Sectors

Since 2017, we have been updating our SPX dividend discount model (DDM) every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Table 1 on the next page summarizes the results of our analysis. Our dividend growth estimates in the DDM result in an SPX 3,000 fair value target. These dividend growth assumptions are slightly more conservative than the GFC experience. In the aftermath of the GFC, dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively. As a reminder, we have been and remain very conservative in our other DDM assumptions. In more detail, we assume that no buybacks will occur, a long-held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel). Our 8.2% discount rate mirrors the corporate junk bond yield historical average (please click here if you would like to receive our DDM and insert your own assumptions, more details can also be found in this Monday’s Weekly Report). Bottom Line: We are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. Table 1

Highlights Portfolio Strategy Our conservative dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – result in an SPX 3,000 fair value target. Relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. An upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all warrant an overweight stance in the S&P software index. Recent Changes Trim the S&P packaged foods index to neutral today, which pushes the S&P consumer staples sector to a benchmark allocation. Boost the S&P software index to overweight today, which lifts the S&P tech sector to a benchmark allocation. Table 1 Feature The SPX jumped to a five-week high last week, on the back of news that the economy will gradually reopen next month. In other news, GILD’s remdesivir drug showed some positive early signs in fighting off the coronavirus, sparking an impressive late-week rally in the SPX. From a macro perspective, flush monetary liquidity and extremely easy fiscal policy remain the dominant market forces. While we remain confident that equities will be higher on a 9-12 month cyclical time horizon, we believe that the easy money since the March 23 lows has already been made and a consolidation phase now looms. Thus, monetizing some of these gains would make sense at the current juncture. Keep in mind that the SPX, junk spreads and the CBOE’s put/call ratio have returned to their respective means since 2018 (horizontal lines denote the historical averages, Chart 1). Tack on the stiff resistance that the S&P 500 will face near the 50-day and 100-week moving averages, and a lateral move is likely in the coming weeks. Meanwhile, in our seminal report “SPX 3,000?” on July 10, 2017 we introduced our SPX dividend discount model (DDM) when we first came up with the SPX 3,000 target.1 It is now custom to update our DDM every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Chart 1Consolidation Mode Chart 2Dividends Rule As a reminder, we have been and remain very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 2). Our 8.2% discount rate mirrors the corporate junk bond yield historical average. This year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. In the spirit of conservatism, we pick the lowest point hit in early April across the different dividend futures expirations. Tables 2 & 3 summarize the results. In the dividend futures derived approach, SPX fair value is close to 2,110. Granted, such dividend contractions for two years running (33% in 2020 and 14% in 2021, Table 2) are extreme and highly unlikely. Moreover, dividend futures have since rebounded violently. However, we stick with them to derive our worst case SPX value. Table 2SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Our own dividend growth estimates result in an SPX 3,000 fair value target (Table 3). While our assumptions are not as dire as the nadir in dividend futures, they are slightly more conservative than the GFC experience. As a reminder, in the aftermath of the GFC dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively (please click here if you would like to receive our DDM and insert your own assumptions). Table 3SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Building up on this analysis, we want to identify sectors that are at risk of a dividend cut, and thus pose the greatest threat to our SPX dividend projections. Table 4 shows the 2019 sectorial dividends, profits, and the payout ratio along with indebtedness. While during the Great Recession financials cut their handsome dividends, the current recession is not a financial crisis and we doubt the financials sector will cut their dividends, at least not as aggressively as in the GFC (Table 5). Table 4S&P 500 GICS1 Sector Dividend Analysis Table 5The GFC S&P 500 GICS1 Sector Dividend Experience Energy is a clear standout, but neither XOM nor CVX will forego their dividend aristocrat status (minimum 25 consecutive years of rising dividends) and chop their dividends. In other words, these Oil Majors will do everything in their power including raising debt to ever so modestly increase their dividends and maintain their aristocrat status. Thus, $24bn of energy sector related dividends are safe or 55% of the overall energy sector’s dividend. Keep in mind that the energy sector increased their dividends in the GFC (Tables 4 & 5). Industrials (GE is no longer a big dividend payer), materials, real estate and select consumer discretionary are sore spots, but not large enough to undermine the SPX (Table 4). Tech, health care and consumer staples are in excellent shape and judging by JNJ’s and COST’s recent dividend hikes, these sectors that enjoy mostly pristine balance sheets may even increase their payouts as they did during the GFC (Tables 4 & 5). While utilities and telecom services are debt saddled, their defensive stature and stable cash flow streams along with their history of steady dividend payments also do not pose a real threat to the SPX’s dividend (Tables 4 & 5). This leaves financials as the key sector to monitor for a possible large inflicted wound to the SPX dividend. In the most adverse scenario where the Fed instructs banks to eliminate their dividends, as the BoE and the ECB recently did in Europe, then the SPX dividend will contract, but only by 15%, ceteris paribus. This is because last year the tech sector had the highest dividend weight in the SPX and also because the financials sector’s dividend weight has fallen from 30% in 2007 to 15% in 2019 (Tables 4 & 5). Netting it all out, we are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. However, given that the easy SPX gains from the March 23, 2020 lows – when we turned cyclically bullish2 – have been made, opportunistic/nimble investors could monetize at least a part of these massive one-month returns. As aforementioned the SPX may face resistance near the 50-day moving average where it attempts to consolidate its recent gains. This week we are downgrading a defensive group to neutral and boosting a deep cyclical group to an above benchmark allocation. Turning Stale Following up from last week’s report, we heed the message from our research to be wary of staples stocks at the depth of the recession and downgrade the S&P packaged foods index to neutral. This move also pushes the S&P consumer staples sector down to a benchmark allocation from previously overweight. While this defensive index had been severely bruised from the accounting scandal at Kraft/Heinz, it has really flexed its safe haven muscles year-to-date. We use this opportunity to trim exposure down to neutral as we deem that this relative advance has run out of steam, despite the once in a lifetime jump in a number of key demand indicators. Chart 3 shows that food & beverage store retail sales now garner 17% of total retail sales a percentage last hit in the early 1990s. Impressively, not only did industry sales rise in absolute terms, but also overall retail sales suffered a severe setback accentuating last month’s spike. Similarly, food output hit a high mark last month, outpacing overall industrial production that came to a standstill. Food products resource utilization also soared, outpacing overall capacity utilization by 10% (bottom panel, Chart 3). As a result, relative share price momentum came close to accelerating by triple digits on a short-term rate of change basis (Chart 4). While such euphoria is warranted, we reckon that most if not all the good news is already reflected in prices, especially given the early signs of a possible reopening of the US economy some time next month. Importantly, sell side analyst optimism has climbed to a similar height observed in late-2015/early-2016 when industry 12-month forward EPS were slated to outshine the broad market by over 10% (bottom panel, Chart 4). Chart 3Demand Boost… Chart 4…Is Already Baked In Worrisomely, despite the rising demand profile, operating margins have been drifting lower over the past decade and a further profit margin squeeze remains a high probability outcome (Chart 5). Finally, on the food export front, the rising US dollar is warning that volumes will remain in check in coming quarters (greenback shown inverted, middle panel, Chart 6). All of this is reflected in valuations that have returned to the 25-year mean with packaged food manufacturers now trading at a 9% forward P/E premium to the broad market (bottom panel, Chart 6). Chart 5Margin Trouble Chart 6Past Expiry Date In sum, relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. Bottom Line: Trim the S&P packaged foods index to neutral, today for a loss of 20% since inception. This downgrade also pushes the S&P consumer staples sector to neutral for a loss of 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PACK – MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, GIS, HSY, HRL, K, LW. Boost Software To Overweight We recently monetized over 50% relative gains in our overweight in the S&P software index, but today we are compelled to lift this heavyweight tech sub-index back to an overweight stance. One key reason for our renewed bullishness is that for the second time in the past 15 months, software stocks managed to eke out relative gains when the broad market fell peak-to-trough 20% and 35% in late-2018 and in Q1/2020, respectively (Chart 7). This resilience on the way down confirms both the defensive stature of this services tech subgroup and simultaneously our long held belief that when growth is scarce investors will flock to secular growth stocks. Chart 7Recession Proof As a result and following up from our recent data processing upgrade, another defensive services tech group, we are compelled to augment exposure to the S&P software index to overweight. Last week we showed that the tech sector (along with financials and consumer discretionary) best the broad market from the recessionary troughs onward, signaling that the key software sub group will likely lead the recovery.3 Software investment is on a multi decade upward trajectory and is slated to rise further in coming quarters as overall spending takes the back seat, but defensive software capex remains resilient (Chart 8). Not only do corporate executives upgrade software in downturns as these upgrades yield near instantaneous return on investment and are immediately productivity enhancing, but also the push to cloud-based services will only accelerate during the ongoing recession (bottom panel, Chart 8). Tack on that the global coronavirus social distancing measures are also boosting demand for remote working services specifically, and software sales will continue to grind higher (Chart 9). Chart 8Capex Market Share Gains Chart 9Rising Demand Buoys Sales Meanwhile, industry M&A remains robust and both the number of deals are still rising at a brisk rate and the premia paid remain near historically high levels (Chart 10). Contrary to a slew of corporations that have announced dividend cuts and equity buyback suspensions, pristine software balance sheets underscore that shareholder friendly activities will remain in place, if not accelerate, during the current recession (bottom panel, Chart 10). Chart 10What’s Not To Like? Chart 11Model Says Buy Our macro-based software EPS growth model does an excellent job in capturing all these moving forces and it is signaling that industry profits will continue to expand at a healthy pace for the rest of the year, in marked contrast to the broad market’s expected profit contraction (Chart 11). Adding it all up, an upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all bode well for an earnings-led outperformance phase in the S&P software index. Bottom Line: Boost the S&P software index to overweight, today. This upgrade also lifts the S&P tech sector to neutral for a loss of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.     Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Banks have an unmatched perspective on the entire economy, … : BCA began by tracking money flows through the banking system to gain advance notice of the direction of markets and the economy. … so we review the five largest banks’ earnings calls every quarter to augment our standard macro analysis: We’re looking for insight into borrower performance, lender willingness, consumer behavior, business sentiment and the condition of the banking system. The biggest banks are bearish on the economic outlook, but bullish on their ability to get through it, … : No management teams are looking for a V-bottom, and their expectations about the duration of the downturn sound a good bit more pessimistic than most investors’. They all expressed confidence in their institutions’ preparedness, however, citing sizable capital buffers and high-quality loan portfolios. … and we agree with their self-assessment: Analysts were skeptical that the banks have adequately reserved for coming loan losses, but we take the more optimistic view that their earnings power will allow them to absorb repeated iterations of reserving while barely scuffing book value. Follow The Money The big banks reported their first quarter earnings last week, and equity investors were decidedly unimpressed, knocking the stocks down 15-19% through Thursday’s close while the S&P 500 was flat. We listen to the calls to hear banks’ observations about households’ and businesses’ financial activity and glean some insight into where lending might be headed. This time we also wanted to use what we heard to inform our investment view on their stocks. We have long been of the view that post-GFC regulatory reforms left the SIFI banks overcapitalized. Even staring down the barrel of the current downturn, it was our sense that the SIFIs had ample capital buffers to withstand a severely adverse scenario, and the sharp de-rating they’ve been subjected to was excessive. With the potential range of credit outcomes so wide, however, it was hard to assess how much their per-share book values might fall, and so we couldn’t state with conviction whether or not the SIFIs’ stocks were as cheap as they appeared to the naked eye. The uncertainty remains, but we heard enough on the calls to conclude that book values are likely to remain resilient. 4Q19 Big Bank Beige Book As a group, the banks offered a pretty grim take on the economy. JPMorgan Chase built its in-house economists’ late-March forecast of a 25% decline in 2Q GDP and an unemployment rate above 10% into its model for calculating its 1Q loan-loss reserve, only to have them revise their forecasts lower, to -40% and 20%, respectively, after the bank closed its books. The rest of the banks, which offered directional GDP and unemployment views instead of point forecasts, uniformly called for weakness well into 2021. The banks were downbeat on the economy, but confident in their ability to manage through it, and not a single one has any intention of cutting its dividend. On the bright side, every bank cited its sizable capital buffer when arguing that it is in a better position than it was in 2008. The banks’ contention that the mix and quality of their loan books makes them safer than they were then didn’t seem to get much traction. The mortgages they hold today were much more carefully underwritten than the ones they held in 2008, but the quality of the banks’ overall loan books won’t be known until the recession has run its course. Many business borrowers are weaker credits that they were when their loans were extended, though the record-low growth in bank lending in the expansion just concluded suggests that the banks committed fewer excesses in this cycle than they normally do (Chart 1). Chart 1An Expansion Without Bank Lending Excesses Businesses drew down their credit lines at a frenzied pace over the last two weeks of March (Chart 2), a sure sign that they feared that liquidity would be in short supply. Since many of the banks saw the funds return to them as deposits (Chart 3), it seems that the draws were precautionary, rather than emergency, measures. It is entirely possible that the lines will be paid down once businesses replace them with forgivable 1% loans from the Paycheck Protection Program (PPP) funded by the SBA,1 though legislative attempts to replenish the PPP's rapidly consumed initial resources are currently in limbo. Chart 2Corporate Borrowers Drew Down Their Credit Lines With Stunning Speed, ... Chart 3... Only To Put It Back In The Bank Every bank asserted that it had the capacity to continue to pay its dividend, and pledged to do so as long as conditions didn’t deteriorate dramatically. Operationally, the banks were largely able to perform their standard functions without interruption, despite having the majority of their employees working from home. Successful remote operations bode well for future productivity and profitability as they may herald a future in which banks are able to reduce their costly branch footprints. They also suggest that their ongoing IT investments are paying dividends. A Sudden Stop In Household Spending (Chart 4) And Borrowing Chart 4Sudden Stop [I]n March, we saw a rapid decline in spend initially in travel and entertainment, which then spread to restaurants and retail as social distancing protocols were implemented more broadly. … [W]e did see an initial boost to supermarkets, wholesale clubs and discount stores as people stocked up on provisions, but even that is now starting to normalize. (Piepszak, JPM CFO) [Credit card] spend in aggregate was down 13% in the month of March, year-over-year, and we are seeing trends like that continue here in April. (Piepszak, JPM) Consumer spend is down over 25% year-over-year this past week with food and drug increasing and other spend down significantly. (Scharf, WFC CEO) March 2020 [card] volumes declined approximately 15% from March 2019. (Shrewsberry, WFC CFO) [Our customers’] … overall spending … seems to have stabilized in the last few weeks. During mid-April, we’re seeing [weekly] spending running about a low $50 billion average level compared to $60 billion … before the crisis. (Moynihan, BAC CEO) [T]he last week of March, the card spend activity just broadly for us was down about 30%. … [W]e would expect there to be continued pressure on purchase sale volumes through most of the second quarter. (Mason, C CFO) A Sharp Rise In Credit Line Utilization, … C&I loans were up 26% [year-on-year] as revolver utilization increased to 44%, which is an all-time high. … [E]arly here in the second quarter, we have seen a pause on revolver draws but … we are assuming … that we will see [them] continue in the second quarter, albeit at lower levels than the first quarter. (Piepszak, JPM) [The draws] really have flattened out, and they have been negligible for the last several days, more than a week. And so they probably peaked at the end of the third week of March, and then came right back down. … It’s worth noting that the high rate of [utilization] growth … has backed off since credit markets have reopened. (Shrewsberry, WFC) The draw activity was pretty normal through the first week of March, but ramped up in the second week before peaking in the third. The requests have come down in every one of the last three weeks. (Moynihan, BAC) [C]oming into the second quarter, we’ve actually seen really de minimis draws on the facilities and … we don’t see or feel that [drawdown] pressure now. (Corbat, C CEO) [T]he drawdowns were high in the third and fourth week in March and started to level out in early April. So I think we saw the peak already occurring. (Dolan, USB CFO) … Accompanied By A Surge In Deposits [A]bout half of [the increase in deposits came] from clients drawing on their credit lines and holding their cash with us as they look to secure liquidity. (Piepszak, JPM) It’s worth noting [that] ... we saw many of those draws come back … as deposits. [T]he 75% of loan draws [that] were not used for other paydowns ended up as deposits with [us]. (Moynihan, BAC) The Current Situation Is Unprecedented, … [T]here is no model that [has] dealt with GDP down 40%, unemployment growing that rapidly. … [There are] no models that ever dealt with a government which is doing a PPP program which might be ... $550 billion, unemployment where it looks like 30-40% [of those unemployed will have] higher income than before they went on unemployment, … or that the government is going to make direct payments to people. So what does that mean for credit card [performance]? (Dimon, JPM CEO) The economy is in an unprecedented situation, but not all of the unknowns are bad. The monetary and fiscal stimulus programs will undoubtedly help at the margin, and they may dramatically reduce the second-round effects of the social distancing measures that have strangled activity. We all know we haven’t seen anything like this before. There is no clear path … with a narrow range of outcomes. And so [I just have a very hard time] making an analogy of what this environment is to other environments. Having said that, … we feel like the portfolios that we have are stronger than they were at other downturns as I think they certainly are in many banks out there. (Scharf, WFC) I would just [dis]courage anyone from imagining that at this point in time that any bank has got perfect clairvoyance about … the future …, and whether it gets better or … worse. (Shrewsberry, WFC) Obviously there are many unknowns including how government fiscal and monetary actions will impact the outcome and how our own deferral programs will impact losses, or perhaps the biggest unknown is how long economic activity and conditions will be significantly impacted by the virus. (Donofrio, BAC CFO) … But Credit Performance Might Not Be Horrendous The real question will ultimately be how long this shutdown actually continues, … but in addition to that, how our actions, … the things that we’re doing very actively to help our clients, and the huge amount of government intervention, whether those things will … bridge individuals and small businesses and larger corporations to the other side of this. (Scharf, WFC) It wouldn’t surprise me to continue to have to add to reserves, … [b]ut … what we know is, we’re strong and the industry is strong to be able to handle this. (Scharf, WFC) For years now, we have been focused on client selection. As you all know, what really impacts banks in recession is not the loans put on your books during stress, but rather the quality of your portfolio booked during the years leading up to the stress. (Donofrio, BAC) [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass. (Corbat, C) I think, generally speaking, all banks are in a good position right now, which is why we’re all able to help our customers while protecting employees. (Cecere, USB CEO) Today we received the first major distribution of the direct payments in terms of the $1,200 stimulus payment. We’re seeing now the unemployment benefits, the extra $600 … coming through. [T]hose programs are just barely hitting the general consumer, general business, et cetera. And so … the stimulus they’ll provide is actually going to be from now on, not from now backwards, because this is a program that didn’t exist literally three weeks ago. (Moynihan, BAC) [T]hese [fiscal and monetary] programs … are extraordinary and should have an extraordinary impact. (Piepszak, JPM) Buy The Banks? The uncertainty around loan losses remains extremely high. No one knows how long the economy will remain locked down, or how long it will take to restart the economy once the most restrictive social distancing measures begin to be relaxed. No one knows how large the package of fiscal and monetary assistance will become, or how effective it will ultimately be. Analysts were clearly skeptical that the amounts the banks set aside in the first quarter as reserves against future losses will be sufficient. They were concerned about the gaps between current reserve levels and the losses the banks realized in the global financial crisis, and the cumulative losses projected under the severely adverse scenario of the 2019 iteration of the Fed’s annual stress tests (Table 1). If the virus drag on the economy persists into the third quarter, as our base-case scenario projects, the banks will likely have to step up their reserving activity aggressively. Given that they were able to do so in the first quarter without impairing their book values (Table 2), however, we think they can handle it. Table 1Loan Loss Reserves Vs. Stress Test Projections Table 2Big Bank Book Values The bull case, as BAC’s CEO put it on the call, rests on the idea that the banks’ quarterly pre-tax pre-provision net revenue – their earnings power – is large enough to absorb the gathering tide of writedowns. After seeing the first quarter results, and believing that monetary and fiscal policy will be able to reduce the overall level of credit losses and spread them out across several quarters, provided the shutdown doesn’t last more than six months, we subscribe to it. We are a buyer of the largest banks on the view that the monetary and fiscal support will reduce and stretch out the inevitable writedowns enough to allow the banks to earn their way through them without suffering meaningful book-value declines. Let’s go back to the beginning on the pre-tax PPNR[.] [W]e feel [that earnings power] has us in good stead in terms of [our] ability to absorb whatever circumstances play out here. The reality is how much earnings capacity [we] have to keep generating capital and … earnings that [we] can offset whatever comes at [us] and that’s what we feel good about. (Moynihan, BAC) Table 3A Solid Month's Work The SIFI put options we flagged four weeks ago have expired worthless, yielding a tidy 9% one-month gain for investors who wrote them (Table 3). That call was founded on the interaction between low book-value multiples and astronomical implied volatilities, but didn’t fully embrace the banks. We are ready to take the next step now because we believe pre-provision earnings will match or exceed the somewhat attenuated stream of credit losses, allowing investors to buy the biggest banks at a price-to-tangible-book multiple with a margin of safety that would comfort Benjamin Graham. We recommend overweighting the largest banks in US equity portfolios.2   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com. 2 Our US Equity Strategy service rates the S&P 500 banks group overweight, albeit with a downgrade alert.

Overweight Home improvement retailers (HIR) were the first consumer discretionary stocks to sniff out the end of the Great Recession, troughing even prior to the China-sensitive materials and industrials equities. As such we believe these economically hyper-sensitive stocks will once again showcase their early cyclical status. We recommend augmenting exposure to above benchmark (please see the most recent Weekly Report for additional details). ZIRP along with the rising gap between house price inflation and mortgage refinancing rates are a tonic for home improvement retailers (fed funds rate shown inverted, top panel). While the residential real estate market will remain in the doldrums for a few months (we recently monetized impressive gains in our underweight stance in the S&P homebuilding index and lifted to neutral), mortgage holders that retain their jobs will be quick to benefit from lower refinancing rates, and boost their savings. Some of these savings will likely flow into home renovation activities courtesy of the recent quarantine rules. Bottom Line: Boost the S&P HIR index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.    

Special Report

Highlights As government bond yields have fallen to zero or below, many of our clients have asked us how to obtain income from other asset classes. In this report we analyze three income opportunities in the equity market: high-dividend yield stocks, dividend growth stocks, and preferred shares. High-dividend yield stocks have a large style bias to the value factor. Thus, investors who wish to invest in high-dividend yield stocks might be better served by investing in dividend plays in the non-value universe. Dividend growth stocks – such as the ones in the S&P 500 Dividend Aristocrats index – are historically less likely to cut their dividends, thanks to their defensive nature and corporate incentives. The Aristocrats should continue increasing dividends during this crisis. Our screening points to the following as the most attractive: ExxonMobil, Franklin Resources, 3M, Procter & Gamble, AT&T, and Genuine Parts. We would not buy US preferred shares, given that they are heavily weighted to Financials, a sector that will do poorly in an environment of low interest rates. Feature As the crisis caused by COVID-19 has battered risk assets, many of our clients have asked us how to obtain income in this current environment. In the past, investors could rely on a consistent coupon provided by government bonds. However, this is no longer the case. The crisis has dragged DM government bond yields around the world to below or near zero, which means that investors looking for income opportunities must search outside of government bonds, in riskier asset classes. One such asset class is equities. Over the last 50 years, income return has accounted for roughly a third of the total return of global equities (Chart 1, top panel). Moreover, in contrast to other sources of equity return such as earnings growth or multiple expansion, income return is always positive, making it much more consistent through time as well as resilient to recessions (Chart 1, middle and bottom panels). However, there are a couple of drawbacks to equities as income-generating assets: The income yield of equities is not particularly high, especially when one compares them with asset classes such as corporate debt which have similar or lower volatility (Chart 2, top panel). As opposed to fixed-income assets, where a set income return is guaranteed provided there is no default and the security is held to maturity, companies can actually cut their equity dividends when they come under stress. As a consequence, while trailing dividend yield is often an accurate indicator of future income return, it can overestimate it during bear markets (Chart 2, bottom panel). Chart 1Dividends Make Up A Substantial Portion Of Equity Returns Chart 2The Income Return Of Equities Is Low And Can Be Deceiving During Bear Markets In this report we examine two different dividend strategies that try to address the issues above: high-dividend yield stocks and dividend growth stocks. In addition to these strategies within the common equity space, we also explore whether preferred shares can be an attractive income opportunity. For each of these three income strategies we try to answer the following questions: How are these dividend indices constructed? How has each strategy performed historically? How has it performed during bear markets? What is the sector composition of each strategy? How are valuations now? To answer these questions, we examine the MSCI High-Dividend Yield indices, the S&P Dividend Aristocrat indices and the iShares Preferred Shares indices. Moreover, based on our analysis, we also make some recommendations as to which is the best income strategy in equity markets for the current environment. Please see our Investment Implications section for more details. High-Dividend Yield Stocks As their name suggests, high-dividend yield indices select for stocks with the highest dividend yields. In practice however, many more screening criteria are imposed. In order to ensure some stability in dividend payout, MSCI excludes REITs, payout outliers, negative dividend growth stocks, low-quality stocks, and low-performance stocks. Once all of these screening criteria are applied, MSCI selects for stocks which have a dividend yield that is at least 30% higher than its benchmark. Table 1 shows details on these screening criteria. Table 1Criteria For MSCI High-Dividend Yield Indices How has the MSCI High-Dividend index performed historically? Since 1996, high-dividend yield stocks have outperformed the benchmark at the global level by 50% (Chart 3, top panel). This outperformance has been mostly a result of the income advantage this index provides, given that price return has outperformed only by a paltry 3%. It is also worth noting that price performance has been particularly poor since the Financial Crisis, and has actually caused high-dividend yield stocks to underperform on a total return basis over the past decade. Relative performance has been flat to down, even in those markets where high-dividend yield had been very successful previously such as Canada, Japan, and Emerging Markets (Chart 3, bottom panel). What has caused this underperformance? One reason is the low allocation that the high-yield index has to Technology (Chart 4, panel 1). Another reason is style tilt. Factor analysis reveals that the high-dividend yield index has a very strong value bias1 (Chart 4, panel 2). This strong style tilt is likely responsible for the poor relative price performance of high-dividend yield stocks, as value has been notorious for underperforming over the past decade (Chart 4, panel 3). Chart 3High-Dividend Yield Stocks Have Not Outperformed In The Past Decade Chart 4The High-Dividend Yield Index Has A Strong Value Bias   But while high-dividend yield stocks are an implicit bet on value, there is evidence that investing in high-dividend yield stocks within the non-value universe is a profitable strategy. In the paper “What Difference Do Dividends Make?”, Coronover et al. found that high-dividend yield companies actually outperform their low-dividend yield counterparts in the high and median price-to-book universes2 (Table 2). Additionally, they found that high-dividend yield stocks also performed better vis-à-vis low-dividend yield stocks in the mid-cap and large-cap universes. Table 2High-Dividend And Low-Dividend Yield Stocks Sorted By Price-To-Book And Market Cap Dividend Growth Stocks Dividend growth stocks are securities that have increased their dividend for a certain number of consecutive years.  In the US, companies with a track record of at least 25 years of dividend increases are usually called “dividend aristocrats”, while companies with a 10-year track record are known as “dividend achievers”.3 However, the requirements to be classified as a dividend aristocrat or a dividend achiever are not uniform across index providers, and even within providers they are not uniform across different countries, which means that investors need to pay attention to selection criteria when investing in a dividend growth index (Table 3). In this report we will focus on the best-known dividend growth index: the S&P 500 Dividend Aristocrats index. Table 3Different Criteria To Become A Dividend Aristocrat In Different Countries How has this index performed historically? The S&P 500 Dividend Aristocrats index has outperformed the S&P 500 by nearly 60% since 1995 in total-return terms and by more than 30% in price terms. Additionally, it has enjoyed less volatility and has outperformed significantly during recessions (Chart 5, panel 1). Chart 5Dividend Aristocrats Outperform During Bear Markets The main difference between the benchmark and the Aristocrats index comes down to sector tilt and leverage.  The second panel of Chart 5 shows that the Aristocrats index has a large overweight in Consumer Staples and a large underweight in Technology relative to the S&P 500. Meanwhile, while valuations are not that different, and equity profitability is actually lower, the companies in the Aristocrats index are significantly less levered than those of the S&P 500, a testament to their defensive nature (Table 4). Table 4Dividend Aristocrats Have Low Leverage But are dividend aristocrats really a more reliable source of income than the rest of the market? Empirically, they have been. In the US, the likelihood of a dividend increase in any given year has historically been a function of how many consecutive dividend increases a company has done before (Chart 6). Beyond the strong balance sheets and stable business models that dividend aristocrat companies have, this is most likely a result of the incentives created by the asymmetry of the index: A multi-decade policy of dividend increases is a significant investment of time and resources to signal stability to the market. However, the status obtained by this policy – and all the resources devoted to it– is immediately lost the moment dividends are cut, with no possibility of reclaiming it in at least a quarter century.4 Importantly, the longer a company raises dividends the bigger the investment becomes, creating a very high incentive to not cut dividends. That being said, sometimes this incentive is not enough to overcome extreme business conditions, such as those that occurred in 2008. Chart 7 shows that the members of the S&P Dividend Aristocrats index declined by roughly a third during the Financial Crisis, mostly as a result of previously reliable banks that had to cut their dividends in 2008 and 2009.5 Chart 6The Likelihood Of A Dividend Increase Is Higher For Dividend Aristocrats Chart 7Extreme Business Conditions Can Force Some Aristocrats Off The Index   Preferred Shares Preferred shares are securities which have traits of both debt and common equity: Like debt, they have a par value, no voting rights, and they provide a prespecified cash flow. Nevertheless, they do not have a maturity date and they represent an ownership stake in the company, just like common equity. Analyzing the historical performance of preferred shares is difficult since most indices begin only around the Financial Crisis. However, from the limited data we have, we can make some observations: Preferred shares in the US have underperformed common equity, investment- grade debt and high-yield debt since 2004 (Chart 8). They also experienced very deep selloffs during recessions, often similar to the selloffs that common equities have experienced (Table 5). However, preferred shares do seem to have similar return drivers to corporate credit. In particular, much like corporate credit, they tend to fall whenever yields on corporate debt rise (Chart 9). Chart 8Preferred Equity Has Underperformed Credit And Common Equity Table 5Preferred Equity Has Similar Drawdowns To Common Equity During Recessions Chart 9US Preferred Shares React Negatively To Rising Credit Yields Chart 10US Preferred Shares Are Heavily Tilted To Financials In theory, the co-movement of preferred equity and corporate debt is not that surprising. Much like credit, preferred shares are fixed-income securities which are subject to credit risk. Whenever yields on risky credit rise, these fixed-income securities become relatively less attractive, making their price fall. Chart 11Canadian Preferred Shares Are An Oil Play However, what is surprising is that preferred shares have underperformed both investment-grade and high-yield credit. How could an asset that technically has more risk – and thus should offer a better rate of return – underperform for such a long time? One plausible explanation is sector skew. Preferred shares are heavily skewed to Financials, a sector that has underperformed significantly over the past decade (Chart 10). While Financials tend to dominate most preferred indices, other factor may also affect returns. In Canada, the preferred share index is most sensitive to changes in the price of oil – a consequence of both the relatively high weight of Energy in the index, and the importance of the commodity for the Canadian economy (Chart 11). There are many types of preferred shares which include rate-resets, perpetuals, and variable rate. We do not analyze them in this report since indices tracking most of these securities have a very short history. We do advise our clients to be wary of compositional differences between indices, since sector composition could be a larger driver of returns than the type of preferred equity itself. Finally, while it is outside the scope of this report, it is worth remembering that preferred shares might still be worth looking at for taxable investors, given that dividends and interest income are often not taxed at the same rates. Investment Implications Dividend Growth Stocks Investors should consider including dividend growth stocks in their portfolios. Their defensive nature means that they should be able to weather the recession brought about by the coronavirus lockdowns better than the overall market, while their long-term dividend policy implies that these companies will be more reluctant to cut dividends. One drawback of the S&P 500 Dividend Aristocrat index is that it is yielding less than 3%. Thus, investors would be better served by selecting individual securities within the index. In order to help with this exercise, we have ranked the companies in the S&P 500 Dividend Aristocrat index according to our own GAA Income Score. The score is based on the following three traits: Raw Income: the company’s current dividend yield. Yield Stability: the number of consecutive years the company has raised its dividend. Attractiveness: The company’s current score from the BCA Equity Trading Strategy service. Please find the ranking of the S&P 500 Dividend Aristocrats in Appendix A. According to our GAA Income Score the best S&P 500 Dividend Aristocrats are ExxonMobil, Franklin Resources, 3M, Procter & Gamble, AT&T, and Genuine Parts. High-Dividend Yield Stocks What about high-dividend yield stocks? The MSCI All-Country World High-Dividend Yield index is currently yielding a formidable 5%, making it an attractive income opportunity. However, investors should remember that high-dividend yield stocks have a significant exposure to the value factor. GAA is currently neutral on value versus growth, but we are concerned that value continued to underperform when equities were falling and has not been able to outperform in recent weeks as equities rebounded. For those who do not want to take on value exposure, overweighting high-dividend yield within non-value stocks and mid and large caps might be a better option. Preferred Equity Currently preferred shares have a dividend yield of roughly 5%. Do they make an attractive income opportunity? We don’t believe so. Low interest rates and tepid loan growth even after the quarantines are over will likely weigh on Financials – the sector which preferred shares are most exposed to. Moreover, its strong similarity to corporate debt makes this asset somewhat redundant for investors who already own credit. Appendix Juan Correa Ossa  Associate Editor juanc@bcaresearch.com Footnotes 1 This is in part by construction. The MSCI Value index uses dividend yield as one of its variables to asses value. 2 Mitchell Coronover, Gerald R. Jensen, and Marc W. Simpson, “What Difference Do Dividends Make?”, Financial Analyst Journal, Volume 72, Number 6 (2016). 3 Companies which have increased their dividend for at least 50 years are sometimes called “dividend kings”. 4 Eberner Asem and Ahamsul Alam, “The Market’s Reaction To Consecutive Dividend Increases,” (December 2017). 5 Not all companies exit the index due to dividend cuts. Some companies exit because of corporate restructurings or because they no longer meet the minimum market capitalization to qualify.

Overweight In the most recent Weekly Report, we boosted the S&P consumer discretionary index to overweight via upgrading its heavy-weight internet retail sub-index to an above benchmark allocation. E-commerce has been garnering a rising market share of total retail sales uninterruptedly for over two decades. In fact, this juggernaut accelerates during recessions not only because overall retail sales level off, but also because internet sales prove resilient during downturns (see chart). AMZN dominates the internet retail space and by extension the broad consumer discretionary index, especially ever since the media complex migrated to the newly formed S&P communications services index in October 2018. Therefore, as AMZN goes, so goes the rest of the consumer discretionary sector. Time and again we have stressed that when growth is scarce investors flock to industries that exemplify growth. The inevitable rise in online retail sales as a percent of total due to the ongoing pandemic will underpin demand for e-commerce services. Bottom Line: Boost the S&P internet retail index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE.  

Highlights Stay tactically neutral to equities. The market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. The long-term threat to equities comes from the pandemic’s lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. Long-term investors should prefer equities over bonds, with the caveat that the threat does not materialise. Long-term equity investors should avoid oil and gas and European banks at all costs… …but healthcare, European personal products, and European clothes and accessories should all form core long-term holdings. Fractal trade: long nickel / short copper. Feature Chart of the WeekSales Per Share Must 'Catch Down' With GDP, Just Like In 2008 The sharp snapback rally in stock markets has reached an important resistance point – the critical Fibonacci level of a 38.2 percent proportionate retracement of the sell-off.1 Technical analysts define the sell-off in terms of the most recent peak to trough. But we define it differently. We define it in terms of the longest time horizon of investors that capitulated at the sell-off. The market may meet some short-term resistance. The longest time horizon of investors that capitulated at the sell-off’s climax on March 18 was a seven-quarter horizon. Hence, we define the sell-off as the seven-quarter decline to March 18. On that basis, and using the DAX as our benchmark, we would expect the index to meet resistance at around a 21 percent retracement rally from the March 18 low. Which is pretty much where the DAX stands right now (Chart I-2).2 Chart I-22020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement After A Sharp Snapback Rally What Happens Next? The maximum length of investment horizons that capitulated on March 18 was unusually long at seven quarters. This should comfort long-term investors because of an important investment identity: Financial markets have fully priced a downturn when the longest time horizon of investors that have capitulated = the length of the downturn. So, the good news is that the March 18 bottom should hold if the downturn does not last longer than seven quarters. In this regard, the main risk of a protracted downturn comes not from the pandemic itself. Even if the pandemic returns in second and third waves, any economic shutdowns, full or partial, should last considerably less than seven quarters. Instead, the main risk comes from lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. The long-term threat comes from the pandemic’s after-effects on economic and political systems. But a protracted downturn of what? As we are focussing on the stock market, the downturn is not of GDP per se but its stock market equivalent: sales per share. In the long run, sales per share and GDP advance at the same rate. But the sector compositions of the stock market and GDP are not the same, so over shorter periods sales per share can underperform or outperform GDP. In which case, sales per share must catch up or catch down (Chart of the Week). In 2008, sales per share had to catch down. As a result, world sales per share declined for seven quarters through 2008-10, considerably longer than the decline in GDP (Chart I-3). Hence, the stock market found its bottom in early March 2009 when the longest time horizon of investors that had capitulated had reached seven quarters (Chart I-4). Chart I-32008-10: Sales Per Share Fell For Seven Quarters Chart I-42009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement From this March 2009 bottom, the Fibonacci retracement equated to a 35 percent advance, which the market achieved by early June 2009. Thereafter, stocks met short-term resistance and gave back some of the snapback rally. Fast forward to 2020. Having likewise reached the Fibonacci retracement, the market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. Assuming no lasting after-effects from financial distress or political backlash, the next sustained advance will happen later this year. Valuations Flatter Equities, But They Still Beat Bonds Turning to long-term investors the three most important things are: valuation, valuation, and valuation. Our favourite valuation measure is price to sales, which has been a good predictor of 10-year prospective returns going back to at least the 1980s (Chart I-5). Chart I-5Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 But the predictive power depends on a crucial underlying assumption – that the past is a good guide to the future. Specifically, today we must assume that the pandemic causes just a brief blip in the multi-decade uptrend in stock market sales and profits. To repeat, the main long-term threat to stock markets comes not from the pandemic itself. The long-term threat comes from the pandemic’s after-effects on economic and political systems – such as crippled banking systems or large-scale nationalisations of the private sector. Furthermore, price to sales will err in its prediction if sales per share have deviated from GDP – implying either a future catch up or catch down. In the 1990s sales per share had underperformed GDP, so future returns outperformed the valuation prediction. However, in 2008 sales per share had outperformed GDP, so future returns underperformed the prediction. Today, just as in 2008, sales per share have become overstretched relative to GDP, so there will be a catch down. Which will weigh down prospective returns relative to what valuations appear to imply. Still, even adjusting for this, equities are likely to produce annualised nominal returns in the mid-single digits, comfortably higher than the yields on long-term government bonds. Hence, with the caveat that the pandemic does not generate lasting after-effects for economic and political systems, long-term investors should prefer equities over bonds. What Not To Buy, And What To Buy If a stock, sector, or stock market maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. In this case, the lower share price is stretching the elastic between the price and the up-trending profits, resulting in an eventual snap upwards. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the elastic may be forced to snap downwards! Do not buy sectors whose profits are in major downtrends. This leads to a somewhat counterintuitive conclusion for long-term investors. After a big drop in the stock market, do not buy everything that has dropped. And do not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. Specifically, the profits of oil and gas and European banks are in major structural downtrends (Chart I-6 and Chart I-7). Long-term equity investors should avoid these sectors at all costs. Chart I-6Oil And Gas Profits In A Major ##br##Downtrend Chart I-7European Banks Profits In A Major Downtrend Conversely, the profits of healthcare, European personal products, and European clothes and accessories are all in major structural uptrends (Chart I-8 - Chart I-10). As such, all three sectors should be core holdings for all long-term equity investors. Chart I-8Healthcare Profits In A ##br##Major Uptrend Chart I-9European Personal Products Profits In A Major Uptrend Chart I-10European Clothing Profits In A Major Uptrend Fractal Trading System* Given the outsized moves in markets over the past month, all assets have become highly correlated making it more difficult to find candidates for trend reversals. Chart I-11Nickel Vs. Copper However, we find that some relative moves within the commodity complex have not correlated with risk on/off. Specifically, the underperformance of nickel versus copper is technically stretched, so this week’s recommended trade is long nickel / short copper, setting a profit target of 11 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 67 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 0.382 = 1- phi. Where phi is the Golden Ratio, defined as the ratio of successive Fibonacci numbers in the limit. Alternatively, phi =1 / (1 + phi). 2 The seven-quarter sell-off in the DAX (capital only) to March 18 2020 was 39.4 percent, so a full retracement rally equals 65.1 percent, and a 0.382 geometric retracement equals 21.1 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Feature In this report, we determine which South and Southeast Asian countries are better equipped to endure the COVID-19 pandemic. Answers to this question combined with our macro fundamental analysis lead us to recommend which countries to favor or avoid. We assess several factors in regard to the COVID-19 shock: (1) the healthcare capacity in each country, (2) the COVID-19 containment measures that have been implemented, and (3) the magnitude of fiscal and monetary stimulus packages that have been announced. We conclude that EM equity investors should keep an overweight position in Thai equities and a neutral one in the Malaysian stock market. Indian, Indonesian and Philippine stock markets, on the other hand, warrant an underweight stance. Healthcare System Capacity The COVID-19 virus can cause individuals with underlying medical conditions and already in poor health, as well as those above a certain age, to become seriously ill when infected. These patients will require the kind of special medical attention  – such as ventilation – that is only provided in a hospital’s intensive care unit (ICU). A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks overburdening the health care system. This would be a social catastrophe. A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks over¬burdening the health care system. Therefore, a key measure of the current coronavirus crisis is the relation between a population’s risk of developing critical illness from COVID-19 infections and a country’s intensive care unit (ICU) availability. We assess the risk of COVID-19 infections developing into critical illnesses in ASEAN countries and in India by gauging (1) the prevalence of diabetes in the population and (2) the share in population of people above the age of 60. Chart I-1 and Chart I-2 illustrate these factors separately. Chart I-1ASEAN & India: Population With Diabetes Chart I-2Population Above 60 Years Old In addition, we combine these two risk variables to calculate the risk of critical illness. This measure is shown in Chart I-3. The measure shows that the population of both Malaysia and Thailand carry the highest risk of developing critical illnesses from COVID-19, owing to Malaysia’s high prevalence of diabetes and to Thailand’s rapidly aging population. Meanwhile, that risk is somewhat lower in India and dramatically lower in both the Philippines and Indonesia.  The next thing to look at is each country’s ICU capacity. Chart I-4 shows the number of ICU beds available per 100,000 people. Thailand has the highest number and Malaysia the second highest. On the other hand, India, Indonesia and the Philippines all have lower rates of ICU capacity. Chart i-3The Risk Of Critical Illness From COVID-19 Chart I-4Intensive Care Unit (ICU) Capacity Finally, we compare the risk of critical illness in each country to its available ICU capacity. Chart I-5 shows a scatter plot between these two variables. The risk of critical illness is shown on the Y-axis and the availability of ICU beds per 100,000 people is plotted on the X-axis. Thailand and Malaysia both have the highest risk of critical illness but also a large number of available ICU beds. India, Indonesia and the Philippines have lower average risk of critical illness but also far fewer ICU bed availabilities. Chart I-5The Risk Of Critical Illness Versus ICU Capacity It is also important to note that Malaysia has the highest relative number of medical doctors per 10,000 people in the region (15 versus an average of 8). Furthermore, both Malaysia and Thailand appear to be performing many more COVID-19 tests. That in turn should help slow the spread of the virus and avoid overwhelming health care systems of Malaysia and Thailand. Bottom Line: Thailand and Malaysia have decent healthcare care capabilities relative to the threat of critical illness among their populations. India, Indonesia and the Philippines, on the other hand, seem relatively unprepared to weather this outbreak. Containment Response The magnitude and effectiveness of social distancing measures implemented is a critical means of protecting a country’s health care system. Indeed, the sooner such measures are put into place, the earlier the threat of the pandemic is likely to subside. This will then allow a country to normalize its economic activities sooner.  It appears that the Philippines and India have enacted the most stringent social distancing measures. Both announced complete lockdowns and called in their respective national armies to intervene. Malaysia has also announced extremely inhibitive measures and their enforcement has been quite successful. In Thailand, while the authorities have not imposed a complete lockdown, they have placed curfews and checkpoints that are subject to extension. Thai authorities have also warned that more restrictive measures could be imposed if residents do not comply. Indonesia, on the other hand, has been much softer on enforcement and is reluctant to introduce additional measures due to its economic concerns. Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Remarkably, the effectiveness of the measures can be quantitatively assessed via Google’s COVID-19 mobility tool and TomTom’s traffic congestion data. The average of all Google’s mobility variables, as of April 5, has declined most significantly in the Philippines, Malaysia, and India, relative to baseline values (Chart I-6).1 Likewise, TomTom’s traffic congestion data for the major cities in these same countries’ shows a similar decline during average peak hours over the first two weeks of April 2020, relative to the same period in 2019 (Chart I-7). Chart I-6How Effective Are Social Distancing Measures? Chart I-7Decline In Traffic From ##br##A Year Ago Bottom Line: The Philippines, India, and Malaysia have imposed the most effective and successful social distancing measures. This is then followed by Thailand. Indonesia on the other hand has not been as effective in this aspect. Fiscal And Monetary Stimulus Table I-1Stimulus Packages So Far Announced The magnitude of the stimulus plans announced by each country is also important. Once the pandemic subsides and social distancing measures are relaxed, countries with a larger stimulus package in place should experience a faster economic recovery. Table I-1 shows the size of the overall stimulus packages announced so far. Malaysia and Thailand have the largest overall stimulus packages to the tune of 16% and 14% of GDP, respectively. India, Indonesia and the Philippines fall well short of these levels. Regarding monetary policy, central banks in all these countries have been cutting policy rates and injecting local currency liquidity. However, some of the programs announced by some of the central banks stand out: The Bank Of Thailand will inject 400 billion baht ($13 billion or 2% of GDP) into the corporate bond market. The central bank is also allocating 500 billion baht ($15 billion or 3% of GDP) of soft loans to small-and mid-sized companies.2 The central bank of the Philippines will be purchasing 300 billion pesos worth of government bonds ($6 billion or 1.6% of GDP) under a 3- to 6-month repurchase agreement to aid government efforts in countering the pandemic. Bank Indonesia may also begin buying government bonds (recovery/pandemic bonds) directly from the primary market. Details are not yet clear but the Indonesian government plans to issue $27 billion worth of these bonds and the central bank might emerge as the largest buyer. Similarly, the Reserve Bank of India has been injecting liquidity and purchasing government bonds for some time now. For instance, it announced a 1 trillion rupees injection in February – or $13 billion – via the long-term repo operation channel. It is now infusing an additional 1 trillion rupees through the same channel. It will also continue purchasing government bonds and securities to keep liquidity aflush and suppress market interest rates. Crucially, Governor Shaktikanta Das indicated that the RBI might even be forced to purchase government bonds directly from the primary market and that all options – including non-conventional ones – are on the table. Bottom Line: Both Thailand and Malaysia have so far announced larger overall stimulus packages than Indonesia, the Philippines and India have. This combined with their better health care capacities, suggests that the Thai and Malaysian economies will recover more quickly than they will in India, Indonesia and the Philippines. Conclusions Having considered risk of critical illness, the ICU availability and general medical capacities, the effectiveness of social distancing measures, and the stimulus packages each country has announced, Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Despite their elevated risk of critical illness, both countries have decent healthcare system capacities. Additionally, Malaysia has put in place very effective social distancing measures. Meanwhile, Thailand is placing curfews and monitoring developments very closely. Finally, both countries have enacted massive stimulus packages that will aid in the recovery of their economies later this year.  Notably, Thailand and Malaysia have been running current account surpluses for a long period of time whereas India, Indonesia and the Philippines generally run current account deficits. This, in turn, will allow the former to implement much larger overall stimulus packages than the latter, without risking major currency depreciation. Despite strong and successful social distancing efforts, India and the Philippines are hampered by a weakness in their health care infrastructures. They also are unlikely to be able to provide a large enough stimulus without subjecting themselves to significant currency depreciation. Additionally, India also has an elevated critical illness risk. Finally, Indonesia is likely to emerge from the crisis in the weakest position. Its healthcare system capacity is weak, the social distancing measures it implemented are insufficient and its enforcement has been lax. Indonesia is likely to emerge from the crisis in the weakest position. The government has also been timid about enacting significant stimulus given that it runs a large current account deficit. Moreover, it is unwilling to tolerate any further large currency depreciation due to the elevated foreign currency debt that Indonesian companies and banks carry. The latter stands at  $124 billion in the form of both bonds and loans. Investment Strategy Chart I-8Thai Stock Prices Vs. Emerging Markets The following is our strategy recommendations for each country: Thailand: Our equity overweight stance on this bourse has been significantly challenged since early this year (Chart I-8). However, Thai stocks seem to be holding up at an important technical support level in relative terms.       Furthermore, as of December 2019, the ownership of the country’s local currency bonds was low at 17% (i.e. even before the global sell-off commenced). Further selling by foreigners should therefore be limited, which should reduce renewed depreciation pressures on the Thai currency. We recommend that respective EM portfolios keep an overweight position on Thai equities, sovereign US dollar and local currency bonds. Malaysia: On the one hand, Malaysian stocks have been underperforming EM benchmarks since 2014. Also, foreign ownership of Malaysian local currency bonds has declined from 34% in 2016 to 25% as of December 2019. This limits the possibility of future foreign selling. On the other hand, the economy was facing severe deflationary pressures even before the COVID-19 shock occurred. The latter will only reinforce these deflationary dynamics. Considering the positives and the negatives together, we recommend a neutral allocation to Malaysia within an EM equity portfolio. The Philippines:  Philippine stock prices relative to EM seem to have broken below a critical support level that will now act as resistance (Chart I-9). Moreover, local currency government bond yields have risen sharply (Chart I-10 and Chart I-11). This does not bode well for real estate and bank stocks that account for a very large market-cap chunk of the Philippine MSCI Index (46%). Critically, government expenditures were strong even before the COVID-19 pandemic occurred and it was only a matter of time before that contributed to higher imports. Now that exports are crashing - due to collapsing global demand - and imports are likely to remain high because of even higher government spending/fiscal stimulus, the current account deficit will widen substantially. This will cause the peso – which has been holding up so far – to depreciate significantly. Stay underweight on this bourse and local currency government bonds relative to their respective EM benchmarks. We also recommend keeping a short position on the Philippine peso versus the US dollar. Chart I-9Philippine Stock Prices Vs. Emerging Markets Chart I-10Philippine Yields In Absolute Terms... Chart I-11...And Relative To Their EM Peers India: We discussed India in detail in a recent report. We recommend an underweight position amid the pandemic. In previous years, private banks lent enormous amounts to consumers via mortgages and consumer loans/credit cards. Therefore, the performance of both sectors has been contingent on the health of the Indian consumer sector. However, the outlook for the Indian consumer has worsened dramatically because of the unprecedented income hit households will suffer from the lockdown. Moreover, social safety nets and health care capacities (as mentioned above) are very weak in India. Indonesia: We also discussed Indonesia in detail in a report published on April 2. In recent years, the Indonesian bourse benefited from lower US interest rates and ignored deteriorating domestic fundamentals and lower commodities prices. Global investors’ increased sensitivity to individual EM fundamentals amid this pandemic will only make Indonesia’s weakest spots – like its exposure to commodities and its anemic domestic demand – more apparent. With global growth being very weak, commodities prices will remain low – reinforcing currency depreciation and pushing corporate bond yields higher. Combined with relapsing domestic growth, the Indonesian bourse will likely continue underperforming. Bottom Line:  Within an EM equity portfolio, we are keeping an overweight position on the Thai stock market. We also recommend keeping Malaysian equities on neutral. Our equity underweights are India, Indonesia, and the Philippines. In terms of fixed income markets, we recommend overweighting Thai, Malaysian and Indian local currency bonds and US dollar sovereign bonds. We recommend underweighting Indonesian and Philippine local and US dollar sovereign bonds.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 The baseline is the median value between January 3 and February 6. Our average calculation includes retail & recreation, grocery & pharmacy, parks, transit stations, and workplaces. It excludes the residential variable. 2 Note that this is part of the stimulus shown in Table 1.

The chart shows that the Fed is on track to balloon its balance sheet over $11tn in the coming year, i.e. almost trebling it, and soaring to over 50% of GDP. Beyond the Fed’s QE5 liquidity injection and skyrocketing bank credit, in response to firms tapping existing credit lines, money seems to be growing on trees. M2 money supply growth spiked to 14.8% of late, the highest rate since WWII! This breakneck pace of M2 growth translates into $2tn created versus last year. In the past two weeks alone, M2 grew by $805bn. Deposits and money market funds’ assets are surging, driving the money supply to unprecedented levels. While we have sympathy to some investors’ view that very little of this money and credit will flow to the real economy, such flush liquidity is likely to spillover from the banking system. Asset prices will be the primary beneficiaries of that flood. Bottom Line: We continue to recommend investors with a cyclical time horizon deploy capital into the market. Please refer to this Tuesday’s Weekly Report for more detail.