Money/Credit/Debt

Highlights Duration: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. Yield Curve: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spreads: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. Fed Policy: The Fed is frantically trying to mitigate the impact of three different (though related) shocks: An economic shock, a liquidity shock and a credit shock. We assess its progress to date and discuss what could be done next. Feature Headfake Chart 1Not A Reflationary Environment Not A Reflationary Environment Not A Reflationary Environment Bond yields jumped early last week, shortly after the Fed cut rates back to the zero bound. At one point the 10-year Treasury yield reached as high as 1.18%. But make no mistake, this was not the start of a protracted bond sell off. By Monday morning, the 10-year was back down to 0.75%. Evidently, the conditions for a sustained move higher in Treasury yields are not yet in place. To see why this is so, we need to look a little bit beyond the headline grabbing change in nominal yields and notice that, even when the nominal 10-year yield moved up early last week, the 10-year real yield increased much more quickly, causing the implied cost of inflation protection to fall (Chart 1). This is unusual behavior. Typically, real yields, nominal yields and breakeven inflation rates are all positively correlated. This is because an improving economic outlook usually leads investors to expect both higher inflation and a higher fed funds rate in the future, and vice-versa. When the correlation breaks down it is usually related to some policy action or constraint. For example, investors could come to believe that the Fed will keep interest rates too low for far too long, causing real yields to fall even as inflation expectations jump. Or, as is the case right now, the market could recognize the zero-lower-bound constraint on Fed policy and start to price-in a scenario where the Fed can’t cut rates far enough to jumpstart economic growth. Real yields move higher in this scenario, but inflation expectations crash. We are seeing the same dynamic of rising real yields and falling inflation expectations that was witnessed in 2008. This same dynamic of rising real yields and falling inflation expectations was witnessed in 2008, when the Fed was rapidly cutting rates but investors did not view that action as sufficient (Chart 2). Falling equity prices and a rising dollar further underscored that the environment was becoming more deflationary, not reflationary. A sustained rise in bond yields can only be caused by a reflationary environment. Chart 2Shades Of 2008 Shades Of 2008 Shades Of 2008 How Close To The Bottom? The relevant question then becomes: How close are we to returning to a reflationary environment? To answer this question we will rely on the checklist to call the bottom in bond yields that we unveiled two weeks ago.1 That checklist contains four factors: A stabilization in confirmed COVID-19 cases Improving global economic growth (particularly in China) Weaker US economic data A trigger from one or more technical trading rules Last week we started to see the first signs of weaker US economic data. Initial jobless claims spiked to 281k and both the New York and Philadelphia Fed regional manufacturing surveys plunged (Chart 3). We expect the bottom in bond yields will occur when the US economic data are very weak and when economies that experienced the outbreak earlier – such as China – are showing signs of rebounding. Investors will superimpose the Chinese experience onto the US. But it is still too early for that. Global growth bellwethers such as the CRB Raw Industrials commodity price index remain in freefall (Chart 3, bottom panel). We also noted that we want to see stabilization in the global number of confirmed COVID-19 cases. Essentially, this would mean the number of daily new cases falling close to zero. We are far from that point, as the daily number of new cases continues to rise exponentially (Chart 4). Chart 3Weaker US Data, But No Global Recovery Weaker US Data, But No Global Recovery Weaker US Data, But No Global Recovery Chart 4New Cases Still Rising New Cases Still Rising New Cases Still Rising We should also mention that we expect risk assets – equities and corporate credit – to bottom before Treasury yields, as the Fed will take care not to signal a premature removal of crisis stimulus measures. Finally, two weeks ago we described several technical trading rules that have demonstrated some success at calling troughs in Treasury yields in the past. Since last week, one of our three proposed trading rules was briefly triggered, but that signal was quickly reversed. Bottom Line: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. A Quick Note On TIPS In last week’s report we made the case for long-term investors to buy TIPS relative to equivalent-maturity nominal Treasuries.2  The reasoning is that TIPS breakeven inflation rates offer exceptional value relative to likely future inflation outcomes. For example, the 5-year TIPS breakeven inflation rate is currently 0.31% and the 10-year rate is 0.75%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.31% per year for the next five years, or 0.75% per year for the next decade. Chart 51-Year TIPS Return Scenarios Life At The Zero Bound Life At The Zero Bound We also observed last week that TIPS breakeven inflation rates have turned negative at the front-end of the curve. We described this pricing as irrational because of the embedded deflation floors in TIPS. This was incorrect. While TIPS will always pay at least par at maturity, seasoned TIPS with only a year or two left to maturity already have inflation-adjusted principal values that are well above par. In other words, there is room for deflation to influence the returns from these securities before any floor is triggered. Specifically, we can take a look at the TIPS maturing in just over one year, on April 15 2021 (Chart 5). This note has an accumulated principal of just under $109 and is currently trading at an ask price of $97.63.3 According to our calculations, this security will earn 2.55% if headline CPI inflation is 0% over the next 12 months. It will only lose money if headline CPI inflation comes in at -2.49% or below. What’s more, it will return more than a 12-month nominal T-bill as long as inflation is above -2.4%. Note that the lowest year-over-year headline CPI inflation print during the Great Financial Crisis was -2.1%. TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year. Bottom Line: TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year.  Treasury Curve: Re-Visiting The Zero-Lower-Bound Playbook Chart 6Curve Will Trade Directionally With Yields Curve Will Trade Directionally With Yields Curve Will Trade Directionally With Yields The Fed’s aggressive policy easing has caused the yield curve to re-shape dramatically during the past few weeks. The 2/10 Treasury slope is up to 55 bps from a 2019 low of -4 bps. The 2/30 Treasury slope is up to 118 bps from a 2019 low of 42 bps, and the 2/5 Treasury slope is up to 15 bps from a 2019 low of -13 bps. Looking through the recent volatility, the fact that the fed funds rate is back to a range between 0% and 0.25% means that we can dust off our yield curve playbook from the last zero-lower-bound period. Fortunately, that playbook is quite straightforward. With the front-end of the curve pinned near zero, the slope of the yield curve will essentially trade directionally with the level of Treasury yields for the foreseeable future. Chart 6 shows that during the last zero-lower-bound period, the 2/30, 2/10 and 2/5 slopes were all positively correlated with the 5-year Treasury yield. This correlation suggests one obvious strategy. If you think yields will rise, put on steepeners. If you think they will fall, put on flatteners. Or if, like us, you suspect that bond yields will be higher in 12 months but are not quite ready to call the bottom, you could hedge benchmark or above-benchmark portfolio duration by entering a duration-neutral steepener. What About Value Across The Curve? Chart 7Bullets Looking Less Expensive Bullets Looking Less Expensive Bullets Looking Less Expensive Until recently, investors could earn large positive carry by owning a barbell consisting of the long and short ends of the Treasury curve (e.g. 2/30) and shorting the belly (e.g. 5yr), in duration-matched terms. But this has changed. The 2/10 barbell now only offers 6 bps of positive carry versus the 5-year bullet, while the 2/30 barbell and 5-year bullet offer approximately the same yield. Both the 2/5/10 and 2/5/30 butterfly spreads are also much closer to the fair values suggested by our models (Chart 7).4 Though we are not ready to call the bottom in Treasury yields, we think the 5-year yield is sufficiently attractive to initiate a duration-neutral curve steepener trade: go long the 5-year bullet and short a duration-matched 2/10 barbell. This trade should perform well if the 2/10 slope steepens going forward. Since a steeper curve is now positively correlated with the level of yields, this trade will profit if yields move higher. Viewed this way, the trade acts as a hedge when implemented alongside our conservative ‘At Benchmark’ portfolio duration recommendation. Bottom Line: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spread Update Corporate spreads continue to widen very quickly. As such, our conclusions from last week about the amount of value in corporate bonds are already out of date. Our value assessment is based on our High-Yield Default-Adjusted Spread, which is the excess spread left over in the high-yield index after removing actual 12-month default losses. Table 1 shows how often the Default-Adjusted Spread has been in different 50 basis point intervals, and what sort of 12-month junk excess returns occurred during those periods. One conclusion from the table: To be confident that high-yield will outperform duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps. Preferably, the spread would be greater than or equal to 250 bps, the historical average. The red numbers down the right-hand side of Table 1 indicate what the Default-Adjusted Spread will be for the next 12 months if the speculative grade default rate hits a specific value. For example, a default rate of 6%, which would correspond to a default cycle of a similar magnitude as 2015/16, implies a very attractive Default-Adjusted Spread of +633 bps. In contrast, a default rate of 14% or greater would lead to a negative Default-Adjusted Spread. For context, the default rate peaked at 15% and 11% in the 2008 and 2001/2 recessions, respectively. Table 1What's Priced In Credit Spreads? Life At The Zero Bound Life At The Zero Bound As of now, our base case scenario is that the current default cycle will be more severe than the 2015/16 episode but probably not as bad as the 2008 financial crisis. Something on the order of 9% - 11% seems plausible. If that’s the case, then the Default-Adjusted Spread will be somewhere between 216 bps and 394 bps. This looks quite attractive. Additionally, yesterday’s announcement that the Fed will effectively be entering the investment grade corporate bond market could be a game changer. As a result, we recommend increasing exposure to investment grade corporate bonds from neutral to overweight. For high-yield, it is possible that spreads will widen more in the near-term, but value is now sufficiently attractive for investors with investment horizons of 12 months or more to start adding exposure. We retain our neutral 6-12 month recommended allocation for now, but will re-visit the question in more detail in next week’s report.  To be confident that high-yield will outper­form duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps.  Bottom Line: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. The Fed’s War On Three Fronts   Events continue to unfold rapidly in financial markets and in terms of the Fed’s response to the market turmoil. We conclude this week’s report with a brief discussion of the three main shocks that the Fed is frantically trying to contain. We also assess how successful the Fed’s responses might be. #1: The Economic Shock The first shock that the Fed is trying to contain is the pure shock to aggregate demand that is occurring as a result of widespread quarantine measures. In cutting rates to zero and signaling that rates will not rise any time soon, the Fed has effectively done all it can to help fight the economic shock. It should help a little. Lower interest rates will ease the debt burden of homeowners who can refinance their mortgages. They may also lower costs for firms that are able to issue debt to weather the current storm. But these effects are minor compared to the fiscal measures currently making their way through Congress.5 Next steps for the Fed: None. The Fed is effectively out of bullets to contain the economic shock. It’s all about fiscal policy now. #2: Market Liquidity Shock Chart 8Bond Market Liquidity Shock Bond Market Liquidity Shock Bond Market Liquidity Shock In addition to the economic shock, the Fed is also responding to a severe market liquidity shock. What we mean by a “market liquidity shock” is that investors are finding it more expensive (or difficult) to transact in certain markets because of the scarce amount of capital being deployed to those areas. This is different than credit risk (see Shock #3). We are not talking about investors having trouble transacting because there are few willing buyers of credit risk. We are talking about high transaction costs in otherwise risk-free parts of the bond market. The issue is critical because these risk-free parts of the bond market (overnight repo, for example) are often used to fund riskier investments. Disruption in funding markets can have ripple-on effects into other, less opaque, areas. We currently see several examples of disruptions to bond market liquidity (Chart 8): Repo rates have spiked relative to the overnight index swap curve (Chart 8, top panel). The iShares 20+ year Treasury Bond ETF (TLT) is suddenly trading at a huge discount to its net asset value (Chart 8, panel 2). Cross-currency basis swap spreads have turned deeply negative, meaning that it is more expensive for non-US actors to obtain US dollar funding (Chart 8, bottom panel). Wider-than-normal bid/ask spreads are being reported in the Treasury market (not shown). These disruptions are occurring because the financial system is not deploying enough capital to market-making activities in these areas. Essentially, nonfinancial firms have drawn on their revolving credit lines during the past few weeks and this has left the financial system short of cash to deploy toward market-making activities. To fix the problem, the Fed has started to transact directly (in large amounts) in both the repo and Treasury markets. This essentially replaces the function that banks were performing until a few weeks ago. But perhaps more importantly, the Fed is also encouraging banks to deploy the capital that already sits on their balance sheets. Unlike during the 2008 financial crisis, banks now carry a lot of capital – the result of Dodd-Frank and Basel III regulations. What the banks need now is tacit permission from regulators to deploy that capital into financial markets, without concern that they will face consequences during a future stress test. Table 2Banks Have Excess Capital Life At The Zero Bound Life At The Zero Bound Even without any specific changes to regulation, Table 2 shows that the big 5 US financial institutions all carry significant buffers above the regulatory minimum 100% Liquidity Coverage Ratio and 6% Supplementary Leverage Ratio. At a minimum, these excess buffers must be deployed to aid market liquidity. Next steps: The Fed is already transacting directly in both the repo and Treasury markets, and behind closed doors it is most certainly encouraging banks to deploy more capital toward market-making activities. If these actions prove insufficient, the next step would be for the Fed – along with other regulators and possibly Congress – to offer temporary regulatory relief for banks, lowering the required Liquidity Coverage and Supplementary Leverage ratios. We view this market liquidity problem as one that regulators will be able to solve. And given the Fed’s aggressive policy response to date, we expect that regulators will get a handle on the issue and restore bond market liquidity fairly soon. #3 Credit Shock Chart 9Can The Credit Shock Be Contained? Can The Credit Shock Be Contained? Can The Credit Shock Be Contained? We draw a distinction between spreads widening because of a lack of market liquidity and spreads widening because investors are unwilling to take credit risk. Though admittedly, it is not always easy to distinguish between these two factors in real time. But there is no doubt that the economy is also grappling with a credit shock, in addition to the economic and liquidity shocks we already mentioned. Some evidence that market players are less willing to take credit risk (Chart 9): The average option-adjusted spread on the Bloomberg Barclays Investment Grade Corporate Bond index has spiked (Chart 9, top panel). The spread between the 3-month commercial paper rate and the overnight index swap rate has surged (Chart 9, panel 2). The Municipal / Treasury yield ratio is higher than it was during the financial crisis (Chart 9, panel 3). The 30-year mortgage rate has so far not followed Treasury yields lower (Chart 9, bottom panel). The Fed can take some measures to mitigate the negative impacts of a credit shock, and it has already taken quite a few. The Fed has set up facilities to back-stop commercial paper and short-maturity municipal debt. It also announced yesterday morning that it will, in conjunction with the Treasury department, enter the investment grade corporate bond market out to the 5-year maturity point, effectively back-stopping a large portion of corporate issuance. The Fed has not yet set up a facility to purchase longer-maturity municipal bonds, but this could be forthcoming. The Fed is also directly purchasing large amounts of Agency MBS in an effort to tighten the spread between the mortgage rate and Treasury yields. The Fed’s measures to guarantee some risky debt can help solve some problems related to a credit shock. For example, if Fed purchases increase asset values for corporate and municipal bonds, then it lessens the risk of bankruptcy both for the issuing firms and for any systemically-important investment fund that may be levered to those markets. However, Fed purchases do not guarantee that stressed firms will be able to take out new debt, nor do they prevent firms from cutting payrolls in the face of lower demand. Only direct cash bailouts from the government can fix those problems. Next steps: The Fed could add another facility to purchase long-maturity municipal bonds. It could also implement a “funding for lending” scheme similar to what the Bank of England has done. These measures, along with what has already been announced, will help ease the credit shock at the margin. But ultimately, cash bailouts from Congress to firms and state & local governments will be required.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 3 Numbers quoted assuming a par value of $100. 4 For details on our yield curve models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 The global fiscal response to the COVID crisis is discussed in more detail in Geopolitical Strategy Weekly Report, “De-Globalization Confirmed”, dated March 20, 2020, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, This week, I provided an update through a webcast on the economic and financial market outlook in the era of the COVID-19 outbreak. You can access the webcast here. In lieu of our regular report this week, we are sending you a Special Report from my colleague Jonathan LaBerge. Jonathan shows why the most widely cited estimate of the US neutral rate of interest, the Laubach & Williams estimate of “R-star”, is very likely wrong and that the true neutral rate may be higher than many investors believe. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. I hope you find the report insightful. Please note that next week we will be publishing our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to the only available real time estimate of the real neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even once economic recovery takes hold unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). This report revisits the “LW” R-star estimate in detail, and demonstrates why the estimation is almost certainly wrong, at least over the past two decades. We also outline an inferential approach that investors can use to monitor where the neutral rate is in real time and whether it is rising or falling. The core conclusion for investors is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, investors should avoid dogmatic medium-to-longer term views about yields as they may rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. Feature Over the past several weeks financial markets have moved rapidly to price in a global recession stemming from the COVID-19 outbreak. As financial market participants began to turn to policy makers for support, eyes focused first on the Federal Reserve, and then fiscal authorities. Earlier this week, the ECB joined the party and announced aggressive further measures of its own. When responding to the Fed’s return to the lower bound and its other recent monetary policy decisions, many market participants have expressed the view that the Fed is largely impotent to deal with a global pandemic. There are three elements to this view. The first is that interest rate cuts are ill equipped to stimulate domestic demand if quarantine measures or other forms of “social distancing” are in effect. The second element is that the Fed has only been capable of delivering a fraction of the reduction in interest rates compared to what has occurred in response to previous contractions. The third aspect of this view is that because the neutral rate of interest is so much lower now than it was in the past, Fed rate cuts will not be as stimulative as they were before. Chart 1Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate While we at least partly agree with the first and second elements of this view, we feel strongly that the third is flawed. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013,1 and have gravitated to the only available real time estimate of the neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. This time series, which is regularly updated by the New York Fed,2 suggests that the real fed funds rate reached neutral territory in the first quarter of 2019 (Chart 1). With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even beyond the near term unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). In this Special Report we revisit the “LW” R-star estimate in detail, and demonstrate why the estimation is almost certainly wrong, at least over the past two decades. Our analysis does not reveal a precise alternative estimate of the neutral rate, although we do provide some inferential perspective on how investors may be able to monitor where the neutral rate is in real time and whether it is rising or falling. However, the core insight emanating from our report, particularly for US fixed income investors, is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once economic activity recovers. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise may be larger than many investors currently expect. Demystifying The LW R-star Estimate The LW estimate of the neutral rate of interest has gained credibility for three reasons. First, as noted above, the evolution of the series fits with the secular stagnation narrative re-popularized by Larry Summers. Second, the series is essentially sponsored by the Federal Reserve even if it is not officially part of the Fed’s forecasting framework, as its two creators are long-time Fed employees (Thomas Laubach is a director of the Fed’s Board of Governors, and John Williams is the current President of the New York Fed). But, in our view, there is a third important reason that global investors have accepted the LW R-star estimate of the neutral rate of interest: the methodology used to generate the estimate is extremely technically complex, and thus is difficult for most investors to penetrate. Much of the technical complexity of the LW estimate is centered around the use of a statistical procedure called a Kalman filter (“KF”). Simply described, the KF is an algorithm that tries to estimate an unobservable variable based on 1) an idea of how the unobservable variable might relate to an observable variable (the “measurement equation”), and 2) an idea of how the unobservable variable might change through time (the “transition equation”). Through a repeated process of simulating the unobserved variable based on a set of assumptions, the KF is able to compare predicted results to actual results on an observation-by-observation basis, and use that information to generate ever more reliable future estimates of the unobserved variable (Chart 2). Chart 2A Very Simplified Overview Of The Kalman Filter Algorithm Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis We acknowledge that a full technical treatment of the Kalman Filter as it relates to the LW estimate of the neutral rate of interest is beyond the scope of this report, and we provide a more technical overview in Box 1. But what emerges from a detailed analysis of the model is that the Kalman Filter jointly estimates R-star, potential GDP growth, potential GDP, and the variable “z”, the determinants of R-star that are not explained by potential GDP growth. As we will highlight in the next section, this joint estimation of these four variables is a crucial aspect of the model, because a valid estimate of R-star necessitates a valid estimate of the remaining variables. Box 1 A Technical Overview Of The Laubach & Williams R-star Model Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Debunking The LW R-star Estimate Before criticizing the LW estimate of the neutral rate of interest, it is important for us to note that we have the utmost respect for the Federal Reserve and its research methods. We fully acknowledge that the LW R-star estimation is rooted in solid economic theory, and we have identified no technical errors in the setup of the LW model. Nevertheless, valid analytical efforts sometimes lead to problematic real-world results, and there are two key reasons to believe that the Kalman filter in the LW model is almost certainly misspecifying R-star, at least in terms of its estimate over the past two decades. The first reason relates to the sensitivity of the model to the interval of estimation (the period over which R-star is estimated). Chart 3 presents the range of quarterly estimates of R-star since 2005, along with the difference between the high and low end of the range in the second panel. The chart shows that while previous estimates of R-star have generally been stable for values ranging between the early-1980s and 2006/2007, pre-1980 estimates have varied quite substantially and we have seen material revisions to the estimates over the past decade. Q1 2018 serves as an excellent example: in that quarter R-star was estimated to be 0.14%; today, the Q1 2018 R-star estimate sits at 0.92%. Chart 3Since 2005, There Has Been Some Instability In The LW R-star Estimates Since 2005, There Has Been Some Instability In The LW R-star Estimates Since 2005, There Has Been Some Instability In The LW R-star Estimates   However, Table 1 and Chart 4 highlight the real instability of the Kalman filter estimation by demonstrating the effect of varying the starting point of the model (please see Box 2 for a brief description of how our estimation of R-star using the LW approach differs slightly from the original procedure). Laubach & Williams originally estimated R-star beginning in Q1 1961; Table 1 shows what happens to today’s estimate of R-star simply by incrementally varying the starting point of the model from Q1 1958 to Q4 1979. Table 1Alternative Current LW Estimates Of R-star By Model Starting Point Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Chart 4Alternative Starting Points Produce Wildly Different Estimates Of R-star Today Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Box 2 The Laubach & Williams R-star Model With Simplified Inflation Expectations Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis The table highlights that the model fails to even generate a result in a majority of the cases (only 39 out of 88 of the model runs were error-free). In addition, Chart 4 shows that of the successful estimates of R-star using the LW procedure and alternate starting dates of the model, the estimate of R-star today varies from -2% (in one case) to +2%. Excluding the one extremely negative outlier results in an effective estimate range of 0% to 2%, but the key point for investors is that this range is massive and underscores that the original model’s estimate of R-star today is heavily and unduly influenced by the interval of estimation. Investors should also note that of all of the alternative estimates of R-star today shown in Chart 4, the estimate using the original interval is very much on the low end of the distribution. The second (and most important) reason to believe that the LW estimate is misspecifying R-star is that the output gap estimate generated by the model is almost certainly invalid, at least over the past two decades. Chart 5 presents the LW output gap estimate alongside an average of the CBO, OECD, and IMF estimates of the gap; panel 1 shows the official current LW output gap estimate, whereas panel 2 shows the range of output gap estimates that are generated using the different estimation intervals highlighted in Table 1 and Chart 4. Given that the Kalman filter in the LW model jointly determines R-star and the output gap (by way of estimating potential output via estimating potential GDP growth) and that these estimates are dependent on each other, Chart 5 highlights that in order to believe the LW R-star estimate investors must believe three things: That the US economy was chronically below potential in the late-1990s when the unemployment rate was below 5%, real GDP growth averaged nearly 5%, and the equity market was booming, That output exceeded potential in 2004/2005 by a magnitude not seen since the late-1970s / early-1980s despite an average unemployment rate, That the 2008/2009 US recession was not particularly noteworthy in terms of its deviation from potential output, and that the economy had returned to potential output by 2010/2011 when the unemployment rate was in the range of 8-9%. Chart 5The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades While we do not believe any of these three statements, the third is especially unlikely. Chart 6 highlights that the economic expansion from 2009 – 2020 was the weakest on record in the post-war era in terms of average annual real per capita GDP growth. To us, this is a clear symptom of a chronic deficiency in aggregate demand, and that it is essentially unreasonable to argue that the economy was operating at full employment prior to 2014/2015. This means that the Kalman filter is generating incorrect and unreliable estimates of the output gap, which means in turn that the filter’s estimation of R-star is almost assuredly wrong. Chart 6The US Economy Was Definitely Not At Full Employment In 2010 Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis How Can Investors Tell What The Neutral Rate Is? An Inferential Approach Table 2 presents the sensitivity of the original Q1 1961 LW estimate of R-star to a series of counterfactual scenarios for inflation, real GDP growth, nominal interest rates, and import and oil prices since mid-2009. While these scenarios do not in any way improve the validity of the LW R-star estimate, they do help clarify the theoretical basis of the model and they help reveal how investors may infer whether the neutral rate of interest is higher or lower than prevailing market rates, and whether it is rising or falling. Table 2 highlights that today’s estimate of R-star using the original LW approach is mostly sensitive to our counterfactual scenarios for growth and interest rates, but not inflation or oil prices. Shifting down import price growth also has a meaningful effect on R-star, but since core import price growth has been particularly weak over the past several years (Chart 7), it seems unreasonable to suggest that they have been abnormally high and thus “explain” a low R-star estimate today. Table 2Sensitivity Of Current LW R-star Estimate To Counterfactual Scenarios (2009 - Present) Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Chart 7Core Import Price Growth Has Been Weak On Average During This Expansion Core Import Price Growth Has Been Weak On Average During This Expansion Core Import Price Growth Has Been Weak On Average During This Expansion Table 2 essentially highlights that the entire question of the neutral rate of interest over the past decade, and the core contradiction that led to the re-emergence of the secular stagnation thesis, can effectively be boiled down to the following simple question: “Why hasn’t US economic growth been stronger this cycle, given that interest rates have been so low?” Based on the (hopefully uncontroversial) view that interest rates influence economic activity and that economic activity influences inflation, we propose the following checklist for investors to ask themselves in order to not only determine the answer to this important question, but to help identify whether R-star in any given country is likely higher or lower than existing policy rates at any given point in time. Are interest rates above or below the prevailing level of economic growth? Are interest rates rising or falling, and how intensely? Are there identifiable non-monetary shocks (positive or negative) that appear to be influencing economic activity? Is private sector credit growth keeping pace with economic growth? Are debt service burdens in the economy high or low? The first question reflects the most basic view of R-star, which is that the real neutral rate of interest should be equal to, or at least closely related to, the potential growth rate of the economy, ceteris paribus. Questions 2 through 5 attempt to determine whether ceteris paribus holds. In terms of how the answers to these questions relate to identifying the neutral rate, consider two economies, “Economy A” and “Economy B” (Chart 8). Economy A has broadly stable or slightly rising interest rates that are well below prevailing rates of economic growth (questions 1 & 2), no obvious beneficial shocks to domestic demand from fiscal policy or other factors (question 3), and strong private sector credit growth that is perhaps above or strongly above the current pace of GDP growth (question 4). Chart 8''Economy A'', Versus ''Economy B'' Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Inferentially, it would seem that interest rates in this hypothetical economy are below R-star today. Question 5 is in our list because the more that active private sector leveraging occurs (thus pushing up debt burdens), the more that we would expect R-star in the future to fall. This is because debt payments as a share of income cannot rise forever, and we would expect that the capacity of economy A’s central bank to raise interest rates in the future are negatively related to economy A’s private sector debt service burden today. Now, imagine another economy (“Economy B”) with interest rates well below average rates of economic growth, an interest rate trend that is flat-to-down, no identifiable non-monetary policy shocks that are restricting aggregate demand, persistently sluggish credit growth, and high private sector debt service burdens in the past. If economy B is growing (even sluggishly) and not in the middle of a recession, it would seem that prevailing interest rates are below R-star, but not significantly so. In this scenario it would seem reasonable to conclude that R-star in economy B has fallen non-trivially below its potential growth rate, and that interest rate increases are likely to move monetary policy into restrictive territory earlier than otherwise would be the case. Is The United States “Economy B”? From the perspective of some investors, our description of economy B above perfectly captures the experience of the US over the past decade: an extremely low Fed funds rate, sluggish to weak growth and inflation, all the result of a huge build-up in leverage and debt service burdens during the last economic cycle. We do not doubt that R-star fell in the US for some period of time during the global financial crisis and in the early phase of the economic recovery. But we doubt that it is as low today as the secular stagnation narrative would imply, in large part because it ignores several important aspects concerning questions 2 through 5 noted above. Chart 9Fiscal Austerity Has Been A Serious Non- Monetary Shock To Aggregate Demand Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Non-monetary shocks to the US and global economies: Over the past 12 years, there have been at least five deeply impactful non-monetary shocks to both the US and global economies that have contributed to the disconnect between growth and interest rates: 1) a prolonged period of US household deleveraging from 2008-2014, 2) the euro area sovereign debt crisis, 3) fiscal austerity in the US, UK, and euro area from 2010 – 2012/2014 (Chart 9), 4) the US dollar / oil price shock of 2014, and 5) the recent trade war between the US and China. Several of these shocks have been policy-driven, and in the case of austerity the negative consequences of that policy has led to a lasting change in thinking among fiscal authorities (outside of Japan) that is unlikely to reverse in the near-future. Private sector credit growth: Chart 10 highlights the extent of household deleveraging noted above by showing the growth in total household liabilities over the past decade alongside income growth. Panel 2 shows the leveraging trend of firms, as represented by the nonfinancial corporate sector debt-to-GDP ratio. Chart 10 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it is now growing again and has largely closed the gap with income growth. The second point is that the nonfinancial corporate sector has clearly leveraged itself over the course of the expansion, arguing that interest rates have not in any way been restrictive for businesses. While it is true that firms have largely leveraged themselves to buy back stock instead of significantly increasing capital expenditures, in our view this reflects the fact that US consumer demand was impaired for several years due to deleveraging. We doubt that firms would have altered their capital structures to this degree if they did not view interest rates as extremely low. Chart 10Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Debt service burdens: Chart 11 highlights that US household debt service burdens were at very elevated levels prior to the financial crisis, suggesting that the neutral rate did fall for some time following the recession. But today, the debt burden facing households is the lowest it has been in the past 40 years due to both rate reductions and deleveraging, arguing against the view that household debt levels will structurally weigh on interest rates in the years to come. Chart 12 shows that the picture is different for nonfinancial corporations, as the substantial leveraging noted above has indeed raised debt service burdens for firms. However, the nonfinancial corporate sector debt service ratio remains 400 basis points below early-2000 levels when excess corporate sector liabilities had a clear impact on the economy, suggesting that the Fed’s capacity to raise interest rates still exists following the onset of economic recovery if corporate sector credit growth does not rise sharply relative to GDP over the coming 6-12 months. Chart 11The Debt Burden Facing US Households Is At A Record Low The Debt Burden Facing US Households Is At A Record Low The Debt Burden Facing US Households Is At A Record Low Chart 12Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise The intensity of recent interest rate changes: Finally, many investors have pointed to sluggish housing activity over the past three years as evidence of a low neutral rate. However, Chart 13 highlights that the rise in the 30-year US mortgage rate from late-2016 to late-2018 was one of the largest two-year changes in US history, and Chart 14 shows that the growth in household mortgage credit did not fall below its trend during this period until Q4 2018, when the US stock market fell 20% from its high in response to the economic consequences of the US/China trade war. Chart 14 also shows that mortgage credit growth responded sharply to a recent reduction in interest rates. All in all, Charts 13 & 14 cast doubt on the notion that the level of mortgage rates over the past three years reached restrictive territory. Chart 13Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Chart 14A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market Investment Conclusions In the face of a global pandemic and an attendant global recession this year, the idea of eventual Fed rate hikes and the notion that the US economy will be able to tolerate them likely seems preposterous to many investors. We agree that over the coming 6-12 months US Treasury yields are unlikely to rise; even at current levels of the 10-year Treasury yield, we are reluctant to call a trough. Chart 15US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade However, Chart 15 highlights that over a long-term time horizon, the bond market is now essentially priced for a repeat of the ten-year path of the Fed funds rate following the global financial crisis. While some investors will view this as a reasonable expectation in the face of what they see as a persistent and unexplainable gap between growth and interest rates over the past decade, we think this gap is explainable and we highly doubt that a pandemic with minimal mortality risk to the working age population and the young will cause the US economy to be afflicted with active consumer deleveraging lasting 4 to 6-years, substantial and wide-ranging fiscal austerity, persistently rising trade tariffs, and sharply lower oil prices. So while we agree that the US economy will be substantially cyclically affected by COVID-19, US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise following the upcoming recession may be larger than many investors currently believe.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1    "IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer," Washington DC, November 8, 2013. 2    "Measuring the Natural Rate of Interest," Federal Reserve Bank of New York. Global Investment Strategy View Matrix Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis

Dear clients, In addition to this short weekly report, you will also receive a Special Report penned by my colleague Jonathan LaBerge on Sweden, with implications for the SEK. I hope you will find the report both useful and insightful. In the interim, I wish safety for you and your families. Best Regards, Chester Ntonifor Highlights The lack of dollar liquidity had been a tailwind behind the dollar bull market. However, an expansion in the Federal Reserve’s balance sheet should help stem the global shortage of dollars. Ditto if there is an expansion of swap lines beyond the five major central banks. The risk is that the shortage of dollars has already begun to trigger negative feedback loops in a few countries. Until tentative signs emerge that the global economy is on better footing, expect spikes in the dollar. The caveat is that a big fiscal spending package in the US should lead to a deterioration in the current account. This will improve the offshore dollar liquidity situation. Feature The latest flare-up in risk aversion has also rotated to the offshore dollar funding market. Across G10 countries, US dollar cross-currency basis swaps - a measure of the costs to obtain greenbacks domestically - have been rising at an alarming pace. During the Federal Reserve’s emergency meeting on Sunday, swap lines were extended to five major central banks. The terms were very generous, with costs at the overnight index swap rate + 25 basis points, as well as a maturity of 84 days. However, the following day, the dollar continued its fervent rally, with the euro-US cross-currency basis swap touching -120 points (Chart 1). Chart 1A Broad-Based Funding Crisis A Broad-Based Funding Crisis A Broad-Based Funding Crisis The lack of follow through from the Fed’s liquidity injection highlights a fundamental risk to our sanguine view that the dollar should top out sooner rather than later. While we maintain this view, it has been discouraging that the DXY has broken above 100. We had anticipated a move higher on February 21, prompting us to close our long DXY position for a loss. Today, we suggest waiting for better signposts to short the greenback outright.1 US Dollar Flows The dollar remains the reserve currency of today, with the Fed at the center of the global financial architecture. The process behind dollar shortages is a simple one: Chart 2Global FX Reserve Growth Was Anemic Global FX Reserve Growth Was Anemic Global FX Reserve Growth Was Anemic Countries that are experiencing falling trade balances (because of a trade slowdown or trade war) will see a fall in their foreign exchange reserves. This naturally means that their supply of dollars is declining (Chart 2). Wary of seeing local dollar interest rates rise (leading to a higher dollar, and some companies going bust), central banks could sell dollars to the private sector in exchange for local currency. As a reserve currency, the US trade deficit is also settled in dollars. This naturally leads to a flow of greenbacks outside US borders. However, it also means that the current account deficit finances the budget deficit. Therefore, a falling trade surplus in exporting countries naturally means a falling deficit in the US. In order to stimulate the US economy, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. The central bank helps finance this fiscal deficit via expanding the monetary base (Seigniorage). The drop in rates causes the yield curve to steepen. This incentivizes banks to lend, which in turn boosts US money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, the current account deficit widens. This leads to a renewed outflow of dollars. It is easy to see where the process can get short-circuited, especially via an external shock. If you accept the premise that the sum of the Fed’s custody holdings together with the US monetary base constitutes the root of global dollar liquidity, then it is not yet accelerating fast enough.2 Like in the past, the Fed has been quick to correct the situation: Recently, it has instituted swap lines. However, they remain inadequate for three key reasons: The swap lines should be extended from the five central banks to many countries, because Covid-19 is now a global pandemic. Not even China (along with other emerging markets) was  included in the swap agreements. The swap lines usually have terms/limits/amounts, which means that even if the domestic central bank decided to be the lender of last resort, it could still run short of dollars. Widespread fiscal measures have been announced, but this has been mostly geared towards sustaining income. Until governments unilaterally backstop airlines, shipping firms, restaurants, or any other company afflicted by the virus from going bankrupt, a negative self-reinforcing feedback loop will remain. Chart 3The Dollar As An Arbiter Of Growth The Dollar As An Arbiter Of Growth The Dollar As An Arbiter Of Growth We continue to recommend standing aside on the dollar until the dust has settled. Longer-term fundamentals suggest a dollar-bearish view, but until the world gets a sense that global growth is bottoming soon, the dollar uptrend remains intact (Chart 3). We continue to use internals and market fundamentals as a guide for when to time a top.3  Finally, we have been stopped out of a few trades and are tightening stops on a few. Please see this week’s trade table for a few recommendations.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1    Please see Foreign Exchange Strategy Weekly Report,  “The Near-Term Bull Case For The Dollar”, dated February 28, 2020, available at fes.bcaresearch.com. 2   Please see Foreign Exchange Strategy Weekly Report,  “Is The World Short Of Dollars?”, dated September 13, 2019, available at fes.bcaresearch.com. 3   Please see Foreign Exchange Strategy Weekly Report,  “Currency Technicals And Market Internals”, dated March 13, 2020, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Since 2004, Sweden’s private sector leverage trend can be explained using a simple Taylor rule approach. The approach clearly highlights three distinct monetary policy phases, and underscores the singular role of inflation (not systemic risk from rising indebtedness) as a driving factor for Riksbank policy. Since 2015, the Riksbank has maintained interest rates well below what a Taylor rule approach would suggest, owing to the desire to raise inflation expectations and Sweden’s high trade exposure to the euro area. This highlights strong similarities between the experience of Sweden and Canada: both countries are in the orbit of a major neighboring central bank, which has created serious distortions in both economies. Given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, our assessment of the Riksbank’s reaction function suggests the odds appear to be high that the repo rate will move back into negative territory at some point this year (despite their reluctance to do so). Over the near-term, Swedish policy easing suggests that investors should avoid the krona versus both the US dollar and euro. Over a medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends, potentially to the benefit of Swedish consumer durable and apparel stocks. Finally, over the long-term, Sweden is very likely to face a period of domestic economic stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. The co-ordinated global response to the pandemic suggests that this is not the end of Sweden’s debt supercycle, but timing the transition from reflation to stagnation will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Feature One of the worrying legacies of the global financial crisis has been a substantial buildup in private sector debt in many economies around the world. This has most famously occurred in China, but private indebtedness is also very high in many developed economies. Among advanced countries, Sweden stands out as being particularly exposed to elevated private sector debt. Chart I-1 highlights that Sweden’s private sector debt-to-GDP ratio has ballooned to a massive 250% of GDP over the past 15 years, from a starting point of roughly average indebtedness. Chart I-1Sweden's Extremely Indebted Private Sector Sweden's Extremely Indebted Private Sector Sweden's Extremely Indebted Private Sector In this report we explore why Sweden has seen an explosion in private sector debt-to-GDP, and highlight that Sweden’s experience can be compared closely with that of Canada – both countries are in the orbit of a major neighboring central bank, which has created distortions in each economy. We also summarize what this implies for Riksbank policy, and what investment recommendations can be drawn from our analysis. We conclude that while the Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, it appears likely that they will forced to do so unless the negative economic impact from the COVID-19 pandemic abates very soon. Over the short-term, this suggests that investors should avoid the Swedish krona, versus either the US dollar or the euro. Why has Sweden seen such an explosion in private-sector debt? Over the medium-term, easy Riksbank policy and the probable absence of any additional macroprudential measures is likely to spur a renewed increase in Swedish house prices and household debt, which will likely benefit consumer durables and apparel stocks relative to the broad Swedish equity market.  But this will reinforce Sweden’s existing credit bubble, and similar to Canada will set the stage for domestic economic stagnation over the very long-term. Riksbank Policy and Sweden’s Private Sector Debt: A Tale Of Three Phases Much of the investor attention on Sweden's extremely high private sector debt load has occurred following the global financial crisis. But Chart I-1 clearly highlights that the process of private sector leveraging began in 2004, arguing that the Riksbank’s easy monetary policy stance following the global financial crisis is not the only cause of Sweden’s extremely elevated private debt-to-GDP ratio. In a previous Special Report for our Global Investment Strategy service,1 we investigated a similar experience in Canada and used a simple Taylor rule approach to show that the Bank of Canada’s decision to maintain interest rates below equilibrium levels for nearly two decades has contributed to a substantial buildup in private sector leverage. A similar approach for Sweden highlights similar conclusions, albeit with some complications: Chart I-2 shows our Taylor rule estimate for Sweden alongside the policy rate, and shows the deviation from the rule in the second panel. Chart I-2Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Compared with Canada’s experience, which has maintained too-low interest rates consistently for the past 20 years, Chart I-2 shows that the stance of Sweden’s monetary policy since 2000 falls into three distinct phases: Persistently easy policy from 2000 to 2008 A period of less easy and then relatively tight policy from 2009 to early-2014 A period of extremely easy policy from 2015 until today. The first phase noted above closely resembles the experience of Canada: policymakers in both countries simply kept interest rates too low during the last global economic expansion. In the second phase, the stance of monetary policy in Sweden became progressively less easy: the Taylor rule collapsed in 2009/2010, and trended lower again during the euro area sovereign debt crisis as well as its aftermath. In fact, Chart I-2 suggests that Sweden’s monetary policy stance was outrightly tight from 2012-2014, and in early-2014 the Taylor rule recommended negative policy rates while the actual policy rate was above 1%. In the third phase, the Riksbank appears to have overcompensated for the second phase of relatively less easy and eventually tight monetary policy. The Riksbank pushed policy rates into negative territory in late-2014, as had been recommended by the Taylor rule a year before, at a time when the rule was rising sharply. Roughly 2/3rds of the rise in the rule from early-2014 to late-2018 occurred due to the significant rise in Swedish inflation, with the rest due to a rise in Sweden’s output gap – which turned positive in late-2016 according to the OECD (Chart I-3). It is this third phase, featuring a massive and glaring gap between Swedish policy rates and a monetary policy rule that correctly recommended easy policy from 2010 – 2014, that has attracted global investor attention over the past few years. But Chart I-4 presents Sweden’s Taylor rule gap alongside its private sector debt-to-GDP ratio, and highlights that over 80% of the rise in the latter since 2000 actually occurred in the first phase described above – a period of persistently easy monetary policy as defined by our Taylor rule approach. The behavior of Sweden’s private sector debt-to-GDP ratio in the second and third phases also seems to validate our approach, as gearing essentially stopped during the second phase and restarted in the third phase. Chart I-3Since 2014, Sweden’s Rising Taylor Rule Has Been Driven Mostly By Inflation Since 2014, Sweden's Rising Taylor Rule Has Been Driven Mostly By Inflation Since 2014, Sweden's Rising Taylor Rule Has Been Driven Mostly By Inflation Chart I-4Sweden’s Monetary Policy Phases Explain Its Private Sector Leveraging Sweden's Monetary Policy Phases Explain Its Private Sector Leveraging Sweden's Monetary Policy Phases Explain Its Private Sector Leveraging The Riksbank: “Talk To Us About Inflation, Not Debt” Chart I-5During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates It is crucial to understand the motivations of Sweden’s central bank during each of these phases in order to be able to forecast the likelihood of a return to negative interest rates this year, as well as the Riksbank’s likely policy response once the COVID-19 pandemic subsides. In the first monetary policy phase that we have described, Sweden was not the only country to maintain persistently easy monetary policy. Given the relative scarcity of private sector deleveraging events in the post-war era, most policy makers, academic economists, and market participants were regrettably unconcerned about rising private sector indebtedness during this period, and only came to understand the consequences during the crisis and its aftermath. Most advanced economies leveraged during the first of Sweden’s monetary policy phases, and Sweden really only stands out as a major outlier from 2007 – 2009 when nearly 60% of the country’s total 2000-2019 private sector leveraging occurred (most of which, in turn, occurred before the collapse of Lehman Brothers in September 2008). In essence, by the time that Swedish policymakers were given a vivid and painful demonstration of the dangers of elevated private sector debt, it was too late to prevent most of the increase in debt-to-GDP that is facing the country today. In the second phase of Sweden's modern monetary policy, our Taylor rule framework highlights that the Riksbank largely acted as appropriate. One complication, however, is the difference in the leverage trend between Sweden's nonfinancial corporate and household sectors. Chart I-5 clearly highlights that Sweden's household sector took advantage of low interest rates during the country’s second monetary policy phase. Household sector leveraging began to rise again starting in late-2011, whereas it was completely absent for the corporate sector during the period. A crucial reason why the Riksbank ignored this renewed household sector leveraging is also part of the reason that it has maintained extremely low policy rates in the third phase noted above. The Riksbank’s monetary policy strategy, which is published in every monetary policy report, includes the following: “According to the Sveriges Riksbank Act, the Riksbank’s tasks also include promoting a safe and efficient payment system. Risks linked to developments in the financial markets are taken into account in the monetary decisions. With regard to preventing an unbalanced development of asset prices and indebtedness however, well-functioning regulation and effective supervision play a central role. Monetary policy only acts as a compliment to these.” In other words, the Riksbank has been very clear that preventing excessive leveraging is not its responsibility, and that the job ultimately falls to the Swedish government. But if the Taylor rule was recommending meaningfully higher interest rates during phase 3, then why did the Riksbank continue to lower interest rates into negative territory until last year? In our view, their behavior can be explained by the confluence of three factors: 1. Sweden’s deflation scare in 2014: Sweden’s underlying inflation rate had been trending lower for four years by the time that it dipped briefly into negative territory in March 2014. By this point, the Riksbank appears to have become increasingly concerned about inflation expectations rather than the trend in actual inflation. Chart I-6 presents Sweden’s underlying inflation rate and an adaptive-expectations based estimate of inflation expectations alongside the repo rate, and shows that inflection points in the repo rate match inflection points in expectations. Specifically, the repo rate continued to fall until inflation expectations stabilized in early-2016, and the Riksbank did not raise the repo rate until expectations crossed above 1.5%, a level that was reasonably close to the central bank’s 2% target. Chart I-6During Phase 3, The Riksbank Focused On Low Inflation Expectations During Phase 3, The Riksbank Focused On Low Inflation Expectations During Phase 3, The Riksbank Focused On Low Inflation Expectations 2. Sweden’s high trade sensitivity: Chart I-7 highlights that Sweden’s economy, like Canada and other Scandinavian countries, is highly exposed to exports to top trading partners. The euro area accounts for a large portion of Sweden’s exports, and Chart I-8 highlights that nominal euro area imports from Sweden remained very weak from 2012-2016. In addition, Sweden’s import sensitivity is also very high, with total imports of goods and services accounting for over 40% of Sweden’s GDP. By our calculations, roughly 2/3rds of Swedish imports are for domestic consumption,2 and Chart I-9 highlights how closely (inversely) correlated imported consumer and capital goods prices are to Sweden’s trade-weighted currency index. By pushing the repo rate into negative territory, the Riksbank reinforced rising inflation expectations by supporting exports and importing inflation from its trading partners via a weaker krona. Chart I-7Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Chart I-8Euro Area Demand For Swedish Goods Remained Weak For Several Years Euro Area Demand For Swedish Goods Remained Weak For Several Years Euro Area Demand For Swedish Goods Remained Weak For Several Years Chart I-9To 'Import' Inflation, The Riksbank Had To Weaken The Krona To 'Import' Inflation, The Riksbank Had To Weaken The Krona To 'Import' Inflation, The Riksbank Had To Weaken The Krona 3. The euro area’s persistently weak inflation and extremely easy monetary policy: While this is related to Sweden's overall trade sensitivity, the fact that the euro area had to combat persistently weak inflation with negative interest rates and asset purchases from late-2014 to late-2018 has had a particularly strong impact on Riksbank policy given the latter’s goal of boosting Swedish inflation via higher import prices. Chart I-10 highlights the strong link between the SEK-EUR exchange rate and the real interest rate differential between the two countries, and in particular shows that the Riksbank had to lower the differential into negative territory in order to bring the krona below “normal” levels (defined here as the average of the past global economic expansion). When faced with a real euro area policy rate of roughly -1.5% during the period (Chart I-11), the only way to achieve a negative real rate differential was to maintain the repo rate at an extremely low level as Swedish inflation rose. Chart I-10To Weaken The ##br##Krona... To Weaken The Krona... To Weaken The Krona... Chart I-11…Deeply Negative Real Policy Rates Were Required ...Deeply Negative Real Policy Rates Were Required ...Deeply Negative Real Policy Rates Were Required Where Next For The Repo Rate? In February 2019 the Riksbank was forecasting that the repo rate would return into positive territory by the end of this year, and would rise as high as 80 basis points by mid-2022. They downgraded this assessment in April, and again in October, highlighting that they expected a 0% repo rate for essentially the entire three-year forecast period. In other words, the Riksbank had been moving in a dovish direction even before the COVID-19 pandemic began. Prior to the outbreak, we would have been inclined to argue that the Riksbank’s forecast of a 0% repo rate beyond 2020 was suspect, given the budding recovery in global growth. Chart I-12 highlights that the global PMI had been improving for several months prior to the outbreak, and the Swedish PMI and consumer confidence index had recently rebounded sharply. A negative repo rate was essential to “import” inflation. But, given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, and our description of the Riksbank mandate and reaction function, the odds appear to be high that the repo rate will move back into negative territory at some point this year. Besides the very negative direct impact to global trade from the pandemic, Chart I-13 highlights that Swedish inflation is now falling, and that our measure of inflation expectations has now peaked. Chart I-12Swedish Economic Momentum Was Building Prior To The Pandemic... Swedish Economic Momentum Was Building Prior To The Pandemic... Swedish Economic Momentum Was Building Prior To The Pandemic... Char I-13...But Inflation Is Falling And The Unemployment Rate Is Rising ...But Inflation Is Falling And The Unemployment Rate Is Rising ...But Inflation Is Falling And The Unemployment Rate Is Rising In addition, the Swedish unemployment rate has been trending higher since early-2018 (Chart I-13, second panel), in response to several factors: a shock to household wealth in late-2015/early-2016 due to sharply falling equity prices, a meaningful decline in house prices driven by newly introduced macroprudential policies, and a sharp albeit seemingly one-off decline in the contribution to Swedish economic growth from government expenditure (Chart I-14). These trends would have likely reversed at some point this year given the building economic momentum that was evident in January and early-February, but it is now clear that the pandemic will more than offset the budding improvement in economic activity. Chart I-14Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Over the past week the Riksbank has announced two policies: it will provide cheap loans to the country’s banks (500 billion SEK) to bolster credit supply to Swedish small & medium-sized enterprises, and it will increase its asset purchase program by 300 billion SEK. The Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, and has argued that strong liquidity support and stepped up asset purchases are more likely to be effective measures in the current environment. However, Charts I-10 & I-11 underscored the link between real interest rate differentials and the currency, and the Riksbank will risk having the krona appreciate versus the euro and other currencies if inflation continues to fall and the policy rate is kept unchanged. Chart I-15 shows that market participants have already begun to price in cuts to the repo rate, and our sense is that the Riksbank will be forced to act in a way that is consistent with the market’s view. Chart I-15The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. Investment Conclusions Over a cyclical (i.e. 6-12 month) time horizon, the Swedish krona is the asset with the clearest link to our discussion of Riksbank policy, and investors should recognize that the krona call is now a binary one based on the evolution of the COVID-19 pandemic. It is one of the cheapest currencies in the G10 space, but foreign exchange markets have recently ignored fundamentals such as interest rate differentials and valuation. This is particularly true in the face of a spike in US dollar cross-currency basis swaps, which have started to send the dollar higher even against the safe haven currencies. In such an a environment, selling pressure could continue to push SEK lower, especially if the Riksbank is pushed to reduce the repo rate sooner rather than later. The SEK is one of the most procyclical currencies in the FX space, suggesting that investors should stand aside until markets stabilize (Chart I-16). Right now, the Swedish krona is the clearest play on Riksbank policy. As for the EUR/SEK cross, any renewed ECB stimulus suggests that Sweden will act accordingly to prevent the SEK from appreciating too far, too fast. EUR/SEK will top out after global growth is in an eventual upswing, and the Riskbank has eased policy further. Over the medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends. House prices will likely decelerate in the near term given the shock to household wealth from falling equity prices, but we showed in Chart I-5 that Sweden’s household sector ultimately took advantage of low interest rates during Sweden’s second monetary policy phase. We expect a similar dynamic to unfold beyond the coming 6-9 months, and Chart I-17 highlights that overweighting Swedish consumer durable and apparel stocks within the overall Swedish equity market is likely the best way to eventually play a resumption of household leveraging and rising house prices. Chart I-16Avoid Krona Exposure ##br##For Now Avoid Krona Exposure For Now Avoid Krona Exposure For Now Chart I-17Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand With the exception of a selloff in 2013, the relative performance of the industry group has closely correlated with house price appreciation, and is now deeply oversold. The companies included the industry group earn a significant portion of their revenue from global sales, but the close correlation of relative performance with Swedish house prices and limited correlation with the global PMI suggests that domestic economic performance matter in driving returns for these stocks (Chart I-17, bottom panel). We are not yet prepared to recommend a long relative position favoring this industry group, but we are likely to view signs of policy traction and a relative performance breakout as a good entry point. Finally, the key long-term implication of our research is that Sweden will at some point likely face a period of stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. While regulators had begun to combat excessive debt with macroprudential measures, further measures to restrict household sector debt are extremely unlikely to occur until after another substantial reacceleration in Swedish house prices and another nontrivial rise in household sector leverage. This will be cyclically positive for Sweden coming out of the pandemic, but will ultimately make Sweden’s underlying debt problem meaningfully worse. Macroprudential control of rising nonfinancial corporate debt has not and is not likely to occur, and no regulatory control measure will be able to significantly ease the existing debt burden facing the private sector. Chart I-18 highlights that while Sweden’s private sector debt service ratio (DSR) is not the highest in the world, is it extremely elevated compared to other important DM countries such as the US, UK, Japan, and core euro area. Several other countries with higher private sector DSRs, such as Canada and Hong Kong, are also at serious risk of long-term stagnation. Chart I-18Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' We have not yet identified a specific list of assets that will be negatively impacted by Swedish domestic economic stagnation over the longer term. Our European Investment Strategy service recently argued that Swedish stocks are attractive over the very long term versus Swedish bonds, based on valuations and the fact that the Swedish equity market as a whole is heavily driven by the global business cycle. We plan on revisiting the question of which equity sectors are most vulnerable to domestic stagnation in a future report, as the onset of stagnation draws nearer. As we noted in our report on Canada,3 it is difficult to identify precisely when Sweden’s high debt load will meaningfully and sustainably impact Swedish economic activity and related equity sectors. The acute shock to global activity from the COVID-19 pandemic is an obvious potential trigger, but the fact that policymakers around the world are responding forcefully to the pandemic suggests that this is not the end of Sweden’s debt supercycle. In this regard, the prospect of globally co-ordinated fiscal spending is especially significant. Our best guess is that Sweden’s true reckoning will come once US and global activity contracts for conventional reasons, instigated by tight monetary policy to control rising and above-target inflation. This may mean that Sweden will avoid a balance sheet recession for some time, but investors exposed to domestically-linked Swedish financial assets should take heed that the eventual consequences of such an event are likely to grow in magnitude the longer it takes to arrive. In short, beyond the acute nearer-term impact of the pandemic, Sweden is likely to experience short-term gain for long-term pain. The short- to medium-term focus of investors should be on the former, but with full recognition that the latter will eventually occur. Timing the transition between these two states will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com 2 We assume that all services imports are consumed domestically. Among goods exports, we assume domestic consumption of all imports of food & live animals, beverages & tobacco, mineral fuels, lubricants, and related materials, miscellaneous manufactured articles, road vehicles, and other goods. 3 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com

Dear Client, Next week we will be publishing a joint Special Report on the Chinese infrastructure investment outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima, China Strategist Feature Chart I-1Chinese Non-Financial Corporations Are Heavily Indebted Chinese Non-Financial Corporations Are Heavily Indebted Chinese Non-Financial Corporations Are Heavily Indebted There are fears that the two-month hiatus in China’s business activities due to the COVID-19 epidemic has sparked acute cash shortages among Chinese companies. In turn, this has increased the danger that the highly leveraged Chinese corporate sector may be pushed into widespread insolvency (Chart I-1). The number of bankruptcies will undoubtedly climb, but small and micro firms are most at risk versus larger companies that have deeper cash reserves and easier access to financing. Our analysis shows that, before the outbreak hit China in January, companies listed in China’s onshore and offshore equity markets exhibited relatively healthy financial statements with adequate operating cash flows to cover debt obligations. This increases the probability that Chinese listed companies will survive the economic and financial shocks from the epidemic, and that their stock prices will rebound along with the expectations of a recovery in the Chinese economy. Chart I-2Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand Both Chinese Economy And Corporate Profits Are Largely Driven By Domestic Demand It also appears that China’s domestic economy is relatively insulated from the global financial market turmoil and impending global recession. China’s corporate profit outlook is dominated by domestic economic conditions rather than external demands. This view is also reflected in the relative performance of Chinese onshore and offshore stocks (Chart I-2). Moreover, the charts in the Appendix illustrate that corporate financial ratios in almost all sectors of China’s onshore and offshore equity markets have somewhat improved from the previous economic down cycle that began in 2014. This underscores our view that if reflationary measures overcompensate for the economic slowdown, as in the 2015/2016 easing cycle, then Chinese stocks will likely rally in absolute terms, as well as outperform global benchmarks. We selected three categories of financial ratios to monitor profitability, leverage and operating cash flow conditions of Chinese domestic and investable listed non-financial companies (Table I-1).1 The financial data in our exercise are from Refinitiv Datastream Worldscope. Its corresponding stock price indexes for China’s overall market and sectors most closely resemble the MSCI China Index and the MSCI China Onshore index. Table I-1 Monitoring Cash Flow Conditions In Chinese Listed Companies Monitoring Cash Flow Conditions In Chinese Listed Companies It is also noted that the Chinese investable index, excluding financial companies, is dominated by large technology companies such as Alibaba, Tencent, and Baidu.2 These tech companies generally have more adequate cash flows and lower debt ratios than the more capital intensive sectors such as industrial and energy. The analysis we present in this report on non-financial companies in the offshore market, therefore, is not indicative of China’s overall corporate financial health. Rather, our findings are indicative of how investors should view the listed companies and their sector performance within China’s investable market. Several observations from our analysis of the listed companies’ financial ratios are noteworthy: Chinese non-financial corporations are highly leveraged, and have not de-levered much despite the financial deleverage campaign that began in late 2017. Contrary to the belief that Chinese corporates’ financial health is significantly weaker than that in developed economies, the leverage ratio, profit margins, and debt-servicing ability among Chinese domestic and investable non-financial companies are actually in the range of their global peers (Chart I-3). Yet, Chinese companies trade at substantial discounts to global benchmarks. This is particularly evident in the offshore market, whereas domestic Chinese stocks were priced at a discount until the recent global market selloffs (Chart I-4). This underpins our view that, when China’s economy and corporate profits recover, Chinese stocks should outperform their global benchmarks on a cyclical time horizon. Importantly, with a stronger aggregate corporate financial health and a large price discount. Chinese investable non-financial stocks have more upside potential than their domestic counterparts. Chart I-3Financial Health Among Listed Chinese Companies Comparable With DMs Financial Health Among Listed Chinese Companies Comparable With DMs Financial Health Among Listed Chinese Companies Comparable With DMs Chart I-4Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks Chinese Investable Stock Prices Remain Deeply Discounted Relative To Global Benchmarks   Utilities, machinery, industrials and construction materials are among the sectors with the lowest cash flow-to-interest expense ratios, in both China’s domestic and investable markets. In particular, machinery, industrials and construction materials are pro-cyclical sectors and their profit growth is positively correlated with economic growth. Their low profitability and high leverage contribute to their poor cash flows. Those sectors have been severely impacted by the stoppages in manufacturing and construction activities due to the COVID-19 epidemic in China, making them vulnerable to cash shortages. However, there is a low risk of a broad-based default among these firms, because state-owned enterprises (SOEs) dominate these sectors in the Chinese equity market. The stock performance in these sectors is also extremely sensitive to shifts in China’s monetary and policy stance, and thus should benefit from the recent loosening in monetary conditions and the push for a substantial increase in infrastructure investment this year. Chart I-5Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones The leverage ratio in the real estate sector has doubled in the past 10 years. The sector’s cash flow-to-total liabilities ratio has also declined sharply since 2017, when the authorities tightened lending standards to property developers. However, the sector’s aggregate cash flow situation is still an improvement from its lowest point in 2014, in both China’s domestic and investable markets. The countrywide lockdowns in January and February will undoubtedly have severe impacts on Chinese property developers’ cash flows. But the real estate sector is perhaps the best example in exhibiting a pronounced divergence in cash flow conditions between larger and smaller firms. Chart I-5 shows that, while the median ratio of cash-to-total liabilities tuned negative among 76 domestic listed real estate developers, the average ratio from total companies in the same sector suggests that the cash situation has actually improved since mid-2018. This divergence indicates that larger developers have more solid financial fundamentals and easier access to liquidity compared with their smaller counterparts, even before the lockdowns. We expect the divergence in cash flow conditions to widen in the coming months, and smaller property developers will face intensifying pressure to consolidate. China’s domestic healthcare companies have a much better cash balance than the investable healthcare sector, which has the lowest ratio of cash-to-interest expenses among all sectors. The poor cash flow conditions in investable healthcare companies are due to high leverage and low profitability, as well as high operating costs and R&D expenses. Chinese domestic healthcare sector has outperformed the broad market since the epidemic broke out in January. While we think the overall Chinese investable stocks have more upside than their domestic peers, domestic healthcare companies’ lower leverage ratio, stronger cash flows, and much higher profit margin make the sector a better bet than investable healthcare stocks on a cyclical time horizon (Chart I-6).  Chart I-6Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Domestic Healthcare Sector Likely To Continue Outperforming The Broad Market Chart I-7Energy Stocks Will Remain Depressed Until Oil Prices Rebound Energy Stocks Will Remain Depressed Until Oil Prices Rebound Energy Stocks Will Remain Depressed Until Oil Prices Rebound Historically, there has been a strong positive correlation between the energy sector’s profitability, cash flow conditions, stock performance and crude oil prices (Chart I-7). In the past two years, the sector’s leverage ratio has risen, profit margins have thinned and the cash flow situation has sharply deteriorated to the same level as in 2014 when oil prices collapsed. The ongoing oil price rout will generate powerful deflationary forces in the energy sector and will likely further deteriorate energy firms’ profitability and cash flow. While we stay long cyclical stocks versus defensives on both a 0-3 month and a 6-12 month view, we recommend a cautious stance towards energy stocks until the evolving oil price war situation is clarified.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Appendix Overall Markets Excluding Financials Overall Markets Excluding Financials Sector Overall Markets Excluding Financials Sector Consumer Discretionary Sector Consumer Discretionary Sector Consumer Discretionary Sector Consumer Staples Sector Consumer Staples Sector Consumer Staples Sector Real Estate Sector Real Estate Sector Real Estate Sector Automobile Sector Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Small Property Developers In China Are Much More Vulnerable To Cash Shortages Than Large Ones Machinery Sector Machinery Sector Machinery Sector Industrials Sector Industrials Sector Industrials Sector Construction Materials Sector Construction Materials Sector Construction Materials Sector Telecommunications Sector Telecommunications Sector Telecommunications Sector Technology Sector Technology Sector Technology Sector Healthcare Sector Healthcare Sector Healthcare Sector Energy Sector Energy Sector Energy Sector   Utilities Sector Utilities Sector Utilities Sector   Footnotes 1    We exclude banks and financial institutions from this analysis, due to discrepancy in Chinese banks’ accounting measures from those of non-financial corporations’. 2   Alibaba, Tencent, Baidu, and JD together account for nearly 40% of the non-financial market cap in Chinese investable index. Cyclical Investment Stance Equity Sector Recommendations

Highlights At the current rate of work resumption, March’s PMI should rebound to its “normal range” from February’s historic lows. If so, our simple calculation, using China’s PMI figures and GDP growth in Q4 2008 as a template, suggests that China's economic growth in Q1 2020 should come in at around 3.2%. Chinese stocks passively outperformed global benchmarks in the last two weeks.  The likelihood of a stimulus overshoot in the next 6-12 months continues to rise, supporting our view that Chinese stocks will actively outperform global benchmark in the coming months. Cyclical stocks have significantly outperformed defensives lately. While this is consistent with our constructive view towards Chinese equities in general, the magnitude of a tech stock rally in the domestic market of late appears to be somewhat excessive. As such, investors should focus their sector exposure in favor of resources, industrials, and consumer discretionary. The depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. Feature Despite the past week’s plunge in global equities due to the threat of a worldwide COVID-19 pandemic, Chinese stocks have outperformed relative to global benchmarks. This underscores our view that epidemic risks within China are slowly abating, and China’s reflationary response to the crisis will likely overcompensate for the short-term economic shock. Tables 1 and 2 highlight key developments in China’s economy and its financial markets in the past month. On the growth front, both the February official and Caixin PMIs dropped to historic lows as a result of the virus outbreak and nationwide lockdown. On the other hand, economic data from January confirmed that pre-outbreak activity in China was on track to recovery. Daily data also suggests that production in China continues to resume. Moreover, monetary conditions have significantly loosened and fiscal supports have materially stepped up.  Chinese equities in both onshore and offshore markets dropped by 2% and 7% respectively (in absolute terms) from their January 13 peaks. Nevertheless, they have both significantly outperformed global equities, particularly in the past week. Equally-weighted cyclical stocks versus defensives in the onshore market have also moved up sharply, driven by a rally in the technology sector stocks. While the outperformance of cyclical stocks is consistent with our constructive view towards Chinese stocks, the magnitude appears to be excessive. Thus, we would advise investors positioning for a cyclical recovery in China to favor exposure in resources, industrials and consumer discretionary stocks. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review In reference to Tables 1 and 2, we have a number of observations concerning developments in China’s macro and financial market data: Chart 1Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand Inventory And Production Shortages Are A Bigger Near-Term Concern Than Weaknesses In Demand February’s drop in the official PMI below 40% is reminiscent of November 2008, which was the height of the global financial crisis. The raw material inventory sub-index of the PMI in February fell to a record low, a clear indication of strain in China’s manufacturing sector. While the finished goods inventory sub-index ticked up slightly compared with January, factories will likely run out of existing raw materials to produce goods if transportation logistics do not return to normal soon (Chart 1). A higher number in the new orders sub-index relative to production output also suggests the pressure on the supply side will intensify if the virus outbreak in China worsens and continues to disrupt manufacturing activities. This will in turn undermine the effectiveness of Chinese policy response.   Daily data from various sources suggests Chinese industrial activities continue to pick up. Between February 10 (the first official return-to-work day after an extended Chinese New Year holiday) and February 25 (the cutoff date for responding to PMI surveys), daily coal consumption in China’s six largest power plants was only about 60% of consumption compared from the same period last year (adjusted for the Lunar Year calendar). This is in line with the 35.7 reading in February’s manufacturing PMI, versus 49.2 a year ago. In the last four days of February, however, coal consumption reached nearly 70% of last year’s consumption. This figure is in keeping with a 10 percentage point increase in the rate of work resumption of enterprises above-designated size in China’s coastal regions.1 If energy consumption and work resumption rates reach about 90% by the end of March compared with Q1 2019, then PMI in March should pick up to 45% or higher. A 45% or higher reading in March’s PMI will imply economic impact from the virus outbreak is mostly limited to February. A simple calculation using China’s GDP growth in Q4 2008 as a template suggests that China's economic growth in Q1 2020 should come in at around 3.2% in real terms. This is in line with the estimate from BCA's Global Investment Strategy service.2 As we pointed out in November last year,3 China is frontloading additional fiscal stimulus in Q1 2020 to secure the economic recovery, which started to bud prior to the virus outbreak. The increase in January’s credit numbers confirms our projection. The monthly flow in total social financing in January (with only three work weeks effectively) reached above RMB 5 trillion. This figure exceeded that in January 2019, the highest monthly credit number last year. Local government bond issuance in January was almost double that a year ago, and a total of 1.2 trillion local government bonds were issued in the first two months of this year - a 53% jump from the same period last year. This suggests that fiscal stimulus has indeed stepped up in 2020. Money supply in January was slightly distorted by the earlier Chinese New Year (it fell in January this year instead of February as in most years) and the COVID-19 outbreak.  M1 registered zero growth from a year ago, whereas it grew by 0.4% in January 2019.4 Normally, during the month of the Chinese New Year, households have more cash in deposits whereas corporations have less as they pay pre-holiday bonuses to employees. This seasonality factor causes the growth rate in M0 to rise and M1 growth to fall. The seasonality was exacerbated by the nationwide lockdown on January 20 this year, as many real estate developers reportedly suffered from a significant reduction in home sales and delays in deposits for down payments. Household consumption in the service sector during the Chinese New Year was also severely suppressed. This explains near-zero growth in M1 and a larger-than-expected increase in household deposits in January (Chart 2). We expect the growth in both M0 and M1 to start normalizing in March, as production and household consumption continue to resume. While we do not expect large fluctuations in housing prices, we think growth in home sales may accelerate from Q2 2020. There are early signs that the government is starting to relax restrictions on the real estate sector, on a region by region basis. Land sales remain a major source of local governments’ income, accounting for more than half of total revenues as of last year. Chart 3 shows that as government expenditures lead land sales, a major increase in fiscal stimulus and local government spending means that a significant bump in land sales will be needed in 2020. A strengthening supply of land, coupled with the unlikelihood of large fluctuations in property prices, suggests that there will be more policy supports to the real estate sector and more incentives to boost housing demand. Chart 2Corporates Are Short On Cash Corporates Are Short On Cash Corporates Are Short On Cash Chart 3Land And Home Sales Likely To Pick Up In 2020 Land And Home Sales Likely To Pick Up In 2020 Land And Home Sales Likely To Pick Up In 2020 In the past two weeks, China’s equity market has registered a near-vertical outperformance in both investable and domestic stocks relative to global benchmarks (Chart 4). While this recent outperformance was passive in nature, our policy assessment supports future active outperformance. The recently announced pro-growth policy initiatives increasingly resemble those rolled out at the start of the last easing cycle in 2015/2016. These policy initiatives increase the odds that the upcoming “insurance stimulus” will overcompensate for the short-term economic shock, and will likely lead to a significant rebound in corporate profits in the next 6-12 months.  This supports our bullish view on Chinese stocks. Chart 5 also shows that, unlike during the 2015’s “bubble and bust” cycle, both the valuation and margin trading as a percentage of total market cap in China’s onshore market remain materially lower than 2015. Equally-weighted cyclical sectors continue to outperform defensives in both China’s investable and domestic markets, particularly the latter where stock prices in the technology sector were up 12% within the past month. While the outperformance of cyclical stocks relative to defensives is consistent with our constructive view towards Chinese equities in general, the magnitude appears to be somewhat excessive. Given this, we would advise investors positioning for a cyclical recovery in China’s economy to focus their sector exposure in favor of resources, industrials, and consumer discretionary stocks. Chart 4Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chinese Stocks Strongly Outperformed Global Benchmarks Over The Past Two Weeks Chart 5Onshore Market Trading Does Not Seem Overly Leveraged Onshore Market Trading Does Not Seem Overly Leveraged Onshore Market Trading Does Not Seem Overly Leveraged China’s three-month repo rate (the de facto policy rate) has fallen significantly in the past month, roughly 30bps below its lowest level in 2016 (Chart 6). China’s government bond yields have also reached their lowest level since 2016. While corporate bond yield spreads in other major economies have picked up sharply in the past month, the reverse is happening in China. This suggests that the market is pricing in further easing and the notion that policy supports will be effective in preventing a surge in corporate bond default rate. From a global perspective, yield spreads on China’s onshore corporate bonds have been elevated since 2016. This indicates that investors have long either priced in a much higher default rate among Chinese corporate bond issuers, or demand an unjustifiably large risk premium (Chart 7). Since we expect Chinese policymakers to continue easing, risks of a surge in China’s corporate bond default rate remain low this year. As such, until we see signs that the Chinese authorities are reverting to a financial de-risking mode, we will continue to favor onshore corporate versus duration-matched government bonds. Chart 6Monetary Policy Now More Accommodative Than 2015-2016 Monetary Policy Now More Accommodative Than 2015-2016 Monetary Policy Now More Accommodative Than 2015-2016 Chart 7Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chinese Corporates Pay High Risk Premium For Their Bonds, Even At A Relatively Low Default Rate Chart 8The RMB Likely To Continue Outperforming Other EM Currencies The RMB Likely To Continue Outperforming Other EM Currencies The RMB Likely To Continue Outperforming Other EM Currencies As we go to press, the Federal Reserve Bank has just made a 50bps cut to the Fed rate, the first emergency cut since the global financial crisis. The USD weakened against the Euro, the Japanese Yen, as well as the RMB immediately following the rate cut. While this reflects the market’s concerns of a worsening virus outbreak and the rising possibility of an economic slowdown in the US, the USD as a countercyclical currency will likely appreciate against most cyclical currencies as the virus continues spreading globally. Hence, the depreciation in the RMB against the dollar will come primarily from a stronger dollar rather than a weaker RMB, and the downside in the value of the RMB should be limited. The continuation of resuming production in China and the expectations of a Chinese economic recovery in Q2 will support an appreciation in the RMB against other EM currencies (Chart 8).   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://app.21jingji.com/html/2020yiqing_fgfc/ 2   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at gis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2020, available at gis.bcaresearch.com 4   M1 is mainly made up by cash demand deposits from corporations, whereas M0 is mainly deposits from households Cyclical Investment Stance Equity Sector Recommendations

Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively.  In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market   Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices   First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone   The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Downside Risks to Bond Prices Downside Risks to Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish   Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese policymakers will deliver more growth-supporting measures in the coming months, but Chinese government bond yields have already priced in a much weaker economic slowdown and a more aggressive policy response. While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. The PBoC’s recent liquidity injections are mostly a preventive measure to avoid an acute cash crunch in the real economy, and the historical path following the 2003 SARS outbreak suggests the additional monetary easing action is unlikely to be sustained over the coming 6-12 months. As such, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. On a cyclical basis, we continue to overweight Chinese equities over government bonds. Feature Chinese bond yields have declined sharply over the past two weeks, as investors weighed both the economic consequences of the Covid-19 outbreak and the likelihood of more accommodative monetary policy. Following the extended Chinese New Year holiday, China’s central bank (PBoC) has carried out five cash injections, pumping nearly 3 trillion yuan into the interbank market (Chart 1). It also lowered the de jure policy rate - the 7-day reverse repo rate - by 10bps to cut the cost of funding for commercial banks. The 3-month SHIBOR (which trades very closely to the 3-month repo rate), which we have long viewed as China’s de facto short-term policy rate, quickly reversed its January rise and fell back to its July-2018 low (Chart 2). Chart 1Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Chart 2Monetary Conditions Turned Much Easier In Just Three Weeks Monetary Conditions Turned Much Easier In Just Three Weeks Monetary Conditions Turned Much Easier In Just Three Weeks The PBoC’s aggressive easing measures of late have sparked market speculation that China is entering another major monetary and credit easing cycle, and that a government bond rally is well underway with even lower yields to come. Chart 3Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields In our January 29 Special Report1 on China’s government bond market, we discussed how there has been a strong relationship in the past decade between unexpected changes in the 3-month SHIBOR and the long-end of China’s government bond yields. In order for the current rally in government securities to be sustained, investors need to believe that the PBoC’s easing measures are here to stay and that there will be additional policy rate cuts in the months to come (Chart 3). There are indications that Chinese policymakers are looking to deliver more growth-supporting measures over the coming months. However, it is likely that the current bond rally will be a near-term event rather than a cyclical (6-12 months) trend. Therefore, on a cyclical time horizon, we continue to recommend overweighting Chinese stocks versus Chinese government bonds and would advise against an aggressively long duration stance. Has The Covid-19 Epidemic Peaked? The fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained.  Chart 4Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Investors appear to concur with our view that the Covid-19 outbreak has largely become a Hubei-specific crisis.2 Chinese stocks in the onshore and offshore markets have recovered more than half of the losses from their bottom on February 3, when the number of new cases outside of the Hubei epicenter reached a tentative peak. The 12-month change in the yields of Chinese 3 and 10-year government bonds also inched up since then (Chart 4). While the Chinese government’s rollout of supportive measures, including liquidity injections and policy rate cuts since early February might have helped improve market sentiment, the fact the epidemic outside Hubei province seems to be contained also helps explain the bottom in equity prices and bond yields. In addition, the number of new suspected cases outside Hubei province has trended down since February 9 (Chart 5). The diagnosis methodology was recently revised to include suspects with clinical symptoms, regardless of whether they had a history of contact with infected cases from Wuhan. This new methodology has lowered the bar for registering newly suspected cases. While the situation surrounding the Covid-19 outbreak is still fluid, the fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained. Bottom Line: Outside of the epicenter, the Covid-19 outbreak may have peaked. This means the fear element driving down Chinese government bond yields may soon end. Chart 5The Situation Continues To Get Better Outside Of The Epicenter Don’t Chase China’s Bond Yields Lower Don’t Chase China’s Bond Yields Lower Current Bond Rally Unlikely A Cyclical Play Bond yields now appear to have largely priced in a delayed economic recovery and more aggressive policy response. We think the current rally in Chinese government bonds will thus only be a short-term event rather than a cyclical (6-12 month) play. The rally in China’s government bond market since mid-2018 was largely driven by market expectations of a significant slowdown in the Chinese economy, and a much easier monetary policy in responding to a slowing Chinese domestic demand and a protracted Sino-US trade war. Bond market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. Cyclically, we think both of these factors are absent from the current situation, and a normalization back to the pre-outbreak monetary stance may come earlier than the market expects. In the last two weeks, Chinese government bond markets have discounted a sharp slowdown in economic activity; 10-year Chinese government bond yields are back below 3.0% for the first time since 2016 and the 3-month SHIBOR is now 25bps lower than the bottom in 2015-2016 (Chart 6). This suggests the market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. The nature of the current situation, as we pointed out in our previous reports,3 represents a temporary delay rather than a derailing of an economic recovery in China.  The Covid-19 outbreak and the unprecedented containment measures paused the Chinese economy in the first quarter, just as it was coming off of a two-year soft patch. But domestic demand was not nearly as weak as in 2015-2016 before the outbreak (Chart 7). Chart 6Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Chart 7A Chinese Economic Recovery Was Budding Pre-Outbreak A Chinese Economic Recovery Was Budding Pre-Outbreak A Chinese Economic Recovery Was Budding Pre-Outbreak Chart 8The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing If the virus is contained outside of the epicenter in the next couple of weeks and the hit to China’s overall economy is limited to Q1, then the PBoC will likely normalize policy back to its pre-outbreak stance. While the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, it was proactive in normalizing its monetary policy following short-term shocks. Chart 8 shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015.  In all three economic slowdowns, there has not been a significant rise in interbank rates in the first nine months of an economic recovery. Following the SARS outbreak, however, the PBoC reversed its easy stance and significantly tightened liquidity conditions in the banking system only four months after the peak of the SARS outbreak. While we do not expect the PBoC to shift into a tightening mode this year, a shift back to the pre-outbreak policy trajectory sometime in Q2 is highly likely, provided the Covid-19 outbreak is contained outside of Hubei province.  In turn, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. PBoC is also unlikely to open a liquidity floodgate. Despite large liquidity injections in the past two weeks, we are not convinced that the PBoC intends to fully open the liquidity tap in the interbank market.  So far, most of the financial support measures have been a combination of targeted low-cost funding to non-financial corporations and fiscal subsidies to local governments and businesses. This differs from 2015-2016 when the PBoC aggressively cut interbank rates and the 1-year benchmark lending rate, and kept excessive liquidity in the interbank system for a prolonged period (Chart 9). As Chart 9 (bottom panel) shows, PBoC’s net fund injections have been extremely volatile since Covid-19 erupted in January. This suggests that while the PBoC has added large doses of liquidity into the interbank market, demand for financial support in the banking system has mostly matched or even outstripped supply. In other words, the PBoC is not flooding the interbank system with cash, rather it is preventing an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  The PBoC is trying to prevent an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  Chart 9Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Chart 10Private Sector Highly Leveraged... Private Sector Highly Leveraged... Private Sector Highly Leveraged... This approach is warranted. Small businesses have been disproportionally hit by the outbreak and are reporting a severe shortage of cash. China’s private sector is particularly vulnerable to cash flow restrictions because many businesses are highly leveraged (Chart 10).  A joint survey of 995 small and mid-size companies by Tsinghua and Peking universities showed that more than 60% of respondents said they can survive for only one to two months with their current savings (Chart 11).   Chart 11…Making Small Businesses Especially Vulnerable To Cash-Flow Constraints Don’t Chase China’s Bond Yields Lower Don’t Chase China’s Bond Yields Lower Additionally, there is a risk that the PBoC is underestimating the demand for cash in the banking system, particularly from small- and medium-sized banks. This underestimation could lead to a rise in the interbank lending rate. This occurred in 2017 when the crackdown of shadow bank lending caused a funding squeeze for China’s small and mid-sized banks, which led to a material rise in interbank lending rates and government bond yields (shown in Chart 6). It is also the reason that we primarily track the 3-month SHIBOR over the 7-day rate, as the former tends to capture the effects of these funding squeezes whereas the latter does not. The demand for cash in the interbank market in the current quarter will be higher than in the same period last year. The government has announced an additional debt quota of 848 billion yuan, on top of the previously authorized quota of 1 trillion yuan worth of local government bonds that would be frontloaded in Q1. This is a 32% increase from a total of 1400 billion yuan of bonds that local government frontloaded in Q1 2019. This implies the demand for cash in the interbank market will remain high as commercial banks account for about 80% of local government bond purchases.4 A temporary spike in corporate bond defaults leading to a jump in the interbank rate could also push up government bond yields. Additionally, the delayed resumption of work, the loss of production and the cash crunch facing small companies raise the risk of a surge in overdue bank loans and defaults. This could also escalate the demand for cash from smaller banks, because large commercial banks may be unwilling to lend to riskier borrowers in the interbank market. The 3-month SHIBOR has inched up since the takeover of Baoshang Bank in May 2019. Chart 12Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields We expect the PBoC to lower the loan prime rate (LPR), following the 10bps cut in the medium lending facility rate (MLF) on February 17. As we pointed out in our January 29 Special Report, this easing by the PBoC will reduce corporate lending rates, but not necessarily interbank rates. Chart 12 shows that the change in average lending rates lags the change in Chinese government bond yields. Therefore, the upcoming cuts in the LPR are a result of lowered interbank rates and bond yields, not a cause for changes in government bond yields going forward. Bottom Line: Monetary policy will remain relatively loose this year, but we think the PBoC’s recent aggressive easing will be a temporary event. Any additional easing by the PBoC this year will likely be through providing short-term cash relief and temporarily lowered funding costs to non-financial corporations. There are also near-term risks that interbank rates may be pushed up due to a liquidity crunch.  Hence, yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Investment Conclusions While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. Barring a lasting economic slowdown from the Covid-19 outbreak, the long-end of the curve has the potential to move moderately higher in the second half of the year, as China’s economy recovers from the outbreak-induced shock. Bond yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Given this, we continue to expect Chinese domestic and investable equities to outperform government bonds in the next 6-12 months, and we would advise Chinese fixed-income investors against an aggressively long duration stance. Onshore corporate bonds, while risking a higher default rate in the near term, shares a similar outlook on a cyclical basis: onshore spreads are pricing in (massively) higher default losses than we believe are warranted. This means that onshore corporate bonds will still outperform duration-matched government bonds without any changes in yield, underpinning another year of Chinese corporate bond market outperformance versus government bonds.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Special Report "How To Analyze And Position Towards Chinese Government Bonds," dated January 29, 2020, available at cis.bcaresearch.com 2   Please see China Investment Strategy Weekly Report "The Evolving Crisis," dated February 13, 2020, available at cis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Recovery, Temporarily Interrupted," dated February 5, 2020, available at cis.bcaresearch.com 4   ChinaBond, as of 2019 Cyclical Investment Stance Equity Sector Recommendations

Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked   Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them.  At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates   Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering   Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Peru: Slow Money Growth Heralds Lower Inflation Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Peruvian Local Rates Have Risen Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Peruvian Local Rates Have Risen Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure.  Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Peru: Rising NPLs Will Depress Banks Share Prices Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Peru: The Economy Is Weak Peru: The Economy Is Weak   Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Peru: Higher Rates Will Hinder Credit Growth Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Peruvian Equities Have Been Underperforming Peruvian Equities Have Been Underperforming   Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates Peruvian Bank Stocks Stagnated Despite Falling Interest Rates Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Some Green Shoots Emerging In The Euro Area Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding EM Asia Is Rebounding EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation.  This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies Growing Housing Imbalances In Some Economies Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions   In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Households Are Saving More Than One Would Expect Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Securitized Auto Loans Have Performed Well Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? A Peak In Profit Margins: An Ominous Sign? A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation.  Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Unit Labor Costs Are Well Behaved For Now (I) Unit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II) Unit Labor Costs Are Well Behaved For Now (II) Unit Labor Costs Are Well Behaved For Now (II)       Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact Correlation Between Labor Market Slack And Wage Growth Remains Intact Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021.  Chart 16Inflation Is A Lagging Indicator Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment?   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1   Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2  Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020.   Global Investment Strategy View Matrix Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? MacroQuant Model And Current Subjective Scores Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? Strategic Recommendations Closed Trades