Policy

Highlights Policy Responses To The Virus: Markets are now pricing in significant monetary policy easing in response to the growth shock from the COVID-19 outbreak and related financial market instability. It is not yet clear, however, that central banks will NOT ease by as much as currently discounted in the low level of bond yields – especially as risk assets will riot anew if policymakers are not dovish enough. Duration: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the virus. Spread Product: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates. Feature What a wild ride it has been for investors. Equity markets worldwide corrected sharply last week as investors were forced to downgrade global growth expectations with the COVID-19 outbreak spreading more rapidly outside of China. US equities were particularly savaged with the S&P 500 shedding -11% of its value in a mere five trading sessions, with the VIX index of implied equity volatility spiking over 40, evoking comparisons to some of the darkest days of the 2008 financial crisis. Chart of the WeekCOVID-19 Concerns Causing Market Jitters COVID-19 Concerns Causing Market Jitters COVID-19 Concerns Causing Market Jitters Government bond yields have collapsed alongside plunging equity values, with the benchmark 10-year US Treasury yield hitting an all-time intraday low of 1.04% yesterday. Investors are betting on aggressive rate cuts by global central bankers to offset weak growth momentum and disinflationary pressures that were already in place before the arrival of COVID-19. At the same time, corporate credit spreads widened worldwide last week, but the moves were relatively subdued and do not signal growing concern over future default losses (Chart of the Week). In this report, we discuss how to best position a global bond portfolio given these competing messages from government bond and credit markets. We conclude that maintaining selective strategic (6-12 months) overweights in global spread product versus governments, while also maintaining a neutral tactical (0-3 months) overall duration exposure - as a hedge against a more “U-shaped” recovery from the virus-driven downturn in global growth - is the best way to position for a backdrop where policymakers will need to be as easy as possible in a more uncertain world. What To Do Next On … Duration Risk assets were staging a massive rebound yesterday as we went to press, after policymakers worldwide signaled the need for stimulus measures to offset the COVID-19 growth shock. Both Fed Chairman Jerome Powell and Bank of Japan (BoJ) Governor Haruhiko Kuroda promised to ease monetary policy, if necessary, to stabilize markets. Meanwhile, looser fiscal policy may finally be on the way in Europe. The government of virus-stricken Italy announced a €3.6 billion stimulus package, while the German Finance Minister has hinted at a temporary suspension of Germany’s constitutional “debt brake” on deficit spending. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus (Chart 2). It’s a different story for government bonds, however, as a rebound in yields from current depressed levels is not assured, even if monetary policy is eased further. This is because central bankers must maintain a dovish bias until the virus-driven uncertainty over global growth begins to fade, or else risk assets will riot once again. It’s all about financial conditions now, especially in the US where COVID-19 and the stock market selloff have become front-page news in a presidential election year. Chart 2How Quickly Will China Rebound? How Quickly Will China Rebound? How Quickly Will China Rebound? For example, the entire US Treasury curve now trades below the mid-point of the fed funds target range, with the market now pricing in a very rapid dovish move by the Fed (Chart 3). Chart 3A Big Grab For Global Duration A Big Grab For Global Duration A Big Grab For Global Duration Yield curves are now very flat in other major developed market (DM) economies, as well. This is partly due to the risk aversion bid for safe assets, which is evident in the deeply negative term premium component of bond yields. Flat curves also reflect a more long-lasting component, with markets pricing in lower equilibrium rates in the future. Investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 4Markets Increasingly Pricing In Global ZIRP Markets Increasingly Pricing In Global ZIRP Markets Increasingly Pricing In Global ZIRP Our simple proxy for the market expectation of the nominal terminal rate- the 5-year overnight index swap (OIS) rate, 5-years forward – is between 0-1% for all major DM countries (Chart 4). The implication is that investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 5Our Central Bank Monitors Say More Easing Is Needed Our Central Bank Monitors Say More Easing Is Needed Our Central Bank Monitors Say More Easing Is Needed Chart 6Global Yields Reflect Dovish Rate Expectations Global Yields Reflect Dovish Rate Expectations Global Yields Reflect Dovish Rate Expectations At the moment, our global Central Bank Monitors – a compilation of economic and financial variables that influence monetary policy decisions – are all signaling a need for rate cuts (Chart 5). This is a function of sluggish growth & weak inflation. The plunge in global government bond yields already reflects that dovish shift in market expectations for central banks. Our 12-month discounters, which measure the expected change in short-term interest rates over the next year as extracted from OIS curves, are all priced for lower policy rates in the US (-97bps as of last Friday’s close), the euro area (-15bps) the UK (-35bps), Japan (-17bps), Canada (-72bps) and Australia (-46bps) (Chart 6). In the US, the current level of the benchmark 10-year Treasury yield is consistent with the extended slump in US industrial activity – as measured by the fall in the ISM manufacturing index – and risk-off sentiment measures like the CRB Raw Industrials/Gold price ratio (Chart 7). Yet at the same time, financial conditions remain very accommodative despite last week’s selloff, suggesting that the US economy can potentially weather a bout of COVID-19 uncertainty – as long as the Fed does not disappoint by delivering fewer rate cuts than the market is demanding and creating another down leg in the equity market. Chart 7UST Yields Need To Stay Lower For Longer UST Yields Need To Stay Lower For Longer UST Yields Need To Stay Lower For Longer Outside the US, other central banks that have non-zero policy rates – like the Bank of Canada, Reserve Bank of Australia and Bank of England – can deliver on the rate cuts discounted in their OIS curves to fight a COVID-19 global growth downturn, if needed. Chart 8UST Bullishness Still Not At Historical Extremes UST Bullishness Still Not At Historical Extremes UST Bullishness Still Not At Historical Extremes The negative rate club of the ECB and BoJ, however, is far less likely to actually cut rates and will rely on greater asset purchases and forward guidance to try and provide more policy stimulus. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. So what should a bond investor do with duration exposure? It is a difficult call with so many uncertainties on global growth momentum, the spread of the virus outside China, the size of any monetary or fiscal policy stimulus measures, and the degree of risk aversion still evident in financial markets. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. Therefore, we are raising our recommended overall duration exposure to neutral this week on a tactical basis. At the same time, we are maintaining an underweight stance on government bonds versus an overweight on corporate debt. We think a true bottom in yields will be reached when there are more decisive signs that bond positioning has reached a bullish extreme, according to indicators like the JP Morgan duration survey and the Market Vane US Treasury bullish sentiment index (Chart 8). In our model bond portfolio, we are expressing that extension of duration by shifting exposure from shorter maturity buckets to longer duration buckets in most countries. While also increasing exposure to “higher-beta” government bond markets like the US and Canada, at the expense of lower-beta Japanese government bonds. Bottom Line: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the COVID-19 outbreak. Increase allocations to countries with higher yield betas, like the US and Canada, at the expense of low-beta markets like Japan. What To Do Next On … Spread Product Allocations Chart 9US HY Selloff Was Focused On Energy Names US HY Selloff Was Focused On Energy Names US HY Selloff Was Focused On Energy Names Last week’s equity market meltdown did spill over into corporate bond markets, with credit spreads widening for both investment grade and high-yield corporate debt in the US and Europe. In the US, however, the jump in high-yield spreads was particularly acute among Energy names, with the index option-adjusted spread (OAS) climbing over 1000bps as oil prices plunged (Chart 9). US high-yield ex-energy has been relatively more stable, with the spread climbing to 436bps, despite the surge in equity volatility. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield.  According to our framework for calculating spread targets for global credit, last week’s selloff pushed US investment grade spreads back to our spread targets from very expensive levels (Chart 10).1 Baa-rated US investment-grade moved slightly above our spread target, but we would describe investment grade spreads as now overall fairly valued. US high-yield spreads, on the other hand, have widened well in excess of our spread targets across all credit rating tiers (Chart 11). Chart 10US Investment Grade Spreads Now Fairly Valued US Investment Grade Spreads Now Fairly Valued US Investment Grade Spreads Now Fairly Valued Chart 11US High-Yield Spreads Look Very Cheap US High-Yield Spreads Look Very Cheap US High-Yield Spreads Look Very Cheap In our framework, the spread targets are determined by looking at 12-month breakeven spreads – the amount of spread widening necessary to eliminate the yield cushion of owning corporates over government bonds on a one-year horizon – relative to their long-run history. We group those spreads according to phases of the monetary policy cycle, as defined by the slope of the US Treasury yield curve. The spread target is then calculated based on the median breakeven spread for that phase of the cycle. Currently, we are in “Phase 2” of the policy cycle, which means that the Treasury yield curve (10-year minus 3-year) is positively sloped between 0 and 50bps. In Charts 10 & 11, we add a new wrinkle to our existing way to present the spread targets. We also calculate the targets using the 25th and 75th percentile observations for the breakeven spreads for that phase of the monetary policy cycle. This gives us a range for the spread target that encompasses more of the historical data. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. The spread widening in US high-yield has very clearly restored value to spreads, which are well above the upper level of our spread target range. The same cannot be said for US investment grade, where spreads are in the middle of the target range. Chart 12European Corporates Now Offer Better Value European Corporates Now Offer Better Value European Corporates Now Offer Better Value Based on this analysis, we remain comfortable in maintaining our neutral recommended stance on US investment grade corporates and overweight stance on US high-yield. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. Thus, this week, we are adding to our recommended high-yield exposure (see Page 12). That increased allocation is “funded” by reducing our US Agency MBS exposure from overweight to neutral. Our colleagues at BCA Research US Bond Strategy are concerned that MBS spreads are likely to widen in the next few months to reflect the higher prepayment risk from the recent steep fall in US mortgage rates. One final note: our spread target framework for euro area corporates also indicates that last week’s global risk-off event also restored some value to European credit (Chart 12). Thus, we are maintaining our recommended overweights for both euro area investment grade and high-yield. Bottom Line: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We presented our framework for calculating global corporate spread targets, which builds on the work from our US Bond Strategy sister service, back in January. Please see BCA Research Global Fixed Income Strategy Special Report, "How To Find Value In Global Corporate Bonds", dated January 21, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Bond Investors Should Do After The "Great Correction" What Bond Investors Should Do After The "Great Correction" ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Supply constraints and unstoppable demand growth – the result of stricter regulations requiring higher loadings in autocatalysts to treat toxic pollution in automobile-engine emissions – will continue to push palladium’s price higher, despite a near-vertical move higher that began in 2H19. South Africa’s power grid is in a state of near-collapse, which will add volatility to mining operations focused on platinum-group metals – chiefly palladium, platinum and rhodium. South Africa accounts for 36% of global palladium production and 73% of platinum production, which makes it difficult to make the case that platinum could be substituted for palladium as its price rises. Palladium stocks are at risk of being further depleted globally as demand from automobile manufacturers in China, the US and Europe remains robust. This will keep palladium forward curves backwardated for the foreseeable future. While pressure to find alternatives for palladium will grow as prices rise, in absolute terms the additional cost resulting from higher prices for the metal – ~ $400 per vehicle – is not yet enough to draw significant investment to this effort. Feature Palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Table 1Top 5 Best Performing Commodities Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In 2019, for the third year in a row, palladium prices outperformed other major commodities, returning an impressive 54% over the year (Table 1). This is the result of a massive 13% increase in demand for the metal – powered by strong autocatalyst demand for gasoline-powered cars in China and Europe, even as collapsing auto production globally and elevated trade uncertainty continue to dog automobile sales (Chart 1). This apparent contradiction is explained by stricter vehicle emissions regulations in major consuming markets – chiefly the Euro 6d, China 6 and US Tier 3 regimes – and power shortages in South Africa, which are introducing considerable volatility on the supply side in the second-largest producing country for the metal. Chart of the WeekSurging Autocatalyst Palladium Demand Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues  Again this year, palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Palladium prices soared 39% YTD, its fastest 40-day increase since 2010. Unlike other commodity markets, palladium is completely disregarding the COVID-19 outbreak that originated in China late last year. Favorable supply-side fundamentals continue to drive the palladium rally: The metal’s decade-long physical supply deficit intensified in 2019 and we expect it to widen this year (Chart 2, panel 1). On the demand side, Chinese consumption is at risk. China is the world’s largest auto manufacturing market. Hubei Province – COVID-19’s epicenter – is a large car manufacturing hub, accounting for ~ 10% of the country’s annual automobile output. In the wake of COVID-19, the country’s car production is expected to fall 10% in 1Q20. In addition, the virus had infected more than 80,000 people globally, and has spread rapidly outside Hubei into Asia, Europe, the Middle East, Africa, and North America, raising the odds of a pandemic. Interestingly, speculative positioning and ETF investment demand is subdued, and is not inflating prices (Chart 2, panel 2). Chart 2Palladium Deficit To Widen This Year Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Palladium Demand Soars As Auto Production Collapses Strong global automobile catalyst demand drove the rally in palladium prices last year. This occurred as car production fell by 9%, 8%, and 15% in US, China, and India – an unusual divergence in fundamentals. The culprit: Technical changes to autocatalysts from stricter emissions regulations. In China, the latest phase of car emissions regulations – China 6 – was gradually introduced in high-population centers, which also suffer from high levels of pollution. These centers accounted for ~ 60% of annual Chinese car sales in 2019. China 6 represents a major shift in emissions regulations and will make the Chinese auto fleet compliant with Europe’s best practices. As a result, palladium loadings in conforming light-duty gasoline vehicles reportedly increased by ~20% in 2019. This pushed China’s autocatalyst consumption up by 570k oz despite the drop in annual car sales, which created the rare dislocation between the country’s car production and palladium prices (Chart 3). We expect this trend to continue this year: China 6 is on track to be enforced countrywide – i.e., the remaining 40% of car sales – by mid-year, providing an additional ~ 10% boost in loadings of the metal. Chart 3Stricter Regulations Support Prices Amid Falling Car Production Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In Europe, the introduction of Euro 6c legislation in September 2018 and the extension to all new vehicles of Euro 6d-TEMP regulations in September 2019 – mainly the real driving emissions (RDE) testing procedure adopted in the wake of the Volkswagen “dieselgate” scandal in 2015 – pushed palladium loading in autocatalysts up by ~ 25% from 2017 to 2019.1 The regulations became stricter in January 2020, putting additional stress on manufacturers to comply with the new standards, which will continue to support higher palladium loadings. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. Lastly, in the US – which remains an important market for autocatalyst palladium demand (Chart 4) – the ongoing implementation of the Tier 3 legislation will continue to gradually increase palladium content in autocatalysts until 2025. For 2020, we do not expect this to significantly boost loadings per vehicle and are factoring in 2% growth. These legislative changes in major automotive markets produced a structural break in our palladium demand model (Chart 5). After adjusting our estimates for greater palladium content in gasoline aftertreatment systems, our model suggests that demand provides strong support to palladium prices, but also suggests other factors – i.e. supply and inventory – are at play. Chart 4North America's Auto Sector Remains A Large Share Of Palladium Demand Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 5Higher Palladium Loadings Largely Explains Last Year's Price Surge Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. In China, we expect the government will overstimulate its economy to meet its long-term goal of doubling its GDP and per capita income by 2020.2 Automobile ownership and vehicle sales there are low vs. DM economies, suggesting more upside for sales in China (Chart 6). In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. Car sales move in cycles around long-term demographic trends: The longer the current economic expansion, the further above-trend car sales can rise (Chart 7). Chart 6China: Structural Outlook For Autos Is Bright China Car Consumption Will Rebound In 2H20... Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 7... Likewise For Europe And US Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Bottom Line: The combination of stricter environmental regulations in key gasoline-powered automobile markets and the post-coronavirus rebound in global auto consumption will push the palladium market further in deficit this year as it faces an inelastic supply, critically low inventories and low substitutability over the short-term (more on this below). Palladium Supply In 2020: Weak growth And Low Price-Elasticity Palladium supply is highly constrained. The largest supplies are concentrated in Russia (42%), South Africa (36%) and North America (14%). From 2015 to 2019, supply and capex grew by a very subdued 7% and 15.2% respectively, completely disregarding the 200% rise in prices (Chart 8, panel 1). This illustrates palladium supply’s extremely low price-elasticity.3 Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Primary supplies declined by close to 2% last year on falling shipments from Russia and record electricity load-shedding – i.e. blackouts – in South Africa (Chart 8, panel 2).4 As tight as palladium markets are fundamentally, South Africa’s crippled power grid – long in need of upgrading and repair – has been, and remains, a key driver of short-term platinum-group metals (PGM) prices.5 Following the breakdown of close to 25% of the country’s generating capacity, Eskom – the nation’s utility monopoly responsible for ~ 90% of its electricity generation – has been forced to implement rolling blackouts to balance power supply and demand and prevent permanent damage to the country’s power grid. Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Consequently, Stage 6 load-shedding events likely will become more frequent. These efforts are complicated by massive debt – ~ $30 billion – which has required government bailouts and forced the company to take loans from a Chinese industrial bank. Chart 8Top Palladium Producers' Capex Price-Elasticity Is Low Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues This is playing havoc with PGM supplies. During the unmatched Stage 6 load-shedding in December 2019 – cutting power to 37% of grid users – PGM supplies were reduced by 50%. Stockpiles covered the loss, but persistent blackouts lasting years could push markets into an actual shortage of palladium as inventories would rapidly be depleted. This is a significant risk: Eskom itself warned rolling blackouts will persist for the next 18 months.6 Elevated local currency PGM prices are postponing announced shafts closures, as miners seek to profit from the favorable pricing environment (Chart 9). But insufficient electricity capacity will weigh on mine supply growth over the next few years as companies hold-back on much-needed long-term investments. The final units of Eskom’s Medupi and Kusile projects are expected to be completed over the next two years – adding 4800MW to its installed capacity. This can partially alleviate South Africa’s electricity difficulties, but these units are not enough to support a rebound in economic and mine production growth. South Africa is in profound need of large-scale investments in its power sector. Close to 5000MW of power capacity is scheduled to shut down over the next five years (Chart 10). Chart 9Favorable Domestic Metal Prices For South African Miners Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 10South Africa Needs Additional Power Generation Capacity Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. The current political and economic climate is not constructive for meeting this challenge. The World Bank recently slashed South Africa’s 2020 GDP growth forecast to 0.9% from 1.5% previously on the back of electricity and infrastructure constraints impeding domestic growth and weak external demand. Likewise, rating agency Moody's signaled – ahead of its review of South Africa’s Baa3 credit rating in March – it could downgrade the country to speculative grade, citing the detrimental impact of recurring power outages on manufacturing and mining output. After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. This will provide much-needed help to the country’s power sector. According to the Minerals Council South Africa, mining companies could bring an additional ~ 1500MW capacity online in the next 9 to 36 months. But doubts remain with regard to the timeline for companies to obtain the necessary licenses and if these can easily be acquired. Johnson Matthey expects supply growth in Russia – the largest producer – will be capped this year as Nornickel’s processing of old mines' copper concentrate – which boosted the company’s palladium supply over the past few years – is finalized. Still, a paltry 1% gain is possible from expected efficiency gains at existing mines, according to Nornickel. The company also announced it will increase production at its Talnakh and South Cluster mines, but this additional supply will only reach markets gradually as processing capacity constraints won’t be resolved until 2023, according to Johnson Matthey. Bottom Line: Growth prospects in the top two palladium-producing countries are weak in 2020. This will not suffice to meet the soaring autocatalyst demand. Higher recycling and inventory releases – both incentivized by higher prices – will be needed to balance the market. Palladium Stockpiles Are Dangerously Low We expect palladium prices will move higher on the expanding deficit, and backwardation in the forward curve will persist to incentivize the release of inventories to market (Chart 11). Yet, global palladium stockpiles have been declining since 2014 and are now at critically low levels, raising the risk of a disrupting shortage of the metal:7 ETF and exchange inventories now stand at a paltry 600k oz (Chart 12). These are the most price-elastic stocks and will get close to zero as prices increase. Chart 10Expect Backwardation To Persist Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 12Price-Sensitive Stockpiles Are Dangerously Low Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. The Russian Ministry of Finance’s reserves – a state secret – are now almost exhausted, according to Russia’s Norilsk Nickel, the largest supplier of physical palladium in the world. Last year, Norilsk Nickel held an estimated 1mm oz of the metal in its Global Palladium Fund, and signaled it is increasingly using its reserves to balance markets and provide needed liquidity. Earlier this year, the company released 3 MT of palladium to the market from stocks. Complete exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. Don’t Count On Substitution, Yet Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers. We expect platinum prices to rise in 2020 supported by improving fundamentals, growing safe-haven demand, and markets pricing in increasing anticipation of substitution from palladium to platinum. Unlike palladium, platinum is also affected by safe-haven demand and gets bid up with gold and silver prices in periods of high uncertainty (Chart 13). With gold prices now above $1,600/oz, platinum will benefit from safe-haven flows due to its relative price advantage (Chart 14). Chart 13Safe-Haven Flows Support Platinum Prices Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 14Platinum Is Cheap Relative To Gold Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues We believe substitution will commence over the coming years, but this is a gradual process. Substitution from expensive palladium to low-priced platinum in industrial applications is the largest risk to our positive view on the palladium-to-platinum (Pd-to-Pt) ratio (Chart 15). This started in smaller and more price-elastic segments (e.g. dental, jewelry and diesel autocatalyst). However, to have a real impact on overall demand and thus the price ratio, substitution needs to take place in gasoline autocatalyst technology. The discount has been at a level consistent with substitution for more than a year, but the urgency to upgrade current designs to meet new environmental legislation and RDE regulations in China, Europe, and the US is the main focus of automakers this year. Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers scrambling to meet the latest anti-pollution regulations globally. Moreover, large-scale substitution will take place only if automakers’ cost-benefit analysis points to significant long-term profits from switching. That said, platinum’s supply security remains a risk in the long-term: South Africa accounts for 73% of global production and our analysis suggests output growth there likely will remain weak over the next few years, especially as Eskom rebuilds its failing power grid. This lack of diversity increases sourcing risks for automakers, who, not without reason, would not want to switch over to platinum only to find that supply is also in doubt down the road. The overall platinum market is 26% smaller than that of palladium. Assuming a one-for-one substitution of Pd to Pt in gasoline catalyzers, a 1.2mm oz reduction in Pd demand – the amount required to reduce palladium’s deficit to zero – would send platinum markets to a 1.4mm oz deficit.8 Without substantial production growth, platinum prices would spike, reducing the profitability of investing in these new catalysts. Thus, substitution will eventually impact the price ratio, but will not be large enough to overturn absolute price level trends. In addition, the amount of PGMs in the typical autocatalyst – ~ 5 grams – adds $400 to the cost of the average automobile (Chart 15, lower panel). We do not believe this cost drives automakers' decisions, which is another reason the substitution of Pt for Pd likely will remain a topic of discussion more than action. Chart 15Palladium's Price Surge Adds ~0 Per Gasoline Car Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Bottom Line: We believe substitution will commence over the coming years, but this is a gradual process and it will not happen on a meaningful scale this year. Thus, we expect the continuation of relative demand and inventory trends will provide a favorable setting for the Pd-to-Pt ratio this year (Chart 16). Chart 16Pd-to-Pt Price Ratio Will Increase Again in 2020 Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent and WTI crude oil lost 5% and 4% this week, as fears of a global pandemic in the wake of the COVID-19 outbreak gripped markets. Reports of outbreaks in Asia ex-China, the Middle East and Europe fueled these concerns. Against this backdrop, OPEC 2.0 will be meeting in Vienna March 5 and 6 to consider cuts of 600k b/d recommended by its technical committee earlier this month. We continue to expect the full coalition to approve these cuts at the upcoming meetings. Saudi Arabia, Kuwait and the United Arab Emirates reportedly are considering an additional 300k b/d of cuts to offset the global demand hit delivered by COVID-19. The IEA estimates the COVID-19 outbreak will reduce Chinese refining throughput by 1.1mm b/d, and will reduce the call on OPEC crude by 1.7mm b/d in 1Q20. Base Metals: Neutral Iron ore prices weakened, following global equities lower, as the COVID-19 outbreak spread around the world. However, traders continue to report lower stocks of iron ore, which should keep prices supported, according to MB Fastmarkets (Chart 17). We remain long December 2020 high-grade iron ore (65% Fe) vs. short the benchmark 62% Fe contract on the Singapore Commodity Exchange, which we initiated November 7, 2019. This recommendation was up 5.3% as of Tuesday’s close, when we mark to market. Precious Metals: Neutral After retreating slightly from its run toward $1,700/oz earlier this week, gold remains well supported by safe-haven demand (Chart 18).  In addition, actual and expected policy stimulus – e.g., Hong Kong's “helicopter money” drop of USD 1,200 to all permanent residents over the age of 18 – and expectations of additional central bank easing globally to offset the global spread of COVID0-19 will keep gold and precious metals generally supported.  Markets should start pricing in higher inflation expectations as additional stimulus starts to roll in.  Ags/Softs:  Underweight Global grain markets could be set to rally sharply, as unusually wet weather in the Middle East and East Africa spawned by higher-than-usual cyclone activity produces perfect breeding conditions for desert locusts in the region over the next two months.  According to National Geographic, by June the locusts could increase their populations “400-fold compared with today, triggering widespread devastation to crops and pastures in a region that’s already extremely vulnerable to famine.”  This could put more than 13mm people in East Africa at risk of “severe acute food insecurity,” and imperil millions more.  Chart 17China's Iron Ore Stocks Tight Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 18Safe Havens Gold, USD Well Bid Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues   Footnotes 1     Please see New legislation planned in response to dieselgate, published by Autocar June 9, 2016. See also  Johnson Matthey’s February 2020 Pgm Market Report. 2     Our view of strong Chinese fiscal and monetary stimulus was discussed in detail in our February 13, 2020 weekly report titled Iron Ore, Steel Poised For Rally. 3    Historically produced as an inferior byproduct from nickel, gold, and platinum mines, the price incentive from palladium alone isn’t enough to generate the needed investments in new mine production. According to Nornickel, this is slowly changing, palladium is an increasingly large part of mining companies’ revenues, making the metal a valuable co-product. This could improve mines investments’ responsiveness to movement in palladium prices over the medium term. 4    According to Eskom, “Load shedding is aimed at removing load from the power system when there is an imbalance between the electricity available and the demand for electricity. If we did not shed load, then the whole national power system would switch off and no one would have electricity.” The company’s load-shedding program includes 8 stages, where each stage represents the removal of 1000MW of demand – e.g., stage 5 removes 5000MW. This is done by shutting down specific sections of the grid.  5    The PGMs are ruthenium, rhodium, palladium, osmium, iridium, and platinum. 6    Things got worse after the December load-shedding event.  Less than a month later, Reuters noted more than two times the power shed in December went “offline because of plant breakdowns. 7    This can be seen in the close to 12mm oz. decline in UK and Switzerland – home of the largest secured vaults of Palladium and Platinum – net imports. 8    Technological improvement in palladium catalysts has made the metal more efficient in for gasoline-powered engines vs. platinum. It has superior properties in terms of thermal durability and NOx reduction. Thus, the conversion could be greater than 1-to-1 and would imply a smaller share of palladium autocatalyst substitution could be absorbed by existing platinum supplies.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues

Highlights In the past week, it is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery. Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016. As manufacturers in regions other than Hubei are returning to work and their production capacity continues to rise, the outbreak-induced economic shock may be smaller than investors currently fear. Hence, the odds are rising that the upcoming “insurance stimulus” may end up overshooting the short-term economic shock. As such, we maintain a constructive view on Chinese stocks over the next 6-12 months. Feature A surge in the number of COVID-19 infections outside of China (including South Korea, Japan, Iran, and Italy) risks delaying a global economic recovery, and has cast doubt on the outlook for the global economy beyond Q1 (Chart 1). Chart 1Pandemic Threats Expanding Globally Pandemic Threats Expanding Globally Pandemic Threats Expanding Globally Despite the sharp uptick in global investor concern, our constructive view on Chinese stocks remains unchanged for the next 6-12 months. Our view on Chinese risk assets is based on a simple arithmetic framework that we described last year when the trade war tensions between the US and China were escalating. In short, when gauging the net impact of an economic shock, investors should determine which of the following two scenarios is most likely: Scenario 1 (Bearish): Stimulus – Shock ≤ 0 Scenario 2 (Bullish): Stimulus – Shock > 0 While this framework is quite simplistic, the point is to underscore that economic shocks are almost always met with a policy response, and the goal is to determine whether this response is sufficient enough to offset the impact of the shock. If the Chinese leadership underestimates the severity of the shock and undershoots on the stimulus, this would be bearish for Chinese stocks (Scenario 1). In the current situation, however, even if the near-term economic outlook is deeply negative, investors should maintain a bullish cyclical (i.e. 6-12 month) outlook for China-related assets as long as the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand (Scenario 2). Major Stimulus Around The Corner? It is becoming evident that the Chinese policymakers, when dealing with an unprecedented public health crisis, are returning to aggressive fiscal and monetary easing. In fact, the odds are rising that the magnitude of the upcoming stimulus may resemble that of 2015/2016, and has an increasing possibility to overshoot in the next 6-12 months. In the past week, there has been a clear shift of policy focus from “financial de-risking” to “mitigating the economic damage from shocks at all costs”, as indicated by high-profile policy announcements. In an unprecedented large-scale teleconference on February 23,1 President Xi stated that China will not lower its economic growth target for this year, and that fiscal policy will be “more proactive” while monetary policy was upgraded from “prudent” to “flexible and moderate". Chart 2PBoC Looks Set For Massive Stimulus PBoC Looks Set For Massive Stimulus PBoC Looks Set For Massive Stimulus Xi also pledged to “introduce new policy measures in a timely manner”. China’s central bank, the PBoC, issued a statement signaling further cuts ahead in the bank reserve requirement ratio rate and interest rate.2 The PBoC has already aggressively eased monetary conditions in the past two weeks, and both the central bank policy and average lending rates are now lower than they were during the last massive easing cycle in 2015/2016 (Chart 2).  Other policy initiatives also suggest the Chinese authorities are stepping up coordinated efforts to boost the economy, beyond short-term and targeted financial support. The stimulative measures now span from infrastructure to housing and automobile sectors, the exact “three prongs” that supported a V-shaped economic recovery in 2016.3 This is in sharp contrast with last year, when Chinese policymakers largely resisted resorting to large-scale stimulus, despite immense pressure from the US-China trade war and tariff impositions.4 The ongoing COVID-19 epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. The ongoing epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. As we predicted in November last year,5 China was to frontload additional fiscal stimulus in Q1 this year to secure an economic recovery, which started to bud in Q4 last year. The increase in January’s credit numbers confirms our projection: local government bond issuance picked up significantly from last year while the contraction in shadow bank lending continued to ease, signaling a less restrictive policy bias on both the monetary and fiscal fronts (Chart 3).  Chart 3Stronger Fiscal Support Likely To Soon Follow Stronger Fiscal Support Likely To Soon Follow Stronger Fiscal Support Likely To Soon Follow The exact economic and monetary expansion growth targets will be officially set at the National People’s Congress meeting, which has been postponed from its usual schedule on March 5. Compared with the 6.1% real GDP growth achieved in 2019, we now think a growth target of 5.6% would be conservative for this year. According to an estimate by BCA’s Global Investment Strategy,6 China’s real GDP growth in Q1 could slow to 3.5% on a year-over-year basis. To achieve 5.6% growth, China would need at least 6.3% average real growth (year-over-year) for the next three quarters, 0.3 percentage points higher than in the second half of 2019. The growth in credit expansion, infrastructure spending and government expenditures will need to significantly outpace last year in the next 6-12 months. Bottom Line: The government appears to be willing to abandon its financial de-risking agenda to secure economic recovery. There is an increasing possibility that the stimulus may overshoot the economic shock this year. China’s Economic Engine Warms Up There are increasing signs that the scale of the upcoming stimulus may match that of the 2015/2016 cycle. The likely magnitude of the shock, on the other hand, might be smaller than investors fear as the evidence is mounting that production is returning to normality in China. Despite a lack of employees and raw materials, industrial activity in regions outside of Hubei is resuming. Chart 4…Small Companies Are Not Far Behind China: Back To Its Old Economic Playbook? China: Back To Its Old Economic Playbook? A survey of China’s 500 top manufacturers by China Enterprise Confederation7 indicated that most of the 342 respondents had resumed production as of February 20. They also reported that more than half of their employees had returned to work and the average capacity utilization rate had reached nearly 60% (Table 1). Furthermore, the China Association of Small and Medium Enterprises8 survey of 6,422 small businesses showed that as of February 14, more than half of the companies have resumed operations (Chart 4). By February 21, the daily coal consumption in China’s six largest power plants has reached 62% of the consumption from the same period last year (adjusted for Lunar Year calendar), 14 percentage points higher than February 10 - the first day officially scheduled for people to return to work.9 Table 1Large Manufacturers Have Reached More Than Half Of Their Production Capacity… China: Back To Its Old Economic Playbook? China: Back To Its Old Economic Playbook? The resurgence in the number of new infections has not slowed those regions down from reopening businesses, particularly along the manufacturing belt in China’s coastal regions (Chart 5). China’s leadership has repeatedly urged local governments to relax aggressive containment measures to allow production to resume. Unless the number of new cases in China picks up again, we expect business operations in regions outside of Hubei to continue re-opening in the coming weeks. Chart 580% Of China’s Coastal Regions Are Back To Work China: Back To Its Old Economic Playbook? China: Back To Its Old Economic Playbook? Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. Bottom Line: The aggressive containment measures seem to be effective inside China. Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. We expect the rate to improve. This will mitigate the impact of the virus outbreak on the Chinese economy.  “Scenario 2” Implies An Upturn In The Corporate Earnings Cycle The impact of the COVID-19 outbreak on China’s economy may be smaller than investors currently fear. The country is also in a better economic condition than in 2015/2016. If the Chinese leadership believes an “insurance stimulus” is warranted and allows credit growth in 2020 to reach near 28% of GDP, as in 2015-2016, then the stimulus will more than offset the outbreak-induced economic shock from Q1 and lead to a meaningful rise in this year’s corporate earnings (Chart 6): China’s households and corporates are actually more willing to spend now than in 2015-2016. We agree that China’s households and companies are both highly leveraged, and re-leveraging may further diminish their debt-servicing ability and willingness to invest or spend. Debt as a share of Chinese household disposable income has climbed by 33 percentage points compared with five years ago (Chart 7). The increase in debt load makes Chinese households particularly vulnerable to income reductions. But this supports our view that policymakers will make every reflationary effort to avoid massive layoffs. Additionally, the willingness to spend among Chinese households is not less than during the down cycle in 2015-2016 (Chart 7 bottom panel). Chart 6A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks Chart 7Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 The debt-to-GDP ratio and debt-servicing cost-to-income ratio in China’s non-financial private sector have trended sideways in the past five years (Chart 8). The corporate cash flow situation is only slightly worse than in 2015 (Chart 9). The virus outbreak and drastic containment measures will temporarily weaken the corporates’ cash positions, but this negative situation can be partially offset by tax, fee and interest relief measures.10 Chart 8Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chart 9...And Their Cash Flow Situation Is Only Slightly Worse ...And Their Cash Flow Situation Is Only Slightly Worse ...And Their Cash Flow Situation Is Only Slightly Worse   Furthermore, China’s non-financial corporates’ marginal propensity to spend is actually higher than in 2015-2016 (Chart 10). This may be due to the more accommodative monetary backdrop than in 2015-2016. If Chinese authorities are to significantly step up their reflationary efforts, the easy monetary policy stance may be here to stay throughout 2020. Prior to the COVID-19 outbreak, the mild deflation in China’s PPI growth was already turning slightly positive on the heels of an improving economy. The historical relationship between China’s producer prices and industrial profits suggests that profit growth for both China’s onshore and offshore markets is highly linked to fluctuations in producer prices (Chart 11). An ultra-easy monetary policy, a weak RMB, and a more forceful boost to domestic demand will provide strong reflationary support to producer prices and industrial profits. Chart 10Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chart 11A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits   Bottom Line: Despite a short-term economic shock, China’s economy is at a better starting point than in 2015-2016. If monetary and fiscal easing in 2020 reaches the same magnitude as five years ago, then the economy and corporate profits will likely begin to respond to the stimulus. Investment Conclusions The clear sign of policy shift to shoring up the economy suggests that, our Scenario 2 is the most likely outcome. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016. The short-term outbreak-induced economic shock, on the other hand, looks to be smaller than the market anticipates. Manufacturers in China continue to resume production in regions outside of Hubei, a trend we believe will go on unless there is a significant threat that the virus will break out again in these Chinese regions. This supports our constructive view on China-related assets over a 6-12 month time horizon. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016, and will likely overshoot the short-term economic shock. There is a risk to our constructive view, though, that the more forceful policy response from the Chinese leadership may imply a greater than anticipated short-term economic shock from the outbreak. This would challenge our bullish stance on Chinese stocks in the next three months. Substantially weaker economic data in Q1 would likely trigger a selloff in Chinese risk assets, both onshore and offshore. However, a severe short-term economic shock, followed by a burst of stimulus, would create strong investment opportunities. If the scale of Chinese policymakers’ reflationary measures ramps up significantly in the coming months, they will likely overshoot the short-term economic shock. Another reflationary cycle would certainly have a positive impact on global investors’ sentiment and Chinese financial assets. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://english.www.gov.cn/news/topnews/202002/23/content_WS5e5286cdc6d0… 2   http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3975864/index.html 3   Please see China Investment Strategy Weekly Report "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 4   Please see China Investment Strategy Weekly Reports "Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10, 2019, "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, "Don’t Bottom-Fish Chinese Assets (Yet)," dated August 14, 2019 and "Mild Deflation Means Timid Easing," dated October 9, 2019. available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 6   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at cis.bcaresearch.com 7   http://www.cec-ceda.org.cn/view_sy.php?id=42633 8   http://www.ce.cn/xwzx/gnsz/gdxw/202002/18/t20200218_34298844.shtml 9   http://www.21jingji.com/2020/2-21/wOMDEzNzhfMTUzNjAwOA.html 10  China has announced targeted measures to defer or lower taxes and administrative fees. It will also provide interest rate subsidies to affected businesses. Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The coronavirus is still weighing on yields and could push them down further in the near-term. However, the history of past viral outbreaks suggests that yields will move sharply higher once the daily number of new cases falls to zero. Fed: We would speculate that, this year, the Fed is very likely to change its framework so that it can seek a temporary overshoot of its 2% inflation target. This may involve moving to an “average inflation targeting” regime implemented via operational inflation ranges. Labor Market: It is very likely that employment growth peaked for the cycle in 2015, but falling employment growth is only consistent with the end of the economic recovery when it breaks below monthly labor force growth, causing the unemployment rate to rise. Feature Chart 1Fresh Lows! Fresh Lows Fresh Lows The ultimate economic fallout from the coronavirus remains uncertain, but bond investors are starting to fear the worst. As we go to press, the 10-year and 30-year Treasury yields have both made new cyclical troughs at 1.36% and 1.83%, respectively (Chart 1). The 3-month / 10-year Treasury slope is once again inverted and the 2/10 slope is down to 11 bps, from 34 bps at the start of the year (Chart 1, bottom panel). This behavior tells us that the market is pricing-in a significant economic slowdown stemming from the coronavirus, one that will force the Fed to ease policy this year. Indeed, the overnight index swap curve is priced for more than 50 bps of rate cuts during the next 12 months, and fed funds futures are discounting 58% chance of a 25 basis point rate cut in either March or April. In direct opposition to the market’s moves, the past week saw several FOMC members push back against the idea of a rate cut. Atlanta Fed President Raphael Bostic said in an interview:1 There are many different scenarios about what’s going to happen between now and say June or July. My baseline expectations are that the economy is not going to see rising risks and it’s going to stay stable, so we won’t have to do anything. St. Louis Fed President James Bullard was even more forceful, saying:2 There’s a high probability that the coronavirus will blow over as other viruses have, be a temporary shock and everything will come back. But there’s a low probability that this could get much worse. Markets have to price that in, and that drags down the center of gravity a little bit. But if this all goes away, I expect that pricing will come back out of the market and we’ll be back to the on-hold scenario. Finally, Fed Vice Chair Richard Clarida challenged the notion that expectations for a 2020 rate cut are widespread. Similar to Bullard, he claimed that market prices reflect hedging against potential downside risks. He went on to cite survey measures that show investors looking for a flat funds rate in their base case scenarios.3 There’s a wide gap between survey and market rate expectations. Clarida’s point about the discrepancy between market and survey rate expectations is well taken. Chart 2 shows that the median forecast from the New York Fed’s Survey of Market Participants calls for an unchanged fed funds rate through 2022. However, it’s important to note that this survey was taken prior to the January FOMC meeting, when the coronavirus was only just starting to hit the news. Chart 2A Wide Gap Between Market And Survey Expectations A Wide Gap Between Market And Survey Expectations A Wide Gap Between Market And Survey Expectations Do They Protest Too Much? We can sympathize with the FOMC’s desire to push back against market expectations that it feels are off target, but we also think the strategy could prove self-defeating. If the market starts to believe that the Fed will not ease policy quickly enough, the yield curve will flatten even more and risk assets (equities and credit spreads) will sell off. Both of those developments would increase the pressure on the Fed to ease policy. Chart 3The History Of Viral Outbreaks The History Of Viral Outbreaks The History Of Viral Outbreaks In fact, if the present market turmoil continues, the Fed is very likely to deliver a rate cut sometime this year in an effort to support confidence and limit the potential economic damage from the coronavirus. Unfortunately, at this point we have no idea whether the coronavirus will spread further during the next couple of months, or whether it will be contained. In the former scenario, financial conditions will continue to tighten and the Fed will ease policy. In the latter scenario, financial conditions will not tighten aggressively and the Fed will stay on hold. In either case, given the uncertainty of the situation, we recommend stepping aside on our prior recommendation to short the August 2020 fed funds futures contract. No matter how long it takes to contain the coronavirus, we would expect growth to rebound quickly once the situation is resolved. This has been the pattern of past viral outbreaks: a steady decline in bond yields that sharply reverses course when the daily number of new cases reaches zero (Chart 3). Even accounting for its sharp drop during the past few days, the 10-year Treasury yield is still tracking the pattern of past viral outbreaks, and a jump in yields seems likely once the virus is contained. For this reason, we are inclined to maintain below-benchmark duration on a 12-month horizon. The US Election Is The Biggest Risk To Our Cyclical View The main risk to our 6-12 month below-benchmark portfolio duration stance is the possibility that as soon as the market is done worrying about the coronavirus it jumps right to worrying about the outcome of the US election. This could keep Treasury yields low throughout all of 2020. We argued last week that Treasury yields could come under downward pressure if Bernie Sanders looks set to win the election, while a victory for Donald Trump or one of the other Democratic candidates would be neutral for yields.4 As it stands now, Sanders has taken a more decisive lead in the Democratic leadership race after winning in Nevada. But President Trump’s approval rating has also been tacking higher. We will continue to monitor this risk closely in the coming weeks, and may alter our cyclical duration view depending on how polls evolve in March. The Fed may be forced to cut rates this year if financial conditions continue to tighten. Bottom Line: The coronavirus is still weighing on yields and could push them down further in the near-term. However, the history of past viral outbreaks suggests that yields will move sharply higher once the daily number of new cases falls to zero. Likewise, credit spreads have near-term upside until the virus is contained, but will tighten anew once the threat has passed. As discussed last week, the fundamental credit cycle backdrop remains supportive.5 The Fed may be forced to cut rates this year if financial conditions continue to tighten. Dual Mandate Update As discussed above, Fed participants generally view the current level of interest rates as appropriate and have been reluctant to hint at any upcoming policy changes. It’s not that difficult to see why. If we recall that the Fed’s dual mandate – as set by Congress – is to pursue maximum employment and price stability, then it’s pretty clear that current policy is delivering on both fronts. Chart 4 shows that the sum of the unemployment rate and 12-month consumer price inflation – the so-called Misery Index – is about as low as it has been since the 1960s. Further, the outlook for 2020 is that employment growth will remain firm and inflation tepid. Chart 4The Fed Has The Economy In A Good Spot The Fed Has The Economy In A Good Spot The Fed Has The Economy In A Good Spot Labor Market Chart 5Employment Growth Greater Than Labor Force Growth Employment Growth Greater Than Labor Force Growth Employment Growth Greater Than Labor Force Growth It is very likely that employment growth peaked for the cycle back in 2015, but falling employment growth is only consistent with the end of the economic recovery when it breaks below monthly labor force growth, causing the unemployment rate to rise. During the past 12 months, monthly employment gains have averaged +171k compared to a +122k average increase in the labor force (Chart 5). In other words, employment growth is slowly trending down but it remains at a comfortable level. Beyond decelerating employment, rising labor force participation is the other important trend in the US labor market. While it’s tempting to think that stronger labor force growth might only raise the bar for what employment growth is necessary to keep the recovery on track, this is not the case. In practice, gross labor flow data show that, since 2017, 73% of people that entered the labor force transitioned directly to being employed. Only 27% of those entering the labor force transitioned to unemployed status. Simply, rising labor force growth tends to push employment growth higher as well. It does not make it more likely that the unemployment rate will rise. Rising labor force participation has not gone unnoticed. The minutes from January’s FOMC meeting revealed that: Many participants pointed to the strong performance of labor force participation despite the downward pressures associated with an aging population, and several raised the possibility that there was some room for labor force participation to rise further. The prime age participation rate is already back to pre-crisis levels and the female 24-54 part rate is making new highs (Chart 6). Nonetheless, US prime age participation remains low compared to other developed countries – like its closest neighbor Canada – making further gains possible. Chart 6Do Part Rates Have More ##br##Upside? Do Part Rates Have More Upside Do Part Rates Have More Upside Chart 7Don't Be Alarmed By The Drop In Job Openings Don't Be Alarmed By The Drop In Job Openings Don't Be Alarmed By The Drop In Job Openings Finally, many have pointed to the recent drop in Job Openings as a reason to be concerned about the state of the US labor market (Chart 7). We view these concerns as unfounded. First, the drop in openings does not appear to be related to flagging labor demand. The Job Hires rate is steady and involuntary layoffs are low. Against a backdrop of steady demand, fewer openings could simply mean that there is a little more slack in the labor market than was previously thought. Inflation On inflation, we see little chance of a meaningful surge this year. The Prices Paid and Supplier Delivery components of the ISM Manufacturing index, two indicators that tend to lead changes in core inflation, are downtrodden (Chart 8). Meanwhile, base effects could cause 12-month core CPI to jump in the next month or two, but are more likely to drag it down on a 6-month horizon (Chart 8, bottom panel). Chart 8Inflation Will Remain Tame In 2020 Inflation Will Remain Tame In 2020 Inflation Will Remain Tame In 2020 At the component level, shelter is the largest component of core CPI but it is unlikely to accelerate in the coming months. The National Multifamily Housing Council’s Survey of Apartment Market Conditions just ticked below 50 (Chart 9). Shelter inflation is more likely to rise when the index is firmly above 50 in “tightening” territory. Further, the recent jump in core goods inflation is set to wane in the coming months. Core goods inflation tracks non-oil import prices with a lag of about 18 months, and import prices have been on a declining trend (Chart 9, bottom panel). Chart 9Shelter And Core Goods Inflation Shelter And Core Goods Inflation Shelter And Core Goods Inflation Bottom Line: The Fed is performing well on its dual mandate. Employment growth is firm, inflationary pressures are tepid and continued accommodative monetary policy might be able to pull more people into the labor force. Absent any desire to preemptively ease to counteract the effects of the coronavirus, the Fed’s on hold policy stance is appropriate. Tracking The Fed’s Balance Sheet We strongly disagree with the suggestion that the increase in the size of the Fed’s balance sheet meaningfully impacted Treasury yields or risky assets this year.6 But the Fed’s balance sheet policy remains a point of interest nonetheless, and last week we received more information about what the Fed intends to do with its balance sheet this year. Specifically, the Fed has decided that $1.5 trillion will serve as a firm floor for bank reserves. That is, the Fed will not allow the supply of reserves to fall below that level, and will typically maintain a significant buffer above $1.5 trillion. To accomplish this, the Fed would prefer to transition away from daily repo transactions. It would rather rely on its Treasury and T-bill purchases to keep reserves at desired levels. $1.5 trillion will be the firm floor on bank reserves.   With that in mind, the Fed now plans to scale daily repo operations back to zero by the end of April. The Fed’s $60 billion per month T-bill purchases will continue through the second quarter. After that, the pace of asset purchases will be lowered, with the goal of simply keeping reserve supply stable. It has not yet been decided whether Treasury purchases after June will be concentrated in T-bills or spread out across the maturity spectrum. Chart 10 and Table 1 show our updated projections for what the Fed’s balance sheet will look like at the end of June. Our projections show a reserve level of $1.7 trillion at the end of June, significantly above the $1.5 trillion floor. This provides a healthy buffer in case a spike in the Treasury’s General Account leads to a temporary drop in reserve supply. Chart 10The Fed's Balance Sheet Securities And Reserves The Fed's Balance Sheet Securities And Reserves The Fed's Balance Sheet Securities And Reserves Table 1Fed's Balance Sheet Projections Fighting The Fed Fighting The Fed The Biggest Changes The Fed Could Make This Year (And More Details About The Ongoing Strategic Review) Chart 11Monitoring Financial Conditions Monitoring Financial Conditions Monitoring Financial Conditions The minutes from the January FOMC meeting, released last week, revealed a few important details about the Fed’s ongoing strategic review. The strategic review is a process that the Fed expects to complete by mid-year, where it will consider potential changes to its monetary policy strategy, tools and communication practices. At the last FOMC meeting, the committee took up the issues of how to incorporate financial stability into the Fed’s monetary policy strategy and of whether it should consider targeting an inflation range instead of a specific point. Financial Stability The traditional consensus in central banking was that interest rates should not be used to manage financial stability risks. Rather, monetary policy should remain focused on the dual mandate of full employment and inflation. In January’s discussion, FOMC participants generally agreed that macroprudential and regulatory policies remain the preferred methods for dealing with financial stability risks. But participants also recognized that this might not suffice: Many participants remarked that the Committee should not rule out the possibility of adjusting the stance of monetary policy to mitigate financial stability risks, particularly when those risks have important implications for the economic outlook and when macroprudential tools had been or were likely to be ineffective at mitigating those risks. At January’s FOMC meeting, the Fed staff also presented the idea of a “financial stability escape clause” that would “provide leeway for the central bank to deviate from its usual monetary policy strategy if financial vulnerabilities become significant.” For our part, we have consistently argued that, if inflation expectations remain stubbornly low, the Fed may eventually lift rates this cycle in response to signs of excess in financial markets.7 So far, we don’t see asset valuations as stretched enough to prompt Fed tightening (Chart 11), but the longer that interest rates stay low, the more likely it is that financial market valuations will reach bubbly levels. Inflation Ranges The FOMC discussed two types of inflation ranges at the January FOMC meeting. They discussed ranges that are symmetrical around the Fed’s 2% target, and “operational ranges” that could be moved around depending on the Fed’s policy goals. In theory, the advantage of a symmetric inflation range around the Fed’s 2% target is that it could help communicate the inherent uncertainty in measuring inflation, and the difficulty in forecasting it with precision. However, participants worried that introducing a symmetric inflation range at a time when inflation has been running below the Fed’s 2% target would signal that the Fed is comfortable with below-target inflation. In contrast, the idea of an operational range has some appeal, especially if the Fed decides to shift from a pure forward-looking 2% inflation target to a target that seeks to achieve average 2% inflation over time. How would this work? In an environment where inflation had been running below 2% for several years, the Fed would set its operational range to be 2%-2.5% for a time (Chart 12). Once it judged that enough of an overshoot of 2% had taken place to make up for past downside misses, it would shift back to a symmetric operational range of say 1.75%-2.25%. Or perhaps, if it judged that inflation needed to undershoot 2% for a time, it would set its operational range as 1.5%-2%. Crucially, the operational range would be moved around at the discretion of the Committee with the goal of achieving 2% inflation on average over time. Chart 12The Fed Could Adopt An Operational Target Inflation Range of 2-2.5 This Year The Fed Could Adopt An Operational Target Inflation Range of 2-2.5 This Year The Fed Could Adopt An Operational Target Inflation Range of 2-2.5 This Year The Most That Could Be Announced This Year Based on the info we’ve received so far from the FOMC minutes and the speeches of several Fed Governors, two in particular from Governor Lael Brainard.8 We now have a decent sense of the most dramatic changes that could be announced this year. In all likelihood, the announced changes will be somewhat less dramatic than those listed below, as consensus amongst committee members on all the details will be difficult to achieve. The Fed will change from a forward-looking 2% inflation target to one that seeks to achieve average inflation of 2% over time. It will implement its new inflation targeting framework by using operational inflation ranges that will be moved around at the discretion of the Committee. The Fed will allow for the possibility of changing interest rates in response to financial stability risks, if it is thought that those risks threaten the dual mandate of full employment and 2% inflation. It will announce a new tool for implementing monetary policy at the zero-lower bound where it puts a hard cap on bond yields out to some specific maturity. The cap won’t be lifted until some specified economic goals are met. We would speculate that, this year, the Fed is very likely to change its framework so that it can seek a temporary overshoot of its 2% inflation target. This may involve moving to an “average inflation targeting” regime implemented via operational inflation ranges, or it could be a more watered down version of the same idea. Similarly, we would also expect that any announced changes to the Fed’s policy strategy will include more explicit language related to financial stability risks. As for the idea of adopting bond yield caps at the zero-lower bound, a policy that is similar to the Bank of Japan’s current Yield Curve Control policy. This may not be announced this year, especially since the Fed probably believes that it has more time to mull over this sort of proposal.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see “CNBC Exclusive: CNBC Transcript: Atlanta Fed President Raphael Bostic Speaks with CNBC’s Steve Liesman on CNBC’s “Squawk Box” Today,” CNBC, dated February 21, 2020. 2 Please see “CNBC Exclusive: CNBC Excerpts: St. Louis Fed President James Bullard Speaks with CNBC’s “Squawk Box” Today,” CNBC, dated February 21, 2020. 3 Please see “CNBC Exclusive: CNBC Transcript: Federal Reserve Vice Chair Richard Clarida Speaks with CNBC’s Steve Liesman,” CNBC, dated February 20, 2020. 4 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over,” dated February 18, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over,” dated February 18, 2020, available at usbs.bcaresearch.com 6 Our rationale is explained in US Bond Strategy Special Report, “The Fed In 2020,” dated December 17, 2019, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Fed In 2020,” dated December 17, 2019, available at usbs.bcaresearch.com 8 Governor Lael Brainard, “Federal Reserve Review of Monetary Policy Strategy, Tools, and Communications: Some Preliminary Views,” dated November 26, 2019, and “Monetary Policy Strategies and Tools When Inflation and Interest Rates Are Low,” dated February 21, 2020,  Board of Governors of the Federal Reserve System, Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The breakout in the DXY indicates the investment universe could become precarious. The euro could fall to 1.04 on such an outcome. The yen and Swiss franc should outperform in this environment, barring recent weakness in the Japanese currency. This will catalyze the Swiss National Bank to start weaponizing its currency. EUR/CHF could first undershoot 1.06 but will then become very attractive. We were stopped out of long AUD/CAD for a loss of 3%. Weighing In On Recent Market Developments The rally in the dollar has been broad-based, with the DXY index threatening to break above 100. What is peculiar about this rally is that it is not driven by relative fundamentals, but rather by sentiment. For example, interest rate differentials across much of the developed world have risen versus the dollar, in stark contrast  with the drop in their exchange rates (Chart I-1). The risk is that as a momentum currency, the surge in the dollar triggers a negative feedback loop that tightens financial conditions in emerging markets, curtailing a key source of global demand (Chart I-2). Chart I-1Dollar Up, Rate Differentials Down Dollar Up, Rate Differentials Down Dollar Up, Rate Differentials Down Chart I-2A Strong Dollar Could Lead To Debt Deflation A Strong Dollar Will Lead To Debt Deflation A Strong Dollar Will Lead To Debt Deflation The most recent TIC data from the US Treasury confirmed that inflows into domestic bonds have surged, especially driven by private concerns. These inflows have been huge enough to alter the structural downtrend of outflows (Chart I-3). Given that hedged yields are currently unattractive for non-US investors, these flows are also a bet on an appreciating dollar. This fits anecdotal evidence that today’s sharp drop in the yen was driven by private investors, stampeding out of the local market, into the safety of US Treasurys and other assets. Chart I-3Positive Momentum Into US Treasurys Positive Momentum Into US Treasurys Positive Momentum Into US Treasurys We have elaborated in numerous reports why the risks to the dollar are to the downside, including expensive valuation and lopsided positioning. However, these obstacles fall to the wayside in a risk-off environment. As such, for risk management purposes, we are closing our short DXY position today for a loss of 2.5%. Bottom Line: The breakout in the dollar is at risk of becoming self-reinforcing in the near term. Stand aside on the DXY for now. Thought Experiment On A Few Scenarios Different market participants have taken different views on the durability and potential impact of the COVID-19 outbreak. Equity market indices in general are looking through a potential blip in the Q1 data on the assumption that the Q2 recovery will be V-shaped and powerful. The peak in momentum of new cases outside of Hubei province as well as a less-alarming death rate compared with the SARS episode certainly supports this view (Chart I-4). Chart I-4ACases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now Chart I-4BCases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now The disconnect has been in the dismal performance of procyclical currencies. SEK/JPY, a key barometer of greed versus fear in financial markets, is near capitulation lows, despite secular highs for the stock-to-bond ratio (Chart I-5). Meanwhile, the EUR/USD has once again begun to inflect lower, continuing a trend in place since the beginning of 2018. Chart I-5Pro-Cyclical Crosses Are Pricing A Malignant Outcome Pro-Cyclical Crosses Are Pricing A Malignant Outcome Pro-Cyclical Crosses Are Pricing A Malignant Outcome This suggests one of three outcomes: Equity markets are correct to price in a benign scenario, with an eventual synchronized growth recovery led by the US (Chart I-6A). This is dollar bullish. Currency markets are right to be pricing in a catastrophic fallout in growth, with anything linked to China/global growth getting slaughtered. This is also dollar bullish. The bond markets are spot on in pricing in a goldilocks scenario, where rates stay low and non-US markets lead an eventual recovery (Chart I-6B). This is dollar bearish. Chart I-6AEquity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Chart I-6BEquity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Bottom Line: Two of three scenarios lead to a higher US dollar. For most developed market participants, the adjustment towards a higher dollar would have to occur through a lower euro, given its weight in the DXY index. How Low Could The EUR/USD Fall? The possibility of either a synchronized recovery led by the US or a catastrophic fallout to growth is certainly valid for the euro area. Chart I-7 plots relative GDP growth between the two regions. The conclusion is very evident: The collapse in the euro since the financial crisis has been driven by falling growth differentials between the Eurozone and the US. Based on higher-frequency indicators, this remains the case as of January – the ZEW survey showed that the expectations component for euro area activity slowed markedly, while that of the US improved. In the absence of a synchronized pickup in global growth, a weaker exchange rate helps.  One way to arrest the rising growth divergence between the euro area and the US is to lower the cost of capital in the entire Eurozone, such that it makes sense even for the less-productive peripheral countries to borrow and invest. This will boost productivity, lifting the neutral rate. This has certainly been the case. Bond yields in peripheral Europe are collapsing relative to those in Germany. And, as expected, investment spending in the periphery is also picking up, which should close the productivity gap with the core countries (Chart I-8). Unfortunately, for the small, open countries that characterize the euro area, external demand is also needed to transform those productivity gains into profits Chart I-7Weak Growth Will Pressure ##br##The Euro Weak Growth Will Pressure The Euro Weak Growth Will Pressure The Euro Chart I-8Investment Spending Was Strong Going Into The Crisis Investment Spending Was Strong Going Into The Crisis Investment Spending Was Strong Going Into The Crisis In the absence of a synchronized pickup in global growth, a weaker exchange rate helps. Our intermediate-term timing model, which has been back-tested as a tool for profitably hedging portfolios, suggests the euro is cheap, but not excessively so. Medium-term bottoms have usually occurred when the euro is around 5% cheaper than current levels, or around 1.03-1.04 (Chart I-9). Since the peak in global trade in 2011, one of the few ways for countries to expand their trade pie has been via a “beggar thy neighbor” policy. This is even more important for the euro area, if the Phase One trade deal between the US and China results in less purchases of European machinery, cars, and aircraft. Coupled with a hiccup in Chinese growth in Q1, the euro will have to be the mechanism of adjustment. The European Central Bank has one powerful tool to ensure this occurs: quantitative easing. By crowding out locals from the domestic fixed-income market, investors will have to flock to either equities or foreign securities. This will weigh on the euro. This is especially the case since quantitative easing from the ECB is open-ended, while that from the Federal Reserve (not-QE) is not. Eventually, investors might begin to front-run the relative expansion in the ECB’s balance sheet. Since the peak in global trade in 2011, one of the few ways for countries to expand their trade pie has been via a “beggar thy neighbor” policy.  Chart I-10 shows that a rising basic balance in the euro area has been a key mechanism in preventing a further drop in the euro. This will change in the case of a catastrophic fallout to growth. Chart I-9The Euro Is Cheap, But Not A ##br##Screaming Buy The Euro Is Cheap, But Not A Screaming Buy The Euro Is Cheap, But Not A Screaming Buy Chart I-10A Positive Basic Balance Has Prevented A Much Lower Adjustment A Positive Basic Balance Has Prevented A Much Lower Adjustment A Positive Basic Balance Has Prevented A Much Lower Adjustment Eventually, all trends reverse, and there will be a pickup in growth, led by more growth-sensitive economies. Given both the internal and exchange rate adjustments in the euro area, the common-currency zone will be primed to benefit. The euro tends to be largely driven by pro-cyclical flows, and European equities, especially those in the periphery, are already trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Watch earnings revisions for euro zone equities versus the US. They tend to firmly lead the euro by about 9-to-12 months (Chart I-11). Chart I-11Watch Earnings Revisions For The Next EUR/USD Move Watch Earnings Revisions For The Next EUR/USD Move Watch Earnings Revisions For The Next EUR/USD Move Bottom Line: There is near-term downside to the EUR/USD towards 1.03. The SNB And The Franc The franc has been in a bull market against pretty much every European currency since the onset of the global growth slowdown, with the latest developments only supercharging that trend. The worst-case scenario for Switzerland is a global growth fallout, since the valuation starting point for the franc is expensive, not only vis-à-vis the euro (Chart I-12), but even more so against the Swedish krona and  Norwegian krone. So, the key question for the franc is the pain threshold for the SNB to step up intervention. Chart I-12The Franc Is Getting Incrementally Expensive The Franc Is Getting Incrementally Expensive The Franc Is Getting Incrementally Expensive The first mandate of the Swiss National Bank is price stability, consistent with inflation at 2%. On this front, it has clearly underdelivered. The central bank expects inflation to gradually pick up to 1.2% by 2023, but the backdrop for prices in Switzerland has been sub-1% for much of the post-crisis period (Chart I-13). Meanwhile, as a small, open economy, tradeable goods prices are important for domestic inflation, and import prices are deflating by over 1.9% year-on-year, in part driven by a strong currency (Chart I-14). If left unchecked, this could begin to un-anchor inflation expectations, leading to a negative feedback loop that the SNB will likely find very difficult to lean against. Chart I-13SNB Forecasts May Not Be Realized Soon SNB Forecasts May Not Be Realized Soon SNB Forecasts May Not Be Realized Soon Chart I-14The Risk From A Strong Franc Is Deflation The Risk From A Strong Franc Is Deflation The Risk From A Strong Franc Is Deflation Domestically, the Swiss economy was holding up well, but it is now an open question as to how much longer it can continue to defy the pull of a slowing external sector. As a highly export-driven country, the manufacturing sector usually dictates trends in the overall Swiss economy (Chart I-15). Sentiment indicators such as the ZEW expectations component were perking up ahead of the onset of COVID-19. It is now a sure bet that these will relapse in the coming months. More importantly, the impact on Switzerland might be bigger relative to its trading competitors, given the expensive franc. It is now an open question as to how much longer Switzerland can continue to defy the pull of a slowing external sector.  A key barometer for the SNB will be exports. Export volumes are already deflating (Chart I-16), yet the trade balance is still benefiting from the large share of precious metals exports, which are currently experiencing a terms-of-trade boost. This will not last forever, given the falling market share of precious metals in the Swiss trade balance Chart I-15How Long Can Employment Defy Gravity How Long Can Employment Defy Gravity? How Long Can Employment Defy Gravity? Chart I-16A Lower Franc Will Support Export Volumes A Lower Franc Will Support Export Volumes A Lower Franc Will Support Export Volumes There is a new twist for “operation weak franc.” The US Treasury department has put Switzerland on the currency-manipulator watch list. In general, the SNB is reticent on the issue of currency intervention, stating only that it intervenes to counteract negative effects on inflation and exports from an overly expensive franc. But it is encouraging that sight deposits at local banks started to accelerate at USD/CHF 0.96 (Chart I-17) and the SNB is also likely to act if EUR/CHF meaningfully breaks below 1.06. Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland and a rising debt-to-GDP ratio that pins it among the highest in the G10. The good news is that a lot of the imbalances resulting from excess liquidity in recent years are being addressed. The housing market is a case in point. Growth in rental housing units, which usually constitute the bulk of investment homes, is deflating, which contrasts favorably with growth in owner-occupied homes (Chart I-18). Macro prudential measures such as a cap on second homes as well as stricter lending standards have helped. Meanwhile, a slowdown in the working-age population in Switzerland has neutered a meaningful source of demand. Chart I-17The SNB Is Stepping Up Intervention The SNB Is Stepping Up Intervention The SNB Is Stepping Up Intervention Chart I-18A Healthy Housing Adjustment A Healthy Housing Adjustment A Healthy Housing Adjustment     Bottom Line: We are lowering our limit-buy on EUR/CHF to 1.05 to account for a potential undershoot. Housekeeping We were stopped out of our long AUD/CAD trade for a loss of 3.0%. As highlighted above, currency markets are beginning to price in a malignant scenario for global growth, where anything non-US gets decimated. In such an environment, the best policy is to stand aside.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mostly positive: Retail Sales excluding autos grew by 0.3% month-on-month compared to 0.2% in January. Industrial production contracted further by 0.3% month-on-month in January. The Michigan consumer sentiment index increased to 100.9 from 99.8 in February. The core producer price index grew by 1.7% in January, from 1.1% in December. Housing starts decreased to 1.57 million from 1.63 million, while building permits increased to 1.55 million from 1.42 million in December. The DXY index appreciated by 0.8% this week. As a momentum currency, the rise could become self-reinforcing. Stand aside on DXY. Report Links: Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: The trade balance increased to EUR 22.2 billion, on a seasonally adjusted basis, from EUR 19.1 billion in December. GDP grew by 0.9% year-on-year in Q4 2019, slowing from 1.2% the previous quarter. ZEW economic sentiment declined to 10.4 from 25.6 in February. The current account surplus decreased to EUR 32.6 billion from 35.2 billion in December. Construction output contracted by 3.7% year-on-year in December, from growth of 1.4% the previous month. The euro depreciated by 0.5% against the US dollar this week. The disappointing ZEW numbers for the Eurozone and Germany and concerns about persistently low growth were a major headwind for the euro this week. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: GDP contracted by 1.6% quarter-on-quarter in Q4 2019, compared to growth of 0.4% the previous quarter. Industrial production contracted by 3.1% year-on-year in December. Capacity utilization decreased to -0.4% in December. The merchandise trade balance fell to a deficit of JPY 224.1 billion in January. Machinery orders contracted by 3.5% year-on-year in December. Imports contracted by 3.6% and exports contracted by 2.6% year-on-year in January. The Japanese yen depreciated by 1.9% against the US dollar this week. Domestic data was very disappointing, with GDP contracting more than expected. Meanwhile technical factors such as portfolio flows were also responsible. That said, short USD/JPY remains cheap insurance. Report Links: Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: The Rightmove house price index grew by 2.9% year-on-year in February. The ILO unemployment rate remained flat at 3.8% in December. The growth in average earnings including bonuses slowed to 2.9% from 3.8% in December. The CPI grew by 1.8% while the retail price index grew by 2.7% year-on-year in January. Retail sales grew by 0.8% year-on-year in January. The British pound depreciated by 1.3% against the US dollar this week. The key worry for incoming BoE governor Andrew Bailey is a stagflationary environment, with increases in inflation driven by weak business investment and productivity growth. Stand aside on GBP for now. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: The six month annualized growth rate in the Westpac leading index fell to -0.46% from -0.28% in January. The wage price index grew by 2.2% year-on-year in Q4, staying flat from the previous quarter. The unemployment rate increased to 5.3% from 5.1% in January. The Australian Dollar depreciated by 1.4% against the US dollar this week. Much of the decline was driven by the perceived dovish tone of the minutes from the Reserve Bank of Australia (RBA) February meeting. The RBA’s primary concerns were slow consumption growth and the effects of the bushfires on growth in the near-term.  However, the housing market, led by Sydney and Melbourne, is picking up quickly. We remain positive AUD/USD but will stand aside if it breaches 60 cents. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Visitor arrivals declined by 0.2% year-on-year in December. The ANZ monthly inflation gauge remained flat at 3.2% year-on-year in January, The REINZ house price index grew by 0.3% month-on-month in January. The Global Dairy Trade price index declined 2.9% in February. The New Zealand dollar depreciated by 1.6% against the US dollar this week. Dairy trade was hampered by weak demand from China and Prime Minister Jacinda Ardern warned of a negative impact on GDP growth in the first half of 2020 from Covid-19.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mixed: Manufacturing sales contracted by 0.7% month-on-month in December. Headline CPI grew by 2.4%, while the BoC core measure grew 1.8% year-on-year in January. The Canadian dollar appreciated by 0.1% against the US dollar this week. The rally was driven by the surge in oil prices over the past two weeks coinciding with a decline in the number of new Covid-19 cases. While acknowledging the negative demand shock from China, our Commodity and Energy strategists currently believe that Chinese policy stimulus will help shore up oil demand going into the second half of this year. This will be bullish CAD. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mixed: Import prices contracted by 1.9% year-on-year in January, compared to a contraction of 3.2% the previous month.  The trade balance increased to CHF 4,788 million in January from CHF 1,975 million the previous month. Industrial production grew by 1.6% year-on-year in Q4 2019, slowing from 7.9% the previous quarter. The CHF depreciated 0.4% against the US dollar this week. The SNB has repeatedly emphasized that it stands ready to prevent rampant appreciation in the Swiss franc which could hurt exports. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The trade balance decreased to NOK 21.2 billion in January from NOK 25.6 billion the previous month. The Norwegian krone depreciated by 0.7% against the US dollar this week. The past two weeks saw a remarkable rally in oil prices, which should help the petrocurrency, but a strong dollar has weighed on NOK/USD. However, our NOK/EUR position, a part of our long petrocurrencies basket trade, has benefitted from the oil rally and weakness in the euro. In an annual speech this week, Governor Olsen of the Norges Bank stressed the need for Norway to decrease reliance on the sovereign wealth fund and transition to a less oil-dependent economy. In the long run, this could mean krona leaving behind the “petrocurrency” moniker. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative. The unemployment rate increased to 7.5% in January from 6% the previous month. The CPI grew by 1.3% year-on-year in January, compared to 1.8% the previous month. The Swedish krona depreciated by 1.9% against the US dollar this week. In the February monetary policy report released last week, the Riksbank revised down inflation forecasts due to lower energy prices in 2020. However, they expect this to be a transitory shock and see inflation moving closer to 2% once it subsides. Although the krona depreciated on the unemployment and inflation data this week, it looks unlikely to be enough for the Riksbank to change its policy stance. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The COVID-19-induced demand shock in China – and a stronger USD – will reduce growth in global crude oil consumption to just over 1mm b/d this year, vs. earlier expectations of ~ 1.4mm b/d. Significant fiscal and monetary stimulus from China will be required to put economic growth back on track over the critical 2020-21 interval. An accommodative monetary-policy backdrop globally also will support demand. On the supply side, OPEC 2.0 likely will cut output by an additional 600k b/d in 2Q20, which will remove 2.3mm b/d off member states’ official quotas. For 2H20, we expect the coalition to revert to its 1.7mm b/d in cuts to keep markets balanced. US shale-oil output growth will continue to slow under market-imposed capital discipline. We are revising our baseline price forecasts in 2020 lower to $62/bbl and $58/bbl for Brent and WTI, respectively (Chart of the Week). This is down $5/bbl vs our previous forecast. Price risk is to the upside, however. 2021 Brent and WTI forecasts remain at $70/bbl and $66/bbl, respectively, as we do not expect long-lived demand destruction from the COVID-19 outbreak. A growing consensus around policy stimulus and production cuts makes us leery. Feature Chart of the WeekCOVID-19 Knocks Oil Forecasts Lower COVID-19 Knocks Oil Forecasts Lower COVID-19 Knocks Oil Forecasts Lower COVID-19 continues to hammer Chinese oil demand, forcing refiners there to drastically reduce output. This crude oil is ending up in inventories, but, so far at least, overall storage capacity in China is not being maxed out by the unintended accumulations of crude and product inventories. Data are difficult to come by, but there are a few observations that provide some insight into the state of the refining market in China as the COVID-19 episode unfolds. Platt’s reported independent refiners in Shandong Province, which has ~ 3.4mm b/d of refining capacity, cut runs to a four-year low of ~ 40% of capacity this month, down from a January rate of 63.5%. Shandong refiners represent 50%-60% of China’s independent refining capacity.1 We estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. Ursa Space Systems’ radar satellite monitoring of inventories close to coastal refineries indicated Chinese oil storage at the beginning of the month was at 60% of capacity.2 This figure likely is higher, given refinery runs remain low, but it does not yet suggest storage capacity in China will be exhausted in the near future. In our modeling of the COVID-19 impact on oil demand, we estimate EM demand – led by downward revisions in China – will fall by ~900k b/d in 1Q20 – when most of the damage to the economy likely will occur – and by an average 300k b/d for the year vs. our previous estimates. This leads us to believe EM oil demand will increase by 1mm b/d this year, down from our earlier expectation of 1.26mm b/d pre-COVID-19. For DM economies, demand growth also will disappoint, revised down by 100k b/d on the back of a warmer-than-expected winter and stop-and-go growth in manufacturing induced by COVID-19. Policy Stimulus Will Revive Chinese Demand The COVID-19 outbreak will result in a significant hit to China’s GDP, which will require substantial stimulus to put growth back on a 6% p.a. track this year. This growth rate is required for the Chinese Communist Party (CCP) to deliver on its pledge to double GDP and per-capita income over 2010-20, a pledge that was memorialized in writing following the Party’s 2012 Congress. In addition, next year marks the 100th anniversary of the founding of the CCP, and, we believe, it is an all-but-foregone conclusion the Party’s leadership will not want a faltering economy on display as it celebrates this important milestone. Given these considerations, the possibility policymakers will over-stimulate the economy to get it back on track is a non-trivial upside risk.3 We do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. Our baseline 2020 forecast envisions prices will falter somewhat versus our previous expectation – with Brent averaging $62/bbl this year, and WTI trading $4/bbl below that, vs. $67/bbl and $63/bbl previously. We are mindful of the impact Chinese policy stimulus can have on the global oil markets. The effects on GDP growth following demand shocks of past stimulus can be seen in the response of China’s GDP following the 2003 SARS outbreak; the 2008-09 GFC; the 2011-12 eurozone debt crisis; and even in China’s 2015-16 slowdown (Chart 2). For this reason, we do not think it is unreasonable to expect policymakers to lean into reviving growth this year and next with policy stimulus. And it is for this reason that we believe price risk tilts to the upside this year. Our updated Ensemble price forecast includes two additional demand-side simulations to assess its sensitivity to changes in EM oil demand: Chart 2Chinese Stimulus Will Support Oil Demand Chinese Stimulus Will Support Oil Demand Chinese Stimulus Will Support Oil Demand Higher EM demand scenario (20% weight): We model the impact of the coronavirus as short-lived, with only a temporary impact on China’s economy. Consumer demand and industrial production in China converge to pre-COVID-19 levels rapidly in 2H20. Chinese policymakers overstimulate in 2Q20, over fears the virus could have severe long-term consequences on the economy. This scenario assumes EM demand increases by 100k b/d vs. our base case in 2020 and 2021. Lower EM demand scenario (10% weight): We model the impact of the coronavirus as a severe and long-lasting event. This triggers a negative feedback loop for EM oil demand; collapsing demand forces production lower, which reduces employment and pushes demand further down. This reverberates to other EM economies and affects global supply chains. This scenario assumes EM demand decreases by 240k b/d in 2020 and returns to our base case in 2021, supported by China stimulus. Oil-Demand Reduction (Not Destruction) The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). The COVID-19 outbreak in China caused us to reduce our expectation for global oil demand growth by ~ 360k b/d, taking 2020 year-on-year growth to ~ 1.04mm b/d, versus our earlier expectation of 1.4mm b/d. The outbreak also is contributing to greater global economic uncertainty, which continues to support the USD broad trade-weighted index (TWIB). Dollar strength produces a headwind for EM GDP growth, which suppresses oil-demand growth. The combination of the COVID-19-induced demand reduction and the stronger USD TWIB likely will compel OPEC 2.0 to maintain its production discipline until the global policy uncertainty abates and the USD TWIB retreats. Such a reversal in trend would become a tailwind for commodity demand (Chart 3). Chart 3Global Economic Uncertainty Keeps A Bid Under USD TWIB Global Economic Uncertainty Keeps A Bid Under USD TWIB Global Economic Uncertainty Keeps A Bid Under USD TWIB Global supply growth will continue to be constrained by demands from investors to return capital to shareholders. We expect the hit to global demand to be offset by increased production cuts from OPEC 2.0, which will be agreed next month. OPEC 2.0 production also will be impacted by continued output losses in Iran and Venezuela, which have seen y/y production fall by ~ 1.8mm b/d in 2019. Global supply growth will continue to be constrained by demands from investors to return capital to shareholders – via stock buybacks – and for steady and increasing dividends to make their equity competitive with alternative sectors (e.g., tech). These capital-market pressures – in addition to growing pressure from Environmental, Social and Governance (ESG) investors – will continue to have a profound effect on capital availability for oil and gas E+P companies for decades to come. This is a theme we will return to often in future research. We summarize these supply-demand dynamics in Chart 4. For OPEC 2.0, the 1.7mm b/d reduction in output the coalition agreed for 1Q20 remains in place, as do losses from Iran and Venezuela. For 2Q20, we assume the coalition adds another 600k b/d of production cuts. After that, we assume OPEC 2.0 reverts to its earlier production cuts of 1.7mm b/d for 2H20. In 2021, we assume OPEC 2.0 takes production cuts back down to 1.2mm b/d in January 2021, then gradually increases its production over 1H21 to balance the market and to avoid spiking prices. We also expect the Kingdom of Saudi Arabia (KSA) to remove 300k b/d of overcompliance next year, as markets tighten. In 2H21, we see OPEC 2.0 production levels remaining flat at ~ 44.8mm b/d (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Oil Demand Should Recover In 2H20 Oil Demand Should Recover In 2H20 Chart 4Supply-Demand Balances Supply-Demand Balances Supply-Demand Balances Chart 5Global Oil Inventories Will Resume Drawing Global Oil Inventories Will Resume Drawing Global Oil Inventories Will Resume Drawing For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. For the US, we reduced our Lower 48 production assumptions, and now have 740k b/d growth in 2020 and 300k b/d in 2021. Shales account for almost all of this increase. We also include a scenario in which US production comes in lower in our ensemble forecast. These fundamentals combine to put global oil inventories back on a downward trajectory in 2H20 (Chart 5). That said, there is an important caveat going into 2H20: If the US Economic Policy Uncertainty Index starts rising in 2H20 on the back of US election risks, markets will continue to price in a stronger USD in 2020 vs. what we now expect. For 2021, we are leaving our Brent forecast unchanged at $70/bbl, and WTI at $66/bbl. Odds favor a return to the pre-COVID-19 price trajectory for oil next year, with continued upside risk from Chinese fiscal and monetary stimulus, and a globally accommodative monetary-policy backdrop. Higher Spare Capacity Reduces Risk Premium The market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. The risk premium in oil prices evaporated following the drop in demand and the increase in spare capacity due to the large OPEC 2.0 cuts. When China’s economy resumes its normal activity, demand will pick up and the market will balance, increasing the impact of possible supply disruptions. However, the market remains partly balanced by OPEC 2.0’s production cuts. This means that the group’s spare capacity is increasing, reducing the risk premium the market typically includes in crude oil prices to reflect sudden output losses. In addition, if production capacity of ~ 300k-500k b/d in the Neutral Zone shared by KSA and Kuwait is restored, the risk premium could drop even lower, given this production is expected to be retained as spare capacity. If this is the case we could have lower prices in 2020 vs. our current forecast (down to ~ $60/bbl). We will be exploring the changes in OPEC 2.0 spare capacity and the consequences for overall production in future research. Bottom Line: Assisted by Chinese policy stimulus, oil demand will recover this year from the COVID-19-induced demand shock. On the supply side, the combination of deeper OPEC 2.0 production cuts – which we expect will be settled at the upcoming March meeting – and capital-market-imposed reduction in US oil production will push oil markets to a supply deficit. The ongoing demand shock forces us to reduce our 2020 Brent price forecast to $62/bbl from $67/bbl previously. For 2021, we maintain our $70/bbl target. Risks to our view are mounting. Three crucial pieces to our 2020 and 2021 expectations remain uncertain: The duration and magnitude of the impact of the coronavirus shock, The level of production cuts by OPEC 2.0 and the degree of compliance by all members, and The trajectory of the US dollar – if global economic policy uncertainty remains elevated the USD could remain well bid, which would continue to pressure EM GDP growth – and commodity demand – at the margin. Our base case remains that prices will rise from here, but our conviction level is slightly lower. One reason for this is the apparent consensus emerging around the likelihood of Chinese stimulus and OPEC 2.0 production cuts. If either of these assumptions prove wrong, oil prices likely would move lower.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight As of Tuesday’s close, Brent prices were up 8% from their Feb 10 low of $53.27/bbl, supported by receding COVID-19 fears and rising expectations OPEC 2.0 will deepen its production cuts at its March meeting. Earlier this week, oil prices received an additional lift from the newly-imposed US sanctions on Rosneft Trading SA – a subsidiary of Russia’s state-own company – for its activities with Venezuela’s PDVSA. Rosneft Trading intensified its involvement in Venezuela’s oil sector and now handles the majority of the country’s crude exports, providing vital support to the Maduro government. The US restrictions include a 90-day wind-down period for companies to end their activities with Rosneft Trading. Base Metals: Neutral Chinese steel consumption – which accounts for ~50% of global demand – has been hit hard by the coronavirus outbreak. Steel and iron ore prices in China plunged 11% and 3% YTD (Chart 6). Steel mills’ inventories increased to record levels, reaching full capacity. Mills are now forced to export their surplus at reduced prices – flooding seaborne steel markets – or to cut output. Accordingly, more than 33% of steel mills are considering cutting steel production, according to a recent Platts survey. Margins at producing mills are declining and could harm high-grade iron ore prices. This is a short-term risk to our view. Precious Metals: Neutral Gold prices surged past $1,600/oz on Tuesday – overlooking positive manufacturing data in the US. Silver shadowed gold’s movement, closing at $18.13/oz. Precious metals are bought as insurance against risks of a wider-than-expected spread of the coronavirus and should remain well bid until uncertainty dissipates. Gold is somewhat overbought based on sentiment, momentum and technical indicators (Chart 7). If, as we expect, the daily increase in confirmed cases ex-Hubei slows meaningfully over the coming months, gold and silver prices will lose some steam. Ags/Softs:  Underweight CBOT March wheat futures surged 4.4% on Tuesday after Australia’s government sharply lowered its estimate of the country’s wheat harvest as severe drought affected crops. The Australian agricultural agency said the crop totaled 15.17 mm MT, the lowest since 2008, paving the way for stronger US exports. Corn also moved higher, with the prompt contract gaining 1.26% on the back of a new round of Chinese tariff exemptions on US goods. A USDA report showed US soybean export inspections bound for China were still half of last year's volumes. Soybeans futures closed 1.25 cents lower at $8.915/bu as markets await large Chinese purchases of US soybeans. Chart 6Increasing Inventories Pressure Steel and Iron ore Prices Increasing Inventories Pressure Steel and Iron ore Prices Increasing Inventories Pressure Steel and Iron ore Prices Chart 7Gold Technical Indicators Signal Overbought Market Gold Technical Indicators Signal Overbought Market Gold Technical Indicators Signal Overbought Market     footnotes 1     Please see China's Shandong independent refiners cut run rates to 4-year low of 40% in Feb, published by S&P Global Platts February 13, 2020. 2     Please see Oil demand falls on coronavirus: how much will inventories rise? posted by Ursa Space Systems February 7, 2020. 3     Please see Iron Ore, Steel Poised For Rally, published January 13, 2020, for a discussion of the significance of 2020 vis-à-vis the Communist Party’s pledge to double GDP and per-capita income vs. 2010 levels, memorialized by the CCP at its 2012 Peoples Congress.  We also discuss the 100th anniversary of the Party’s founding next year, which also will be a significant milestone for the CCP – and another reason the Party will not want the Chinese economy faltering as it is celebrated.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Oil Demand Should Recover In 2H20 Oil Demand Should Recover In 2H20 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Oil Demand Should Recover In 2H20 Oil Demand Should Recover In 2H20

Highlights The elevated uncertainty about global growth stemming from the COVID-19 virus in China has not only made investors more anxious, but central bankers as well. This means that, only six weeks into the year, policymakers may already be having to rethink their expected strategies for 2020 - which were, for the most part, sitting on hold after the monetary easing in 2019. This has important implications for the direction of global bond yields, which were starting to see a cyclical increase before the viral outbreak. In this report, we present what we see as the most important data for investors to focus on in the major developed markets to get the central bank call correct. This is based on our interpretation of recent speeches, press conferences and published research. We also provide our own suggested data series to watch for each country – which do not always line up with what central bankers are saying they are most worried about. We conclude that it is still not clear that the global growth backdrop has turned sustainably more bond bullish, but there is no pressure on any of the major central banks to move away from extremely accommodative policy settings. Feature Over the past four weeks, all of the major central banks have had the opportunity to formally communicate their current views to financial markets. Whether it was through post-policy- meeting press conferences or published monetary policy reports, central bankers have tried to signal their intentions about future changes in the direction of interest rates, given the heightened uncertainties about the momentum of global growth. At the moment, our global leading economic indicator (LEI) is still signaling that 2020 should see some rebound in global growth – and bond yields – after the sharp 2019 manufacturing-led slowdown (Chart 1). Unfortunately, the latest read on the global LEI uses data as of December, so it does not include what is almost certainly to be a very severe slowdown in the Chinese (and global) economy in the first quarter of 2020 due to the COVID-19 virus outbreak. Underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year.  Central bankers are in the same spot as investors, trying to ascertain the extent of the hit to global growth from the virus, both in terms of size and, more importantly, duration. This comes at a time when many central banks were already formally rethinking how to meet their own individual inflation-targeting mandates given the persistence of low global inflation alongside tight labor markets (Chart 2). Chart 1Global Bond Yields: Think Globally, Act Locally Global Bond Yields: Think Globally, Act Locally Global Bond Yields: Think Globally, Act Locally Chart 2Common Worries For All CBs: China & Global Inflation Common Worries For All CBs: China & Global Inflation Common Worries For All CBs: China & Global Inflation That all sounds potentially very bond-bullish, but a lot of bad economic news is already discounted in the current low level of global bond yields. More importantly, the underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year. In this Weekly Report, we provide a brief synopsis of what we believe are the biggest concerns for each of the major developed economy central banks. This is based on our read of recent policy decisions and central banker statements, as well as our own understanding of the current reaction function of policymakers. Our intention is to provide a short list of indicators to watch for each central bank, to help cut through the noise of data and news during this current period of unusual uncertainty, as well as our own assessment of what policymakers should be focusing on more. We conclude that it is still too soon to expect a new wave of bond-bullish global monetary policy easings in 2020. It will take evidence pointing to an extended shock to global growth from the COVID-19 virus to reverse the bond-bearish signal from other indicators like our global LEI. Federal Reserve Chart 3Federal Reserve: Focus On Financial Conditions & Inflation Expectations Federal Reserve: Focus On Financial Conditions & Inflation Expectations Federal Reserve: Focus On Financial Conditions & Inflation Expectations Currently, the Fed’s commentary suggests a policy bias that can be described as “neutral-to-dovish”, but it is giving no indication that additional rate cuts are likely in 2020 after the 75bps of cuts last year. Markets remain skeptical, however, with -42bps of cuts over the next twelve months now priced into the USD overnight index swap (OIS) curve according to our Fed Discounter (Chart 3). What the Fed seems most focused on: Fed officials seem focused on measures of market-based inflation expectations, like TIPS breakevens, as the best indication that current policy settings are appropriate (or not) relative to the growth outlook of investors. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019 (middle panel). Right now, with the 10-year TIPS breakeven at 1.67% and the 10-year/3-month US Treasury curve now at only -1bp, another decline in longer-term inflation expectations will likely invert the Treasury curve. What the Fed should be more focused on: US financial conditions are highly stimulative, with equity indices back near all-time highs and corporate credit spreads remaining well-contained at tight levels. Given the usual lead times of financial conditions indices to US cyclical growth indicators like the ISM manufacturing index (bottom panel), a continuation of the most recent bounce in the ISM is still the most likely result – even allowing for a near-term hit to global growth from China. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019. Bottom Line: The incoming US growth data is critical to determine the Fed’s next move. If there is no follow through from easy financial conditions into faster growth momentum, the odds increase that the Treasury curve will become more deeply inverted for a longer period of time – an outcome that would likely prompt more rate cuts, especially if equity and credit markets also begin to sell off as growth disappoints. European Central Bank Chart 4ECB: Focus On Manufacturing & Inflation Expectations ECB: Focus On Manufacturing & Inflation Expectations ECB: Focus On Manufacturing & Inflation Expectations The ECB has been clearly signaling that it still has a dovish bias, although central bank officials have acknowledged that the options available to them to ease further are limited with policy rates already in negative territory. The market agrees, as there are only -7bps of cuts over the next twelve months now priced into the EUR OIS curve according to our ECB Discounter (Chart 4). What the ECB seems most focused on: The ECB has been paying the most attention to the contractions in euro area manufacturing data (like PMIs) and exports seen in 2019. Rightly so, as nearly all of the two percentage point decline in year-over-year euro area real GDP growth since the late-2017 peak has come from weaker net exports. The central bank has also been concerned about the depressed level of inflation expectations, with the 5-year EUR CPI swap rate, 5-years forward, now at only 1.23% - far below the ECB’s inflation target of “at or just below” 2%. What the ECB should be more focused on: We agree that the focus for the ECB should be most concerned about the weakness in manufacturing/exports and low inflation expectations – the latter having not yet responded to extremely stimulative euro area financial conditions (most notably, the weak euro). The euro area economy is highly leveraged to Chinese demand, with exports to China representing 11% of total euro area exports. This makes leading indicators of Chinese economic activity, like the OECD China LEI and the China credit impulse, critically important indicators in determining the future path of European export demand. The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. Bottom Line: The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. If the China demand shock to euro area exports is large enough, the ECB will likely be forced to deliver a modest interest rate cut – or an expansion of the size of its monthly asset purchases – to try and boost growth. Bank Of England Chart 5Bank Of England: Focus On Business Sentiment & Labor Costs Bank Of England: Focus On Business Sentiment & Labor Costs Bank Of England: Focus On Business Sentiment & Labor Costs The Bank of England (BoE) has a well-deserved reputation as having an unpredictable policy bias under outgoing Governor Mark Carney, but the central bank does appear to be currently leaning on the moderately dovish side of neutral. Short-term interest rate markets also feel the same way, with -19ps of easing over the next twelve months priced into the GBP OIS curve according to our BoE Discounter (Chart 5). What the BoE seems most focused on: The BoE has been paying a lot of attention to indicators of UK business sentiment, which had been negatively impacted by both Brexit uncertainty and global trade tensions in 2019. The BoE has focused on the link from depressed business sentiment to weak investment spending and anemic productivity growth as an important reason why UK potential GDP growth has been so low and why UK inflation expectations have been relatively high. What the BoE should be more focused on: We agree that business sentiment should be the BoE’s greatest area of focus. Sentiment has shown a solid improvement of late, after the signing of the “phase one” US-China trade deal in December and the formal exit of the UK from the EU on January 31. The CBI Business Optimism survey (measuring the net balance of optimists versus pessimists) soared from -44 in October to +23 in January – the biggest quarterly jump ever recorded in the series. It remains to be seen if this improvement in confidence can be sustained and begin to arrest the steady decline in UK capital spending and productivity growth, and the associated surge in unit labor costs and inflation expectations, that has taken place since the 2016 Brexit vote. Bottom Line: The BoE’s next move, under the new leadership of incoming Governor Andrew Bailey, is not clear. Inflation expectations remain elevated but the recovery in business sentiment is still fragile. One potential risk to watch: UK Prime Minister Boris Johnson may choose to take a bolder stand on trade negotiations with the EU after his resounding election victory in December, risking an outcome closer to the “no-deal Brexit” scenario that was most feared by UK businesses. Bank Of Japan Chart 6Bank of Japan: Focus On Exports & The Yen Bank of Japan: Focus On Exports & The Yen Bank of Japan: Focus On Exports & The Yen The Bank of Japan (BoJ) seems to have had a perpetually dovish bias since the 1990s. Yet the current group of policymakers under Governor Haruhiko Kuroda, realizing that they have run out of realistic policy options after years of extreme stimulus, has not been signaling that fresh easing measures are on the horizon, even with economic growth and inflation remaining very weak in Japan. Markets have taken the hint, with only -6bps of rate cuts over the next twelve months priced into the JPY OIS curve according to our BoJ Discounter (Chart 6). What the BoJ seems most focused on: The BoJ has been vocally concerned about the recent slump in Japanese consumer spending, which declined -2.9% (in real terms) in Q4 after the sales tax hike last October. That blow to consumption was expected, but could not have come at a worse time for a central bank that was already worried about plunging Japanese manufacturing activity and exports – the latter declining by -8% in nominal terms as of December 2019. There is little hope for a near-term rebound given the certain hit to global growth and export demand from virus-stricken China. What the BoJ should be more focused on: Given that Japan is still an economy with a large manufacturing sector that is levered to global growth, the BoJ should remain focused on the path for Japanese exports. A bigger risk, however, comes from the Japanese yen, which has remained very stable over the past year. It has proven very difficult to generate any rise in Japanese inflation without some yen weakness, and with headline CPI inflation now only at +0.2%, a burst of yen strength would likely tip Japan back into outright deflation. Bottom Line: The BoJ is now stuck in a very bad spot, with no real ability to provide a major monetary policy stimulus for the stagnant Japanese economy. At best, all the central bank could do is deliver a small interest rate cut and hope for a quick rebound in global manufacturing activity and/or some yen weakness to boost flagging inflation. Bank Of Canada Chart 7Bank of Canada: Focus On Housing & Capital Spending Bank of Canada: Focus On Housing & Capital Spending Bank of Canada: Focus On Housing & Capital Spending The Bank of Canada (BoC) surprised many observers by keeping policy on hold last year, even as central banks worldwide engaged in various forms of monetary easing to offset the effects of the global manufacturing downturn. The BoC’s recent messaging has been relatively neutral, in our view, although Governor Stephen Poloz has not completely dismissed the possibility of rate cuts in his speeches. The markets are strongly convinced that the BoC will need to belatedly join the global easing party, with -32bps of rate cuts now priced into the CAD OIS curve according to our BoC Discounter (Chart 7) What the BoC seems most focused on: The BoC remains highly concerned over the high level of Canadian household debt, especially given how Canadian consumer spending has been highly geared towards trends in house price inflation over the past few years. This is likely why the BoC has been reluctant to cut policy rates as “insurance” against the effects of a prolonged global growth slump, to avoid stoking a new Canadian housing bubble. Interestingly, the commentary from BoC officials has taken on a bit more dovish tone whenever USD/CAD has threatened to break down below 1.30, suggesting some fears of unwanted currency appreciation. What the BoC should be more focused: The BoC should continue to monitor developments in the Canadian housing market, given the implications for consumer spending and, potentially, financial stability if there is another boom in house prices. The central bank should also pay even greater attention than usual to the subdued level of oil prices, which has triggered a deep slump in the oil-rich Alberta province that has weighed on the overall level of Canadian business investment spending. Persistently soft oil prices would also force the BoC to continue resisting strength in the Canadian dollar. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Bottom Line: The BoC appears under no pressure to make any near-term interest rate adjustments, especially with realized inflation now sitting at the midpoint of the BoC’s 1-3% target band. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Reserve Bank Of Australia Chart 8Reserve Bank Of Australia: Focus On Underemployment & Housing Reserve Bank Of Australia: Focus On Underemployment & Housing Reserve Bank Of Australia: Focus On Underemployment & Housing The Reserve Bank of Australia (RBA) has been very transparent over the past year, loudly signaling a dovish bias and following through with 75bps of rate cuts that took the Cash Rate to a record low of 0.75%. The latest messaging has been a bit more balanced, while still leaving the door to additional rate cuts if the economy worsens. Markets are expecting at least one more easing, with -24bps of rate cuts over the next twelve months priced into the AUD OIS curve, according to our RBA Discounter (Chart 8). What the RBA seems most focused on: The RBA’s main concerns have centered around the persistent undershoot of Australian inflation, with core inflation remaining below the central bank’s 2-3% target band since the beginning of 2016. The central bank has attributed this to persistent excess capacity in the Australian labor market, as evidenced by the elevated underemployment rate. The RBA is also paying close attention to the Australian housing market and its links to consumer spending, with house prices already responding positively to last year’s RBA rate cuts. The outlook for exports is also on the RBA radar, particularly after the recent surge that lifted the Australia trade balance into surplus but is now at risk from a plunge in Chinese demand. What the RBA should be more focused on: We agree that the labor market should be the main focus for the RBA, particularly the underemployment rate which is still high at 8.3%, signaling that core CPI inflation should remain subdued (bottom panel). We also see the RBA as potentially being more sanguine about the risks of a renewed upturn in the housing market than many observers expect, since that would provide a potential offset to a likely pullback in exports which are now a record 25% of GDP (middle panel). Bottom Line: The RBA still has a clear dovish bias, even though they are currently on hold to assess the impact of last year’s easing. RBA Governor Philip Lowe noted in a recent speech that more cuts may be necessary “if the unemployment rate deteriorates”, suggesting that the labor market is the main area of focus for the central bank. Reserve Bank Of New Zealand Chart 9Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation The Reserve Bank of New Zealand (RBNZ) was one of the more dovish central banks in 2019, cutting the Cash Rate by 75bps to a record low of 1%. The overall tone of the central bank’s recent commentary remains cautious, but has taken on a more balanced tone. Markets are priced appropriately, with only -13bps of rate cuts over the next twelve months discounted in the NZD OIS curve according to our RBNZ Discounter (Chart 9). What the RBNZ seems most focused on: The latest messaging from the RBNZ has highlighted the downside risks to New Zealand from weak global growth, but those are now more manageable since the central bank estimates the economy is operating at full employment. In its latest Monetary Policy Statement (MPS), the RBNZ noted that the economy has been able to weather the weakness in global growth thanks to the positive terms of trade effect from elevated New Zealand export prices – a trend that the central bank expects will persist in 2020 even if external demand remains sluggish (middle panel). The central bank has also expressed some concern over the recent pickup in domestically-driven inflation measures, with core CPI inflation back above 2% (bottom panel). What the RBNZ should be more focused on: The RBNZ is right to focus on global growth, particularly given the coming demand shock from virus-stricken China. While the New Zealand dollar has always been a critical variable for the RBNZ in its policy decisions, the currency now takes on added importance given the central bank’s expectation that export prices and the terms of trade will remain elevated. If the latter turns out to be wrong, the RBNZ will be far more likely to take actions to ensure that the Kiwi dollar stays undervalued. Bottom Line: The RBNZ still has a dovish policy bias, but the hurdle to deliver additional rate cuts after last year’s easing seems a bit higher now. It would likely take a major downturn in global growth, combined with a decline in New Zealand export prices and some cooling of domestic inflation, to get the RBNZ to cut again in 2020. Investment Conclusions Based on our “whirlwind tour” of the major developed market central banks in this report, we can make the following conclusions regarding the expected path of interest rates, and bond yields, in these countries: There are no central banks with anything resembling a hawkish bias – not surprising in the current slow global growth environment with heightened uncertainty. The least dovish central banks are the BoC and the RBNZ, which are not signaling any urgency to cut rates. The most dovish central bank is the RBA, which is indicating a clear willingness to cut again if domestic growth deteriorates. The Fed and the BoE are somewhere in the middle of the “dovishness” spectrum, with both likely willing to ease policy but only under a specific set of circumstances. The ECB and BoJ are clearly boxed in having policy rates already below the zero bound, limiting their ability to ease further if needed. In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months.  Looking back at our Central Bank Discounters, the largest amount of rate cuts over the next year are now discounted in the US (-42bps), Canada (-32bps), Australia (-24bps) and the UK (-19bps). At the same time, the fewest cuts are priced in Japan (-6bps), the euro area (-7bps) and New Zealand (-13bps). In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months. The odds seem more “fair” in the other countries, in terms of the size of rate cut expectations versus the probability of those cuts actually being delivered because of domestic economic considerations. What does this all mean for global bond investing this year? For that we can turn to our Global Golden Rule framework, which links expected returns of government bonds versus cash to the difference between actual and expected rate cuts.1 US Treasuries and Canadian government bond yields are most at risk of underperforming their global peers in 2020 as the Fed and BoC disappoint the current dovish rate cut expectations discounted in interest rate markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Central Banks Are (Or Should Be) Watching What Central Banks Are (Or Should Be) Watching Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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 An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted Chinese Households Are Indebted Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse China: Share Prices And Money Impulse China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact The US Dollar Rally Is Intact The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation Turkey: Rampant Money Creation Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging Turkey: Wages Are Surging Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations