For Japan, the period since the Bank of Japan initiated its Yield Curve Control policy in September 2016 has seen breakevens stay nearly 60bps below fair value as derived from JPY-denominated oil prices and the trend in actual Japanese inflation. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. In Charts 3 to10 over the next four pages, we show the models for each country. 10-year inflation breakevens versus the independent variables in the models are shown in the top two panels, the model fair value is presented in the 3rd panel, and the deviation from fair value is in the bottom panel. In all cases, breakevens are below fair value, suggesting that inflation-linked bonds look relatively attractive versus nominal government bonds. Chart 3Our US 10-Year TIPS Breakevens Model Chart 4Our UK 10-Year Breakeven Inflation Model Chart 5Our France 10-Year Breakeven Inflation Model Chart 6Our Italy 10-Year Breakeven Inflation Model Chart 7Our Japan 10-Year Breakeven Inflation Model Chart 8Our Germany 10-Year Breakeven Inflation Model Chart 9Our Canada 10-Year Breakeven Inflation Model Chart 10Our Australia 10-Year Breakeven Inflation Model Chart 11Real Inflation-Linked Bond Yields Will Remain Subdued For Longer The largest deviations from fair value can be found in Canada (-70bps), Australia (-48bps), the UK (-29bps), and the US (-26bps). 10-year breakevens are also below fair value in the euro zone countries and Japan, but not by more than one standard deviation as is the case for the other four countries. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. Focus on the four markets with breakevens furthest from fair value, although from a market liquidity perspective it is easier to implement those positions in the US and UK, which represent a combined 69% of the Bloomberg Barclays Global Inflation-Linked bond index. A rise in inflation expectations should also, eventually, put some sustained upward pressure on nominal bond yields. We would rather play that initially by positioning for higher inflation breakevens, rather than having outright below-benchmark duration exposure, as developed market central banks will stay accommodative for longer given the severity of the COVID-19 recession - that will keep real bond yields lower for longer (Chart 11). Breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Bottom Line: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy starts to awaken from the coronavirus induced slumber, breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Favor linkers over nominals in those countries. Where Is The Value In UK Corporate Bonds? Chart 12Upgrade UK IG Corporates To Overweight On BoE Buying The Bank of England (BoE) initiated its Corporate Bond Purchase Scheme (CBPS) in August 2016 as part of a package of stimulus measures to cushion the economic blow from the UK’s vote to exit the European Union. As we noted in recent joint report with our sister service, BCA Research US Bond Strategy,2 the CBPS helped tighten spreads by lowering downgrade and default risk premiums and also helped spur corporate bond issuance (Chart 12). Shortly after that report was published, the BoE announced that it would be purchasing a further £10 billion in investment grade nonfinancial corporate bonds in the coming months, doubling the scheme’s aggregate holdings to £20 billion. In addition, the bank would make these purchases at a significantly faster pace than in 2016, which implies a faster transmission towards tightening of spreads. Compared to other central bank peers, however, the BoE’s program still has room to expand, which makes UK investment grade credit attractive over tactical and strategic investment horizons. Using the market value of the Bloomberg Barclays UK corporate bond index (excluding financials) as a proxy for the total value of eligible bonds, the CBPS is on track to own roughly 9% of all eligible bonds by the time the £20 billion target is reached. The neighboring European Central Bank, on the other hand, already owns 23% of the stock of eligible euro area corporate bonds in its market, and that figure is only set to increase with policymakers set to do “whatever it takes” to backstop the investment grade market. Year-to-date, UK corporate bonds appear to have recovered somewhat from the panicked selloff earlier this quarter (Table 2), with the Bloomberg Barclays UK investment grade corporate bond index down only -0.3% in total return terms. In excess return terms relative to duration-matched UK corporate bonds, however, the index is down -5.2%, indicating that weakness has persisted in the pure credit component. Table 2UK Investment Grade Corporate Bond Returns At the broad sector level, Other Industrials appear to be the outlier, having delivered positive excess returns (+0.6%) and significant total returns (+16%). These returns are not nearly as attractive, however, on a risk-adjusted basis once you consider that this sector has an index duration more than three times that of the overall index.3 Outside of that sector, the best performers, in excess return terms, are predominantly the more “defensive” sectors—Utilities (-3.4%), Technology (-3.7%), Communications (-4.2%) and Consumer Non-Cyclical (-4.6%). Meanwhile, the sectors most exposed to vanishing consumer demand and weak global growth have performed the worst—Transportation (-9.5%), Capital Goods (-7%), Energy (-6.8%), and Basic Industry (-6.2%). Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases. Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases (Chart 13). The overall index spread, although still elevated at 228bps, has already tightened by 57bps from the peak in late March. The gap between the index spreads of Baa-rated and Aa-rated UK debt remained relatively stable through the wave of sell-offs, peaking at +53bps, below the 2019 high of +55bps, and settling now to +36bps. Outside the purview of the CBPS, however, the situation is a bit rockier, with the overall high-yield index spread +590bps above that of the investment grade index. Broadly speaking, there is a clear disparity between those credit tiers that have the support of the monetary authorities and those that do not. Investment grade spreads will continue to tighten as the BoE rapidly increases its holdings of investment grade corporate bonds. However, high-yield bonds remain exposed to downgrade/default risk and ongoing uncertainty stemming from the COVID-19 economic shock. To drill down into which credit tier spreads offer the most value within the UK investment grade space, we use the 12-month breakeven spread percentile rankings. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. Chart 14 shows the 12-month breakeven spread percentile rankings for all the credit tiers in the UK investment grade space. Aaa-rated debt appears most unattractive, with the spreads currently ranking below the historical median. Between the other three tiers, Aa-rated debt offers the most value, although all three are at historically attractive levels. Chart 13UK IG Has Held Up Well During The COVID-19 Shock Chart 14UK IG Breakeven Spreads Look Most Attractive For Aa-Rated Bonds On the sector-level, the disparity in spreads is most clearly visible in the sectors most exposed to the pandemic. In Charts 15 & 16, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays UK investment grade corporate index. Spreads look widest relative to history for sectors such as Energy and Transportation, while spread widening has been contained in more insulated sectors such as Financials. Chart 15A Mixed Performance For UK IG By Sector In 2020 … Chart 16… But Spreads, In General, Remain Below Previous Cyclical Peaks Another way to assess value across UK investment grade corporates is our sector relative value framework. Borrowing from the methodology used for US corporate credit by our colleagues at BCA Research US Bond Strategy, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall UK investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The dependent variables in the model are each sector's duration, 12-month trailing spread volatility and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. We see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. The latest output from the UK relative value spread model can be found in Table 3. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 17 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 17UK Investment Grade Corporate Sectors: Valuation Versus Risk We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. Amid a backdrop of global uncertainty, we reiterate one of our major themes this quarter—buy what the central banks are buying. Given that UK corporate spreads are attractive on a breakeven basis, and with the BoE purchasing corporate debt at an even faster pace than during the volatile period following the shock Brexit vote in 2016, we see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. This is both on a tactical (0-6 months) and strategic basis (6-12 months). In our model bond portfolio, we have added two percentage points to our recommended UK corporate bond allocation, funded by reducing further our existing underweight on Japanese government bonds. At the sector level, given this positive backdrop for credit performance, we do not see a need to favor lower risk sectors with a DTS score below that of the overall UK investment grade index. On that basis, we are looking to go overweight sectors with higher relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 17. Based on the latest output from the relative value model, the strongest overweight candidates are the following UK investment grade sectors: selected Financials (Insurance, Subordinated Bank Debt, and Other Financials), Media Entertainment, Cable Satellite, Tobacco, Diversified Manufacturing, and Communications. The least attractive sectors within this framework are: Packaging, Lodging, REITs, Other Industrials, Metals, Natural Gas, Restaurants, Transportation Services, Financial Institutions, and Midstream Energy. Bottom Line: The BoE is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases. Spreads have already begun to tighten in response but are still at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across credit tiers, favor Aa-rated debt. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from the CBPS. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, "US Storage Tightens, Pushing WTI Lower", dated April 16, 2020, available at ces.bcaresearch.com. 2 Please see BCA US Bond Strategy Special Report, "Trading The US Corporate Bond Market In A Time Of Crisis", dated March 31 2020, available at usbs.bcaresearch.com. 3 Other Industrials has an index duration of 28.6 years, compared to 8.5 years for the overall UK investment grade corporate bond index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay. Such testing will become available, but probably not for a few more months. Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains. Despite the fact that the supply of goods and services has fallen sharply during this recession, the overall effect has been deflationary. Deflationary pressures should subside later this year as demand picks up, commodity prices rise, and the US dollar weakens. Looking several years out, deglobalization and the increasing politicization of central banking could lead to accelerating inflation. Long-term investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. Now What? Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm's way. Or so you think. You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark. This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows. Yet, we have neither a vaccine nor a cure for the virus (although as we go to press, unconfirmed news reports suggest that Gilead’s drug, remdesivir, has had success in treating patients at a Chicago hospital). Chart 1Widespread Social Distancing Dampened The Spread Of All Flus And Colds COVID-19 is part of the coronavirus family, which includes four members that are responsible for up to 30% of common colds (most other colds are caused by rhino-viruses). Social distancing has driven the number of cold and influenza-like cases in the US to very low levels (Chart 1). But does anyone really think that the common cold or flu will be permanently eradicated because of recent measures? If not, what will prevent COVID-19, which is no less contagious than these other illnesses, from resurfacing? In short, the bear is still there, waiting for us to reopen the economy. A Deep Recession As we wait, the economic damage continues to mount. The IMF’s baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is far deeper than during the 2008/09 financial crisis (Chart 2). The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020 relative to the Fund’s already bleak baseline. A second outbreak next year would push global GDP almost 5% below the IMF’s baseline in 2021, while the combination of a longer outbreak this year and a second outbreak next year would cause the level of output to fall 8% below the 2021 baseline (Chart 3). Chart 2Severe Damage To The Global Economy This Year Chart 3Downside Risks To The IMF's Projections The Ties That Bind The sudden stop in economic activity has led to a dramatic surge in unemployment. US initial unemployment claims have risen by a cumulative 22 million over the past four weeks. The true scale of layoffs is probably higher than that, given that some state websites have been unable to handle the flood of insurance applications. Chart 4Only About One-Third Of Those Who Lose Their Jobs Apply For Benefits Historically, only about one-third of those laid off have applied for benefits (Chart 4). While the take-up rate will be higher this time – the CARES Act increases weekly unemployment compensation, while expanding eligibility to self-employed workers – it is still reasonable to assume that the claims data do not capture how much of the workforce has been laid idle. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed. In this respect, the recovery in employment following this recession may end up resembling that of another “man-made” recession: the 1982 downturn (Chart 5). Back then, policymakers felt that a recession was a price worth paying to quash inflation. Once inflation fell, central banks were able to cut rates, allowing economic activity to recover. Today, the hope is that by shutting down all nonessential businesses, the virus will be quashed, and life will return to normal. Chart 5Comparing The 1982 Recession Versus Today: Employment Edition Exit Plans It remains to be seen whether vanquishing the virus will be as straightforward as vanquishing inflation was in the early 1980s. As we noted last week, in the absence of a vaccine or an effective treatment, our best hope is that mass testing will allow businesses to reopen.1 The technology for such tests already exists; it just has yet to become available on a large enough scale. Just like during the Second World War, the production of weapons necessary to fight the virus will grow at an exponential pace (Chart 6). Chart 6Now Let's Do The Same For Test Kits Near-Term Pressures On Risk Assets Exponential change is a difficult concept for the human mind to grasp. What seems painfully slow at first can quickly become unfathomably fast later on. The apocryphal story about the origins of the game of chess comes to mind.2 This puts investors in a bit of a quandary. Growth is likely to recover in the latter half of 2020 as COVID-19 testing becomes pervasive and the effects of fiscal and monetary stimulus make their way through the economy. But, the near-term picture could be soured by news stories of continued acute shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. Indeed, bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. Our US equity strategists are projecting only $100 and $140 in EPS, respectively. Stock prices and earnings estimates generally travel together (Chart 7). On balance, we continue to favor global equities over bonds on a 12-month horizon, owing to the fact that the cyclically-adjusted earnings yield is quite a bit higher than the bond yield (Chart 8). However, we have less conviction about the near-term (3-month) direction of stocks, and would recommend that investors maintain above-average cash levels for now which can be deployed on any major selloff. Chart 7Negative Earnings Revisions Will Weigh On Stocks In The Near Term Chart 8Favor Equities Over Bonds Over A 12-Month Horizon Inflation And Supply Shocks: A Keynesian Paradox? One of the distinguishing features of this recession is that it has involved a simultaneous supply shock and a demand shock. Businesses have had to curb supply in order to allow workers to stay at home, while workers have reduced spending out of fear of going to stores or other venues where they could inadvertently contract the virus. Worries about job losses have further dented demand. There is no question about what happens to output when both demand and supply decline: output falls. In contrast, the impact on the price level depends on which shock dominates (Chart 9). Chart 9Inflation And Supply Shocks As Appendix 1 illustrates with a set of simple numerical examples, in theory, a negative supply shock spread evenly across all sectors of the economy should cause the price level to rise. This is because unemployed workers, who are no longer contributing to output, will still end up consuming some goods and services by tapping into their savings, taking on new debt, or by receiving income transfers from the government. In the current situation, however, the supply shock has not been spread evenly throughout the economy. Some businesses have been completely shuttered, while others deemed essential have been allowed to operate. As the appendix shows, in such cases, the drop in aggregate demand is likely to be larger than if all sectors were equally impacted. In fact, it is possible for a supply shock to trigger a demand shock that is larger than the supply shock itself, leading to a perverse situation where a decline in supply results in a surfeit of output. A recent paper by Guerrieri, Lorenzoni, Straub, and Werning argues that the current pandemic represents such a “Keynesian supply shock.”3 Intuitively, such perverse supply shocks can arise if workers are cut off from purchasing many of the goods that they would normally buy. When the menu of available goods shrinks, even workers who are still employed could end up saving much of their income. Deflationary For Now All this implies that the pandemic is likely to be deflationary until more businesses reopen. The data seem to bear this out. The US core consumer price index fell by 0.1% month-over-month in March on a seasonally adjusted basis, led by steep declines in airfares and hotel lodging prices. High-frequency indicators, as well as the prices paid components of various purchasing manager indices, suggest that deflationary pressures have persisted into April (Chart 10). Chart 10Deflation Reigns For NowShelter inflation was reasonably firm in March but should soften over the coming months. A number of major apartment operators have announced rent freezes. In addition, the lagged effects from a stronger dollar and lower energy prices will contribute to lower goods inflation, while higher unemployment will hold back service inflation. Inflation Should Bounce Back In 2021 The discussion of Keynesian supply shocks suggests that aggregate demand will increase faster than supply as more sectors of the economy reopen. This should ease deflationary pressures. In addition, a rebound in global growth starting in the second half of 2020 will prompt a recovery in commodity prices. The forward oil curve is predicting that Brent and WTI crude prices will rise by 42% and 79%, respectively, over the next 12 months (Chart 11). Inflation expectations and oil prices tend to move closely together (Chart 12). Chart 11H2 2020 Rebound In Growth Will Lift Oil Prices Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together As a countercyclical currency, the US dollar will weaken over the next 12-to-18 months as global growth rebounds, providing an additional reflationary impulse (Chart 13). Falling unemployment will also eat into labor market slack, helping to support wages. Chart 13Stronger Global Growth In The Back Half Of The Year Will Weaken The Dollar, Putting Upward Pressure On US Inflation The Structural Outlook For Inflation… And Bond Yields Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or abate. On the one hand, it is possible that the pandemic will cast a pall over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth. On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labor market recovers. This could eventually lead to economic overheating in two-to-three years. Chart 14Global Trade Was Already Stagnating A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up (Chart 14). The pandemic may further inflame nationalist sentiment. Against the backdrop of high unemployment, Donald Trump is likely to campaign as a “war president,” relentlessly chiding Joe Biden for having too cozy a relationship with China. On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on TIPS breakevens. Market-based inflation expectations are even more subdued in most other advanced economies. If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. APPENDIX 1: Keynesian Supply Shocks Suppose there are two sectors, A and B. The economy consists of 2,000 workers, with each sector employing 1,000 workers. To keep things simple, assume that workers in each sector evenly split their consumption between the two sectors. Thus, a worker in sector A spends as much on goods from sector A as from sector B, and vice versa. Also assume that each worker, if employed, produces $1,000 of goods and receives a salary of $1,000 for his or her efforts. With this in mind, let us consider three scenarios: Scenario 1: Both Sectors Are Open For Business In this scenario, $1 million of good A and $1 million of good B are produced and supplied to the market. Since each of the 2,000 workers spends $500 on good A and $500 on good B, a total of $1 million of both goods are demanded. Aggregate demand equals aggregate supply. Scenario 2: Partial Closure Of Both Sectors Suppose that half the workers in both sectors are laid off. While the unemployed workers do not earn any income, they still spend half as much as they used to by tapping into their savings ($250 on good A and $250 on good B for each unemployed worker). Each employed worker continues to spend $500 on good A and $500 on good B. Now there is $500,000 in total of each good produced, but $750,000 of each good demanded. Aggregate demand exceeds supply. Scenario 3: Sector A, Deemed The Essential Sector, Remains Completely Open, While B Is Closed In this case, all sector A workers are still employed, earning $1,000 each. Since good B is no longer available for purchase, sector A workers increase spending on good A by 20% (from $500 to $600 per worker). Workers in sector B are all unemployed. However, they continue to tap into their savings. Rather than spending $250 on good A as they did in scenario 2, they increase their expenditures on good A by 20% (from $250 to $300). A total of $900,000 of good A is now demanded ($600*1,000+$300*1,000), which is less than the $1 million of good A supplied. Aggregate supply now exceeds demand for the part of the economy that is still open. The chart and table below summarize the results. The key insight is that a 50% shock to the entire economy curbs aggregate demand less than a 100% shock to half the economy. This implies that demand is likely to grow faster than supply as mass testing allows more of the economy to reopen. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 2 In one account, the King of India was so impressed when the game of chess was demonstrated to him that he offered its inventor any reward he desired. After thinking for a while, the inventor said “Your Highness, please give me one grain of rice for the first square on the chessboard, two grains for the next square, four grains for the one after that, doubling the number of grains until the 64th square.” Stunned that the inventor would ask for such a puny reward, the King quickly agreed. A week later, the King’s treasurer informed His Highness that he would need to give the inventor 18 quintillion grains of rice, which is more than enough rice to cover the entire planet’s surface. “Holy Ganges, what have I done?” the King exclaimed, before having the inventor executed. 3 Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?” NBER Working Paper No. 26918 (April 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores
Dear Client, I will be discussing the economic and financial implications of the pandemic with my colleague Caroline Miller this Friday, March 27 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). I hope you will be able to join us for this webcast. Next week, we will send you a special report prepared by BCA’s Chief Economist Martin Barnes. Martin will provide his perspective on the current crisis, focusing on some of the longer-run implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The world is in the midst of a deep recession. Growth should recover in the third quarter as the measures taken to compensate for the initial slow response to the crisis are relaxed and existing measures are better calibrated to reduce economic distress. Continued monetary support and unprecedented fiscal stimulus should help drive the recovery once businesses reopen and workers return to their jobs. Investors should maintain a modest overweight to global equities. US stocks will lag their foreign peers over the next 12 months. The US dollar has peaked. A weaker dollar should help lift commodity prices and the more cyclical sectors of the stock market. High-yield credit spreads will narrow over the next 12 months, but we prefer investment-grade credit on a risk-reward basis. Investors are understating the potential long-term inflationary consequences of all the stimulus that has been unleashed on the global economy. Buy TIPS and gold. I. Macroeconomic Outlook The global economy is now in recession. The recession has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus. Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On a sequential annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history. Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus. Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending. A One-Two Punch The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would. This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash. All this reduces aggregate demand. On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home (Chart 1). Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally. Chart 1US: Who Can Work From Home And Who Cannot? Think of this as a Great Depression-style demand shock combined with a category five hurricane supply shock. The fact that both of these shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse (Chart 2). During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing. This time is different. Chart 2The Service Sector Accounts For A Big Chunk Of GDP And Has Been Very Hard Hit The Shape Of The Recovery: L, U, or V? Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. What will the recovery look like? From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP. Chart 3 shows three scenarios: 1) An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend; 2) A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year; and 3) A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend. Chart 3Profile Of The Recovery: L, U, or V? We had previously thought that the recovery from the pandemic would be V-shaped. Compared to the sluggish recovery following the Great Recession, that is likely still true. However, at this point, we would prefer to characterize the probable recovery as being more U-shaped in nature. This is mainly because the measures necessary to contain the virus may end up having to remain in place, in one form or another, for the next few years. Why Not L? Given the likelihood that containment measures will continue to weigh on economic activity, how can an L-shaped “recovery” be avoided? While such a dire outcome cannot be ruled out, there are three reasons to think “U” is more likely than “L”. Reason #1: We Will Learn From Experience It is almost certain that we will figure out how to fine-tune containment measures to reduce the economic burden without increasing the number of lives lost. There are still many questions that remain unanswered. For example: Are restaurants where family members sit together really more dangerous than bars or conferences where strangers are milling about talking to one another? How dangerous is air travel? Modern airplanes have hospital-grade filtration systems that recirculate all the air in the cabin every three minutes. Might this explain why there has only been a handful of flight attendants that have tested positive for the virus? How contagious are children, who often may not present any symptoms at all? Which drugs might slow the spread of the disease or perhaps even cure it? To what extent would widespread mask-wearing help? Yes, a mask may not prevent you from catching the virus, but if there is major social stigma associated with being unmasked in public, then people who have the virus and may not know it will be less of a threat to others. One study estimates that the virus could be completely eradicated if 80% of people always wore masks.1 With time, we will learn the answers to these questions. We will also be able to stockpile masks, ventilators, respirators, and test kits – all of which are currently in short supply – to better combat the virus. Reason #2: We Are NowOvercompensating For Lost Time Second, most countries are currently at the stage where they are trying not just to bring down the basic reproduction number for the virus to 1, but to drive it down to well below 1. There is merit in doing so. If you can reduce the reproduction number to say, 0.5, meaning that 100 people with the virus will pass it on to only 50 other people, then the number of new infections will fall rapidly over time. This is what China was finally able to achieve. A recent study documented that China succeeded in bringing down the reproduction number in Wuhan from 3.86 to 0.32 once all the containment measures had been implemented (Chart 4).2 Chart 4Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak The critical point is that once you reduce the number of new infections to a sufficiently low level, you can then relax the containment measures by just enough so that the reproduction number rises back to 1. At that point, the number of new infections at any given point in time will be constant. One can see this point by imagining a bicycle coasting down a mountain road. Ideally, the rider should apply uniform pressure on the brakes at the outset of the descent to prevent the bicycle from accelerating too quickly. However, if the rider is too slow to apply the brakes and ends up going too fast, he or she will then need to overcompensate by pressing hard on the brakes to slow the bike down before easing off the brakes a bit. Most of the world is currently in the same predicament as the cyclist who failed to squeeze the brakes early on. We are overcompensating to get the infection rate down. However, once the infection rate has fallen by enough, we can ease off the most economically onerous measures, allowing GDP to slowly recover. Reason #3: Containment Measure Will Be Eased As More People Acquire Immunity Much of the popular discussion of the epidemiology of COVID-19 has failed to distinguish between the basic reproduction number, R0, and the effective reproduction number, Re. The former measures the average number of people a carrier of the virus will infect in an entirely susceptible population, whereas the latter measures the average number of people who will be infected after some fraction of the population acquires immunity either by surviving the disease or getting vaccinated. Mathematically, Re = R0*(1-P), where P is the proportion of the population which has acquired immunity. For example, suppose P=0.5, meaning that half the population has acquired immunity. In this case, the average number of people a carrier will infect will be only half as high as when no one has immunity. As we discuss below, there is considerable uncertainty about how fast P will increase over time, including whether it could spike upwards if a vaccine becomes widely available. Still, any increase in P will make it more difficult for the virus to propagate. Over time, this will permit policymakers to raise R0 at an accelerating rate towards the level it would naturally be in the absence of any containment measures (Chart 5). Such a strategy would allow economic activity to increase without raising Re; that is to say, without triggering an explosion in the number of new cases. Chart 5Populations Acquiring Immunity Is Key The Virus Endgame How long will it take to dismantle all the containment measures completely? This partly depends on what medical breakthroughs occur and what measures are needed to “flatten the curve” of new infections (Chart 6). Right now, most countries are trying to drive down the number of new infections to very low levels in the hopes that either a vaccine will be invented or new treatment options will become available. Chart 6Flattening The Curve We are not medical experts and will not offer an opinion on how likely a breakthrough may be. What we would say is that combating the virus has become a modern-day Manhattan project. If the project succeeds, a V-shaped recovery could still ensue. What if the virus evades the best efforts of scientists to eradicate it? In that case, the only way for life to return to some semblance of normalcy is for the population to acquire herd immunity. How many people would need to be infected? In the context of the foregoing discussion, this is equivalent to asking how high P needs to rise for Re to fall below 1. The equation above tells us this must correspond to the value of P for which R0 (1-P) <1. Solving for P yields P > 1-1/R0. In the absence of social distancing and other containment measures, most estimates of R0 for COVID-19 place it between 1.5 and 4. This implies that between one-third (1-1/1.5) to three-quarters (1-1/4) of the population would need to be infected for herd immunity to set in. Even if one allows for the likelihood that significantly more resources will be marshalled to allow hospitals to service a greater number of patients, we estimate that it would take 2-to-3 years to reach that point.3 To be clear, the virus’ ability to spread will decline even before herd immunity is achieved. An increase in the share of the population who survived and became naturally inoculated against the virus would allow policymakers to relax containment measures, perhaps to such an extent that eventually only the simplest of actions such as increased hand-washing and widespread mask-wearing would be enough to prevent hospitals from being overwhelmed. This underscores our baseline expectation of a U-shaped economic recovery. Second-Round Effects Suppose the global economy starts to recover in the third quarter of this year as the measures taken to compensate for the initial slow response to the crisis are relaxed, existing measures are better calibrated to reduce economic distress, and more younger and healthier people acquire natural immunity to the virus, thus reducing the vulnerability of the old and frail. Does that mean we are out of the woods? Not necessarily! We still have to worry about the second-round economic effects. Even if the virus is contained, there is a risk that the economy will be so scarred by the initial drop in output that it will fail to recover. A vicious circle could emerge where falling spending leads to higher unemployment, leading to even less spending. In the current environment, the tendency for unemployment to rise may be initially mitigated by the decision of a few large companies with ample financial resources to pay their workers even if they are confined to their homes. This would result in a decline in labor productivity rather than higher unemployment. That said, given the severity of the shock and the fact that many of the hardest-hit firms are in the labor-intensive service sector, a sharp rise in joblessness is still inevitable, particularly in countries with flexible labor markets such as the US. Chart 7Worries Over Job Security Abound Today’s spike in US initial unemployment claims is testament to that point (Chart 7). In fact, the true increase in the unemployment rate will probably be greater than what is implied by the claims data because many state websites did not have the bandwidth to handle the slew of applications. In addition, under existing rules, the self-employed and those working in the “gig economy” do not qualify for unemployment benefits (this has been rectified in the bill now making its way to the White House). The Role Of Policy Could we really end up in a world where the virus is contained, and people are ready and able to work, only to find that there are no jobs available? While such a sorry outcome cannot be dismissed, we would bet against it. This outcome would only arise if there is insufficient demand throughout the economy when it reopens. Unlike in 2008/09 when there was a lot of moralizing about how this or that group deserved to be punished for their reckless behavior, no one in their right mind today would argue that the workers losing their jobs and the companies facing bankruptcy somehow had it coming. What can policymakers realistically do? On the monetary side, policy rates are already close to zero in most developed economies. A number of emerging markets still have scope to cut rates, but even there, many find themselves not far from the zero bound (Chart 8). Chart 8DM Rates At The Zero Bound, With EM Rates Approaching Chart 9A Mad Scramble For Cash That said, cutting interest rates right now is not the only, and probably not the most important, way for central banks to stimulate their economies. The global economy is facing a cash shortage. Companies are tapping credit lines at a time when banks would normally be looking to increase their own cash reserves. The mad scramble for cash has caused libor, repo, and commercial paper spreads to surge (Chart 9). And not just any cash. As the world’s reserve currency, the dollar is increasingly in short supply (Chart 10). This explains why cross-currency basis spreads have soared and why the DXY index has jumped to the highest level in 17 years. Chart 10Dollars Are In Short Supply Flood The Zone Chart 11US Mortgage Spreads Have Spiked The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency mortgage-backed securities (MBS) since relaunching its QE program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields (Chart 11). The Fed has also dusted off the alphabet soup of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses. In order to ease overseas funding pressures, the Fed has opened up swap lines with a number of central banks. We expect these lines to be expanded to more countries if the situation necessitates it. The Coming Mar-A-Lago Accord? We also think that there is at least a 50-50 chance that we could see coordinated currency interventions designed to drive down the value of the US dollar. Federal Reserve, Treasury, and IMF guidelines all permit currency intervention to counter “disorderly market conditions.” While a weaker dollar would erode the export competitiveness of some countries, this would be more than offset by the palliative effects of additional dollar liquidity stemming from US purchases of foreign securities, as well as the relief that overseas dollar borrowers would receive from dollar depreciation. Thus, on balance, a weaker dollar would result in an easing of global financial conditions. Liquidity Versus Solvency Risk Some might complain that the actions of the Fed and other central banks go well beyond their mandates. They might argue that it is one thing to provide liquidity to the financial system; it is quite another to socialize credit risk. We think these arguments are largely red herrings. For one thing, concern about credit risk can be addressed by having governments backstop central banks for any losses they incur. Moreover, there is no clear distinction between liquidity and solvency risk during a financial crisis. The former can very easily morph into the latter. For example, consider the case of Italy. Would you buy more Italian bonds if the yield rises? That depends on two competing considerations. On the one hand, a higher yield makes the bond cheaper. On the other hand, a higher yield may make it more difficult for the government to service its debt obligations, which raises the risk of default. If the second consideration outweighs the first, your inclination may be to sell the bond. To the extent that your selling causes yields to rise further, that could lead to another wave of selling. As Chart 12 illustrates, this means that there may be multiple equilibria in fixed-income markets. It is absolutely the job of central banks to try to steer the economy towards the good ”low yield” equilibrium rather than the bad “default” equilibrium. Chart 12Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort In this light, ECB president Christine Lagarde’s statement on March 12th that “we are not here to close spreads” – coming on the heels of a spike in Italian bond yields and a 13% drop in euro area stocks the prior day – was one of the most negligent things a central banker has ever said. To her credit, she has since walked back her comments. The ECB has also launched the Pandemic Emergency Purchase Programme (PEPP), a EUR 750bn asset-purchase program, which gives the central bank considerable flexibility over the timing, composition, and geographic makeup of purchases. Further actions, including upsizing the PEPP, creating a “conditionality-lite” version of the ESM program, and perhaps even issuing Eurobonds, are possible. All this should help Italy. Accordingly, BCA’s global fixed-income team upgraded Italian government bonds to overweight this week. Using Fiscal Policy To Align Financial Time With Economic Time While central banks will play an important role in mitigating the crisis, most of the economic burden will fall on fiscal policy. How much fiscal support is necessary and what should it consist of? To get a sense of what is optimal, it is useful to distinguish between the concept of financial time and economic time. Financial time and economic time usually beat at the same pace. Most of the time, people have financial obligations – rent, mortgage payments, spending on necessities – that they match with the income earned from work. Likewise, companies have expenses that they match with the revenue that they derive from various economic activities. No one worries when economic time and financial time deviate in predictable ways. For example, GDP collapses around 5pm on Monday only to recover at 9am on Tuesday. The fact that many western Europeans take most of August off for vacation is also not a problem, since everyone expects this. The problem occurs when economic time and financial time deviate in unpredictable ways. That is the case at present. Today, economic time has ground to a halt as businesses shutter their doors and workers confine themselves to their homes. Yet, financial time continues to march on. This implies that in the near term, the correct course of action is for governments to transfer money to households and firms to allow them to service their financial obligations. One simple way of achieving this is through wage subsidies, where the government pays companies most of the wage bill of their employees who, through no fault of their own, are unable to work. Note that this strategy does not boost GDP. By definition, an idle worker is one who does not contribute to economic output. What this strategy does do is alleviate needless hardship, while creating pent-up demand for when businesses start to open their doors again. Once the virus is contained, traditional fiscal stimulus that boosts aggregate demand will be appropriate. How much money are we talking about? In the case of the US, suppose that annualized growth is -5% in Q1, -25% in Q2, and +10% in Q3 and Q4, respectively. That would leave the level of real GDP down 4% on the year compared to 2019. Assuming trend GDP growth of 2%, that implies an annual shortfall of income (consisting of wages and lost profits) that the government would have to cover amounting to 6% of GDP. The $2 trillion stimulus bill amounts to 10% of GDP, although not all of that will be spent during the next 12 months and about a quarter of the amount is in the form of loans and loan guarantees. Still, on size, we would give it an “A”. On composition, we would give it a “B”, as it lacks sufficient funding for state and local governments to cover the likely decline in the tax revenues that they will experience. This could result in layoffs of first responders, teachers, etc. Given that the US was running a fiscal deficit going into the crisis, all this additional stimulus could easily push the budget deficit to over 15% of GDP. While this is a huge number, keep in mind that in a world where interest rates are below the trend growth rate of the economy, a government can permanently increase its budget deficit by any amount it wants while still achieving a stable debt-to-GDP ratio over the long haul.4 Today, we are not even talking about a permanent increase in the deficit, but a temporary increase that could last a few years at most. If we end up in a depression, don’t blame the virus; blame politicians. Fortunately, given that the political incentives are aligned towards fiscal easing rather than austerity, our guess is that a depression will be averted. Appendix A summarizes the monetary and fiscal measures that have already been taken in the major economies. II. Investment Strategy As anyone who has ever watched a horror movie knows, the scariest part of the film is the one before the monster is revealed to the audience. No matter how good the makeup or set design, our imaginations can always conjure up something much more frightening than Hollywood can invent. Right now, we are fighting an invisible enemy that is ravaging the world. Victory is in sight. The number of new infections has peaked in China and South Korea. I mentioned during last week’s webcast that we should watch Italy very carefully. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control. While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past five days (Chart 13). Chart 13A Peak In The Number Of New COVID-19 Cases In Italy Would Send An Encouraging Signal Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. However, as we spelled out in this report, there are good reasons to think that these measures will not need to be as severe as the ones currently in place. As such, it is likely that global growth will begin to rebound in the third quarter of this year. Equities: A Modest Overweight Is Warranted We turned more cautious on the near-term outlook for global equities earlier this year, but upgraded our recommendation on the morning of February 28th after the MSCI All-Country World Index fell by 12% over the prior week. While stocks did rally by 7% during the following three trading days, they subsequently plunged to multi-year lows. In retrospect, we should have paid more attention to our own warnings in our earlier report titled “Markets Too Complacent About The Coronavirus.” 5 For now, we would recommend a modest overweight to stocks on both a 3-month and 12-month horizon. Monetary and fiscal easing and the prospect of a peak in the number of new cases in Italy could continue to support stocks in the near term, while a rebound in growth starting this summer should pave the way for a recovery in corporate earnings over a 12-month horizon. Chart 14US Equity Valuations Are Not Yet At Bombed-Out Levels Of course, when it comes to financial markets, one should always be prepared to adjust one’s conviction level if prices either rise or fall significantly. We mentioned two weeks ago that we would move to a high-conviction overweight if the S&P 500 fell below 2250. While the index did briefly fall below this level, it has since bounced back to about 2630. At its current level, the S&P 500 is trading at 15.3-times forward earnings (Chart 14). While this is not particularly expensive, it is still well above the trough of 10.5-times forward earnings reached in 2011 during the height of the euro crisis. And keep in mind that current earnings estimates are based on the stale assumption that S&P 500 companies will earn $172 over the next four quarters, down only 3% from the peak earnings estimate of $177 reached in February. With this in mind, we are introducing a lower and upper bound for global equity prices at which we will adjust our view. To keep things simple, we will focus on the S&P 500, which accounts for over half of global stock market capitalization. If the S&P 500 falls below (and stays below) 2250, we would recommend a high-conviction overweight to global stocks. If the index rises above 2750, we would recommend a neutral equity allocation. Anything between 2250 and 2750 would justify the current stance of modest overweight. Going forward, we will adjust this range as events warrant it. Our full slate of views can be found in the table at the end of this report. Sector And Regional Equity Allocation: Favor Cyclicals and Non-US Over A 12-Month Horizon Not surprisingly, defensive equity sectors outperformed cyclicals both in the US and abroad during this month’s selloff. Financials also underperformed on heightened worries about rising defaults and the adverse effect on net interest margins from flatter yield curves (Chart 15). Chart 15Cyclicals And Financials Underperformed On The Way Down Chart 16Non-US Stocks Are Cheaper Even After Adjusting For Differences In Sector Weights Cyclicals and financials have outperformed the broader market over the past few days as risk sentiment has improved. They are likely to continue outperforming over a 12-month horizon as global growth eventually recovers and yield curves steepen modestly. To the extent that cyclicals and financials are overrepresented in stock market indices outside the US, this will give non-US equities the edge. Stocks outside the US also benefit from more favorable valuations. Even after adjusting for differences in sector weights, non-US stocks are quite a bit cheaper than their US peers as judged by price-to-earnings, price-to-book, and other valuation measures (Chart 16). The US Dollar Has Probably Peaked Another factor that should help cyclical stocks later this year is the direction of the US dollar. The greenback has been buffeted by two major forces this year (Chart 17). Chart 17The Dollar Has Been Facing Crosscurrents Chart 18USD Is A Countercyclical Currency Between February 19 and March 9, the dollar weakened as US bond yields fell more than yields abroad. This eliminated some of the yield advantage that had been supporting the dollar last year. Starting around the second week of March, however, global financial stresses escalated. Money began to flow into the safe-haven Treasury market. Global growth prospects also deteriorated sharply. As a countercyclical currency, this helped the dollar (Chart 18). Looking out, interest rate differentials are unlikely to return anywhere close to where they were at the start of this year, given that the Fed will probably keep rates near zero at least until the middle of 2021. Meanwhile, aggressive central bank liquidity injections should reduce financial stress, while a rebound in global growth will allow capital to start flowing back towards riskier foreign markets. This should result in a weaker dollar. Once Growth Bottoms, So Will Commodities Chart 19Low Prices Force US Shale Cutbacks The combination of a weaker dollar, a rebound in global growth starting this summer, and increased infrastructure stimulus spending in China should help lift resource prices. This will also buoy currencies such as the AUD, CAD, and NOK in the developed market space, and RUB, CLP, ZAR, and IDR, in the EM space. Oil prices have tumbled on the back of the sudden stop in global economic activity and the breakdown of the agreement between OPEC and Russia to restrain crude production. BCA’s commodity strategists expect the Saudis and Russians to come to an agreement to reduce output, as neither side has an incentive to pursue a prolonged price war. They see Brent prices averaging $36/barrel in 2020 and $55/barrel in 2021. However, prices are not likely to go much higher than $60/barrel because that would take them well above the current breakeven cost for shale producers, eliciting a strong supply response (Chart 19). Spread Product: Favor IG Over HY A rebound in oil prices from today’s ultra-depressed levels should help the bonds of energy companies, which are overrepresented in high-yield indices. This, together with stronger global growth and improving risk sentiment, should allow HY spreads to narrow over a 12-month horizon. Chart 20High-Yield Credit Is Pricing In Only A Moderate Recession Nevertheless, we think investment grade currently offers a better risk-reward profile. While HY spreads have jumped to more than 1000 basis points in the US, they are still nowhere close to 2008 peak levels of almost 2000 basis points. Like the equity market, high-yield credit is pricing in only a modest recession, with a default rate on par with the 2001 downturn (Chart 20). Moreover, central banks around the world are racing to protect high-quality borrowers from default. The Fed’s announcement that it will effectively backstop the investment-grade corporate bond market could be a game changer in this regard. Unfortunately for HY credit, the moral hazard consequences of bailing out companies that investors knew were risky when they first bought the bonds are too great for policymakers to bear. Government Bonds: Deflation Today, Inflation Tomorrow? As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary impulse will be exacerbated by rising unemployment. Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be deflationary. On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. This could be particularly true in the US, where our geopolitical team now expects Joe Biden to win the presidential election. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy. Our hunch is that the more inflationary scenario will unfold over the next 2-to-3 years. Interestingly, that is not the market’s opinion. For example, the 5-year US TIPS breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take. Finally, a word on gold. Just as during the Global Financial Crisis, gold failed to be an attractive hedge against financial risk during the recent stock market selloff – bullion dropped by 15% from $1704/oz to $1451/oz, before rebounding back to $1640/oz over the past few days as risk sentiment improved. Nevertheless, gold remains a good hedge against long-term inflation risk. And with the US dollar likely to weaken over the next 12 months, gold prices should move up even if near-term inflationary pressures remain contained. As such, we are upgrading our outlook on the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Appendix A Appendix A Table 1Central Banks Still Had Some Options When Crisis Hit Appendix A Table 2Massive Stimulus In Response To Pandemic Footnotes 1 Jing Yan, Suvajyoti Guha, Prasanna Hariharan, and Matthew Myers, “Modeling the Effectiveness of Respiratory Protective Devices in Reducing Influenza Outbreak,” U.S. National Library of Medicine, (39:3), March 2019. 2 Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. 3 This calculation assumes that 5% of infected people need ICU care and each spends an average of 2 weeks in the ICU. It also assumes that hospitals are able to expand their capacity by 30 additional ICU beds per 100,000 people per year to treat COVID-19. 4 Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, available at gis.bcarearch.com. 5 Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020, available at gis.bcaresearch.com. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades