Asia

Feature We closed our short position in EM equities last week but still maintain our short recommendation on EM currencies. Going forward we will be looking for signs of a durable bottom in risk assets. The clash between forthcoming massive economic stimulus around the world and the unprecedented plunge in global economic activity has generated a great deal of uncertainty over the magnitude and duration of the global recession. In turn, enormous ambiguity continues to produce extreme gyrations in financial markets. The unparalleled drop in the level of business activity and uncertainty over the length of lockdowns make it impossible to determine how much stimulus is required to produce a V-shaped recovery. Notably, all these stimuli will have an effect on the real economy with a lag. In the meantime, the real economy will remain in an air pocket. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Chart 1China: Level Of Business Activity Is Still Lower Than A Year Ago Even in China, where the authorities have been stimulating and trying hard to restart the economy following lockdowns, the level of business activity remains below last year’s levels. In particular, Chart 1 illustrates that residential floor space sold in Shanghai in the past couple of weeks remains 60% lower than a year ago. This reveals how difficult it is to reboot discretionary consumer spending and business investment following a negative income shock. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Such heightened uncertainty warrants a higher risk premium. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Review Of Indicators The following market-based indicators lead us to believe that the selloff is in a late-stage, but not over. Chart 2More Downside In This Risk-On/Safe-Haven Currency Ratio Our Risk-On/Safe-Haven1 currency ratio is in free fall but has not reached the level that marked its 2011 and 2015 troughs (Chart 2). It is still well above its 2008 level.  Odds are that this indicator will drop to 2011 and 2015 levels before staging a major recovery. EM share prices, commodities and global cyclical stocks correlate closely with this ratio. A further drop in Risk-On/Safe-Haven currency ratio will be consistent with more downside in EM equities, resource prices and global cyclicals. The global stock-to-US 30-year bond ratio has crashed but is still above its 2008 trough (Chart 3). Given this global recession is worse than the one in 2008, it is reasonable to expect the ratio to drop to its 2008 level before recovering. The gold-to-US bonds ratio2 has not yet broken out of its rising channel (Chart 4). Only a decisive breakout above the upper boundary of this channel will confirm a sustainable rally in reflation plays. Chart 3Global Stock-To-Bond Ratio: More Downside Is Likely Chart 4The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade Meanwhile, the industrial metals-to-gold ratio has plunged below its 2008 and 2015/16 lows (Chart 5). This qualifies as a structural regime change in this indicator. Odds are that this ratio will continue to fall, heralding further weakness in global cyclicals in general and EM risk assets in particular.   The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows (Chart 6). Such a breakdown typically entails additional decline. The latter will be consistent with more weakness in global cyclicals versus defensives. Chart 5A Noteworthy Breakdown Chart 6Cyclicals Vs Defensives Interestingly, Chinese equity indexes have dropped less than their global and EM peers. Nevertheless, cyclical sectors within the Chinese equity universe are exhibiting very disturbing chart patterns. Chinese bank stocks appear to be in a genuine downtrend, with no immediate support (Chart 7, top panel). Property developers in the onshore A-share market have hit key resistance levels and appear to be vulnerable to the downside (Chart 7, middle panel). Finally, Chinese investable small-cap stocks have broken down, and their path of least resistance is down (Chart 7, bottom panel). Overall, the relative resilience of Chinese share prices has been due to tech and “new economy” stocks. The rest of Chinese equities have been quite week in absolute terms. Finally, the net aggregate long position in US equity futures by asset managers and leveraged funds as of March 17 was still above its 2011 and 2016 lows (Chart 8).  It is reasonable to expect that the ultimate capitulation in US stocks will be consistent with a lower reading of this indicator. Chart 7Weak Internals Of Chinese Equity Markets Chart 8No Capitulation Among Investors In US Equity Futures     Bottom Line: The recent rebound in EM risk assets is unlikely to be sustainable. Several important indicators are not confirming a durable rally in reflation plays. Investment Strategy Even though EM equities have become cheap and very oversold as we discussed last week, odds are that the bear market in EM risk assets and currencies is not yet over. It might be too late to sell EM stocks, but also too risky to buy them aggressively. Chart 9EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction Provided the selloff in EM fixed-income markets commenced only a couple of weeks ago, it will likely persist as investors facing losses are forced to further trim their positions (Chart I-9). We continue to recommend staying put on EM fixed-income markets. As EM US dollar and local currency bond yields rise, EM share prices will struggle. Finally, EM currencies remain vulnerable against the greenback. We are maintaining our short in a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Reshuffling EM Equity Country Allocation We are making the following changes within a dedicated EM equity portfolio: Upgrading Peru from neutral to overweight, and Colombia from underweight to neutral. Both bourses have underperformed substantially and warrant a one-notch upgrade. Peru will - on the margin - benefit from relative resilience in gold and silver prices. The collapse in Colombia’s relative equity performance is advanced. While we are not bullish on oil prices, we are protecting our gains on the underweight Colombian stocks allocation by moving it to neutral. Reiterating our underweight allocations in both Indonesian and Philippine equities. Both bourses are breaking down relative to the EM benchmark (Chart I-10). More downside is in the cards. Readers can click here to access our latest fundamental analysis on financial markets in Indonesia and the Philippines.  Maintaining our overweight positions in Korean and Thai equities. Underperformance in both bourses relative to the EM benchmark is at a late stage. We expect the relative performance of these markets versus the overall EM equity index to find a support close to current levels (Chart I-11). Chart 10Continue Underweighting Indonesian And Philippines Equities Chart 11Overweight Korean And Thai Stocks Within The EM Universe Downgrading UAE from overweight to underweight. We have been bearish on oil prices, but the speed of the collapse in crude prices has wreaked havoc on Gulf equity markets. Similarly, the speed of decline in oil prices has caused considerable tremors in Mexican and Russian financial markets. Our overweight position in Russian equities is now back to its breakeven level, but the one in Mexican stocks is deep under water. We are reiterating our overweight in both bourses but have much lower conviction on Mexican stocks versus Russian ones. We will publish an updated analysis on Mexico in the near term. Finally, we have been and remain neutral on the following equity markets relative to the EM benchmark: China, Taiwan, India, Malaysia, Brazil and Chile. We have been negative on Brazil but have not formally downgraded it to underweight. Among our underweights are also Turkey, South Africa and Hong Kong domestic stocks. The complete list of our equity recommendations is available on page 8. Our fixed-income and currencies recommendations are available on page 9 (all of our recommendations are always enclosed at the end of our Weekly Reports and are available on our Website as well).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Average of CAD, AUD, NZD, BRL, IDR, RUB, CLP, MXN & ZAR total return indices relative to the average of CHF & JPY total returns. 2   It is calculated by dividing gold prices by total return on 10-year US government bonds. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Bank Credit Analyst

Highlights The global economy is in the midst of a painful recession. Monetary and fiscal authorities are responding forcefully to the crisis, but the lengths of the lockouts and quarantines remain a major source of downside risk to the economy. Investors should favor stocks over bonds during the next year. The short-term outlook remains fraught with danger, so avoid aggressive bets. Central banks can tackle the global liquidity crunch, thus spreads will narrow and the dollar will weaken. The long-term impact of COVID-19 will be inflationary. Feature “The only thing we have to fear is fear itself.”    Franklin Delano Roosevelt  1932 A violent global recession is underway. Last month, we wrote that a deep economic slump would be unavoidable if COVID-19 cases could not be controlled within two to three weeks.1 Since then, the number of new, recorded COVID-19 cases has mounted every day and fear prevails. Consumers are not spending; firms will face a cash crunch and/or bankruptcy, and employment will be slashed. The next few quarters could result in some of the worst GDP prints since the Great Depression. Risk assets have moved to discount this dire scenario. The global stock-to-bond ratio has collapsed by 47% since its peak on January 17th and stands at the 1st decile of it post-1980 distribution. 10-year US bond yields temporarily fell below 0.4%. The dollar has rallied against every currency and even gold traded below $1500 an ounce. Brent crude trades below $30/bbl. In this context, investors must assess if risk asset prices have declined enough to compensate for the economic hazards created by the COVID-19 pandemic. If the massive amount of monetary and fiscal stimulus announced can turn around the economy in the second half of the year, then stocks and risk assets are attractive. Otherwise, they are still not cheap enough and cash remains king. We think it is a good time to begin to parsimoniously deploy capital into risk assets. A Global Recession And An Extraordinary Response The global economy has suffered its worst shock since the Great Financial Crisis (GFC), but policymakers are deploying every tool available. In our base case, GDP will contract more quickly for two quarters than it did during the GFC, and then will recover smartly. It is hard to pinpoint exactly how quickly global GDP will contract in the next six months, but key indicators point to a grim outcome. Chart I-1Global Growth Is Plunging China’s economy was at the forefront of the COVID-19 pandemic and its trajectory provides a glimpse into what the rest of the world should anticipate. In February, Chinese retail sales contracted by 20.5% annually and industrial production plunged by 13.5%. The German ZEW survey for March paints an equally bleak picture. The growth expectations component for the Eurozone and Germany fell to its lowest level since the GFC. The same indicator, but computed as an average of US, European and Asian subcomponents is also collapsing at an alarming pace (Chart I-1). The European flash PMI for March also points to a deep slowdown, with the services PMI plunging to 28.4, an all-time low. The performance of EM carry trades flashes a somber warning for our Global Industrial Production Nowcast (Chart I-2). Carry trade returns are imploding because global liquidity is incapable of meeting the demand for precautionary money by economic agents. This lack of liquidity is inflicting enormous damage on worldwide growth. Live trackers for US and global economic activity are also melting down. Traffic in some of the US’s largest cities is a fraction of last year's (Chart I-3). Globally, restaurant bookings have dried up and fewer airlines are flying compared to 2008. Initial jobless claims in the US have surged to 3.28 million, rapidly and decisively overtaking the weaknesses seen during the GFC. Chart I-2The Liquidation Of Carry Trade Is A Bad Omen Chart I-3Live Trackers Are In Free Fall   Despite the dismal situation, some positive developments are emerging. It has been demonstrated that quarantines contain the spread of the virus. On March 18th, Wuhan recorded no new COVID-19 cases. Moreover, 10 days after its January 24th quarantine began, new cases started to fall off quickly (Chart I-4) in the city. If the recent softening in new cases in Italy’s Lombardy region continues, it will illustrate that democratic regimes can also reduce the pace of infection. Chart I-4Quarantines Do Work Most importantly, policymakers around the world have shown their willingness to do “whatever it takes.” Governments are easing fiscal policy with abandon. Germany’s state bank KfW is setting aside EUR550 billion to support the economy. France will spend EUR45 billion and has earmarked EUR300 billion in small business loan guarantees. Spain announced EUR200 billion to protect domestic activity. The White House just passed a stimulus package of $2 trillion, and Canada follows suit with a CAD82 billion relief bill. (Table I-1). As A. Walter and J. Chwieroth showed, the growing financial wealth of the middle class is forcing governments to always provide large bailouts after financial crises and recessions. Otherwise, their political parties suffer extreme repudiation from power.2 Table I-1Massive Stimulus In Response To Pandemic Central bankers have also become extreme reflators. Nearly every central bank in advanced economies has cut interest rates to zero or into negative territory. Most importantly, central banks have become lenders of last resort. The US Federal Reserve has announced it will engage in unlimited asset purchases; it has reopened various facilities to provide liquidity to the market and is using the US Department of the Treasury to lend directly to the private sector. Among its many measures, the European Central Bank is scrapping artificial limits on its bond purchases that were its capital keys and has offered a EUR750 billion bond purchase program. The ECB is also looking to open its OMT program. Other central banks are injecting cash directly into their domestic markets (Table I-2). The list and size of actions will expand until the markets are satiated with enough liquidity. Table I-2The Central Banks Still Had Some Options When Crisis Hit The impact of these policy measures is threefold. First, the actions are designed to alleviate the global economy’s cash crunch. Secondly, they aim to support growth directly. The private sector needs direct backing to survive the lack of cash inflows that will develop in the coming weeks. If fiscal and monetary authorities can plug that hole, then spending will not have to collapse as deeply nor for as long as would otherwise be the case. Finally, it is imperative that policymakers boost confidence and ease financial conditions to allow “animal spirits” to stabilize. If risk-taking continues to tailspin, then spending will never recover and the demand for cash will only grow, creating the worst liquidity trap since the Great Depression. Policymakers around the world have shown their willingness to do “whatever it takes.” The economy will continue to weaken in the second half of 2020 if quarantines remain in place beyond the summer. Not being epidemiologists, we are not equipped to make this call with any degree of certainty. Much depends on the evolution of the disease and the political decisions taken. We do not yet know if the population will be willing to endure the economic pain of a depression, or if political pressures will rise to force isolation on those over age 60 and those suffering dangerous comorbidities who are at higher risk, and allow everyone else to return to work and school.3 Investment Implications Part 1: Bonds and Stocks Chart I-5The Stock-To-Bond Ratio Has Capitulated While the short-term outlook remains murky for asset markets, investors with a 12-month or longer investment horizon should begin to move capital into equities at the expense of bonds. Beyond the relative technical and valuation backdrops (Chart I-5), the outlook for fiscal and monetary policy favors this allocation decision. US Treasury yields have dropped from 1.9% at the turn of the year to as low as 0.31% on March 9th. According to the bond market, inflation will average less than 1% during the coming 10 years. The OIS curve is pricing in a fed funds rate of only 68 basis points in five years. In response to this extreme pricing, Treasury bonds are exceptionally expensive (Chart I-6). Moreover, using BCA Research’s Golden Rule of Treasury Investing, there is little scope for yields to fall any lower. The Golden Rule states that the return of Treasury bonds is directly linked to the Fed's rate surprises. If over the next year the Fed cuts interest rates more than is currently priced into the OIS curve, then bond yields will fall in the next 12 months (Chart I-7). Given that the fed funds rate is already at its lower limit, the Fed will not be able to deliver such a dovish surprise and yields will have limited downside. Chart I-6Bonds Are Furiously Expensive Chart I-7The Fed Cannot Pull Another Dovish Surprise Out Of Its Hat   The bond market is also vulnerable from a technical perspective. Our Composite Technical Indicator is as overbought today as it was in December 2008 (Chart I-8). Thus, bond prices are vulnerable to good news. Economic activity will be weak for many months, but the recent policy announcements will boost global fiscal deficits by more than $3 trillion in the next 12 to 18 months. Such a large supply of paper is bearish for bonds, especially when they are very expensive. Moreover, global central banks are engaging in large-scale quantitative easing (QE). Globally, monetary authorities have already announced the equivalent of at least $1.9 trillion in asset purchases. The GFC experience showed that QE programs put upward pressure on Treasury yields (Chart I-9). This time will not be different given the combination of QE, supply disruptions caused by quarantines and large fiscal stimulus. Chart I-8A Dire Combination For Bonds Chart I-9QE Pushes Yields Up     Equities offer the opposite risk/reward ratio to bonds. Technical indicators are consistent with maximum pessimism toward equities and imply that most of the selloff is behind us, at least for the time being. The Complacency-Anxiety Indicator developed by BCA Research’s US Equity Strategy service points to widespread pessimism among investors,4 an intuition confirmed by our Sentiment indicator (Chart I-10). Moreover, our Equity Capitulation Index is as depressed as in March 2009. Investors with a 12-month or longer investment horizon should begin to move capital into equities at the expense of bonds. Despite the magnitude of the shock hitting the global economy, equities will rally if they become cheap enough and monetary conditions are accommodative enough. The BCA Valuation indicator has collapsed to “undervalued” territory and our Monetary Indicator has never been more supportive of equities (both variables are shown on page 2 of Section III). The gap between these two indicators is at its lowest level since Q1 2009 or 1982, two points that marked the end of bear markets (Chart I-11). Chart I-10Equities Have Capitulated Chart I-11Supportive Combined Valuation And Monetary Backdrop For Equities   Equity multiples also offer some insight into the risk/reward ratio for stocks. The S&P 500 has collapsed by 34% since its February 19th peak and trades at 13 times forward earnings. True, analysts will revise their forecasts, but the market also only trades at 14 times trailing earnings, which cannot be downgraded. Most importantly, investors are extremely gloomy about expected growth when multiples and risk-free rates are so subdued. Risk assets cannot stabilize durably as long as the demand for dollar liquidity is not satiated. Table I-3Evaluating Where The Floor Lies We can use a simple discounted cash flow model to extract the expected growth rate of long-term earnings embedded in the S&P 500. To do so, we assume that the ERP is 300 basis points, close to the long-term outperformance of stocks versus bonds. At current multiples and 10-year yields, investors are pricing in a long-term growth rate of -2% annually for earnings (Table I-3). In comparison, investors were more pessimistic in 1974, 2008 and 2011 when they anticipated long-term earnings contractions of -2.5% annually. If we assume that the long-term growth of expected earnings will fall to that depth, then we can estimate trailing P/E multiples will be under different risk-free rates. If yields fall to zero, then the P/E would be 17.7 or a price level of 2,692; however, if they rise to 1.5%, then the P/E would decline to 13.9 or a price level of 2,115 (Table I-3). Chart I-12Expected Earnings Growth And Interest Rates Are Co-Integrated This method suggests that 2200 is the S&P 500’s likely floor. Risk-free rates and the expected growth rate of long-term earnings are correlated series because the anticipated evolution of economic activity drives both real interest rates and earnings (Chart I-12). Thus, it is unlikely that yields will climb if expected earnings growth falls. Instead, if the expected growth rate of long-term earnings drops to -2.5%, then yields should stand between 1% and 0.5%, implying equilibrium trailing P/Es of 15 to 16.3 times, or prices levels of 2,278 to 2,468. P/E will only fall much further if the dollar scramble lasts longer. As investors seek cash and liquidate all assets, the process can push anticipated growth rates lower while pulling bond yields higher (see next section).   Investment Implications Part 2: The Uncontrolled Liquidity Crunch Is Still An Immediate Risk Risk assets cannot stabilize durably as long as the demand for dollar liquidity is not satiated. The large programs announced around the world seem to be calming this liquidity crunch. However, the situation is fluid and the crunch can come back at a moment's notice. Despite the magnitude of the shock hitting the global economy, equities will rally if they become cheap enough and monetary conditions are accommodative enough. Credit spreads blew up as investors priced in the inevitable increase in defaults that accompanies recessions (Chart I-13). Junk spreads moved to as high as 1100 basis points, their highest level since 2009. If we assume that next year, US EBITDA contracts by its average post-war magnitude (a timid assumption), then the interest coverage ratio will deteriorate to readings not seen since the S&L crisis, which will force default rates higher (Chart I-14). Chart I-13Defaults Will Rise Chart I-14Corporate Fundamentals Will Deteriorate     The anticipated contraction in cash flows creates another more pernicious and dangerous consequence: an insatiable demand for dollar liquidity by the private sector. Companies are worried they may not generate the necessary cash flows to service their debt. This is especially worrisome for foreign borrowers who have loans in US dollars. The BIS estimates that foreign currency debt denominated in USDs stands at $12 trillion. Meanwhile, these foreign borrowers are hoarding dollars. The risk aversion of US-based companies is accentuating the dollar crunch. US companies have pulled on their credit lines en masse. US commercial banks must provide this cash to their clients. However, US banks must still meet liquidity requirements imposed by the Basel III rules. As a result, the banks are also hoarding as much cash as possible in the form of excess reserves and curtailed their capital market lending, especially in the repo market. Repos are the lifeblood of capital markets and without repos, market liquidity (the ability to sell and buy securities) quickly deteriorates. This chain of events has caused a sharp widening in Treasury bid-ask spreads, LIBOR-OIS spreads and commercial paper-T-Bill spreads, and has fueled weaknesses in mortgage and municipal bond markets (Chart I-15). The evaporation of the repo market accentuates the foreign liquidity crunch. Without functioning repo markets, dollar funding in offshore markets becomes more onerous, as highlighted by the widening in global cross-currency basis swap spreads (Chart I-16). Borrowers are buying dollars at any cost. This has led to the surge in the dollar from March 9th, which forced the collapse of risky currencies such as the NOK, the BRL or the MXN, but also of safe-haven currencies such as the JPY and the CHF. Chart I-15Symptoms Of A Liquidity Crunch Chart I-16Offshore Funding Pressures Point To A Dollar Shortage   The strength in the dollar is problematic. As a symptom of the liquidity crunch, it accompanies forced selling of assets by investors seeking to acquire cash. Moreover, the USD is a funding currency, hence a strong dollar also tightens the global cost of capital for all foreign borrowers who have tapped into US capital markets. For US firms, it also accentuates deflationary pressures and the resulting lower price of goods sold increases the risk of bankruptcies. Thus, a strong dollar would feed the weakness in asset prices and further widen credit spreads. Moreover, because the liquidity crunch hurts growth and can concurrently push yields higher, it could pull P/Es below 15 and drive equity prices far below our 2,200 floor. On the positive side, central banks worldwide are keenly aware of the danger created by the liquidity crunch. The Fed has started and restarted a long list of liquidity facilities (Table I-2). Its unlimited QE program also addresses the dollar shortage directly by expanding the supply of money. Crucially, the Fed has re-opened dollar swap lines with other central banks, including emerging markets such as Korea, Singapore, Mexico and Brazil. Even the ECB and the Bank of England are relaxing liquidity ratios for their banks, which at the margin will alleviate the supply of liquidity in their domestic economies. The Fed will likely follow its European counterparts, which could play a large role in alleviating the global dollar shortage. Investors seeking to assess if the supply of liquidity is large enough should pay close attention to gold prices. The global, large-scale fiscal stimulus programs will also address the dollar liquidity crisis. When investors judge there is sufficient fiscal stimulus to put a floor under global economic activity, the markets will take a more sanguine view of the risk of default. If large enough, government spending will support corporate cash flows and, therefore, limit corporate bankruptcies. Consequently, demand for liquidity will also decline and mass asset liquidations will ebb. Chart I-17Gold Is The Ultimate Liquidity Gauge Investors seeking to assess if the supply of liquidity is large enough should look for some key market signals. We pay close attention to gold prices; after March 9th they fell despite the global spike in risk aversion due to gold's extreme sensitivity to global liquidity conditions. Both today and in the fall of 2008, gold prices fell when illiquidity grew. Our gold fair-value model shows that the precious metal is extremely sensitive to inflation expectations and real bond yields (Chart I-17). As illiquidity grows and the dollar appreciates, inflation breakevens collapse and real yields spike. Thus, the recent gold rebound suggests that the Fed and other major central banks have expanded the supply of liquidity sufficiently to meet demand, the price of money will fall (real interest rates) and inflation expectations will rebound. Monitor whether gold can remain well bid. Investment Implications Part 3: FX And Commodity Markets Chart I-18China's Stimulus Will Once Again Be Paramount China’s stimulus will be a key driver of the FX market in the post-liquidity-crunch world. Historically, because Chinese reflation has lifted the global manufacturing cycle, it possesses a large influence on the dollar’s trend (Chart I-18). We believe that China’s stimulus will be comparable to the one implemented in 2008 and will boost global growth. Moreover, the interest rate advantage of the US has declined and global macro volatility will not remain at current extremes for an extended time. These three factors (Chinese stimulus, lower interest rate differentials and declining volatility) will weigh on the USD in the coming 18 months (Chart I-18, bottom panel). EM currencies and the AUD will benefit most from the dollar depreciation later this year. In the short term, these currencies remain exposed to any flare up in the liquidity crunch and can cheapen further. But, as Chart I-19 highlights, investing in those currencies will likely generate long-term excess returns because they have cheapened significantly. Commodities, too, are becoming attractive at current valuations. Industrial metals such as copper will benefit greatly from China’s stimulus. A rising Chinese credit and fiscal impulse lifts the price of base metals because it pushes up Chinese infrastructure spending as well as residential and capex investment (Chart I-20). Moreover, a lower dollar and accommodative global monetary policy will further boost the appeal of industrial metals. Chart I-19EM FX Is Cheap Chart I-20China Will Drive Metal Prices Higher China’s stimulus will be a key driver of the FX market in the post-liquidity-crunch world. The oil outlook is particularly unclear as both demand and supply factors are in flux. At $27/bbl, Brent is cheap enough to compensate investors for the decline in demand that will emerge between now and the end of the second quarter. However, the market-share war between Saudi Arabia and Russia layers on the problem of supply risk. Saudi Aramco is set to increase production to 12.3 million barrels by April and Saudi’s GCC allies have announced they are increasing output as well. According to BCA Research’s Commodity and Energy Strategy service, the oil market is already oversupplied by 1.6 million barrels per day, a number that will expand if the KSA and its allies fulfill their production pledges. If this situation persists, oil will lag behind industrial metals when global risk aversion recedes. Nonetheless, our commodity strategists believe that the collapse in oil prices is more painful for Russia than for KSA. We believe there will be a compromise between OPEC and Russia in the coming weeks that will push supply lower.5 Additionally, the Texas Railroad Commission is preparing to impose limitations on Texas oil production, which has not been done since the 1970s. Such a decision would magnify any rebound in oil prices. Thinking Long-Term: The Return Of Stagflation? The COVID-19 outbreak will likely be viewed as an epoch-defining moment. The policy response to the outbreak will be far reaching and the disease will change the way firms manage supply chains for decades to come. There will be a substantial pullback in globalization. COVID-19 has generated an inflationary shock in the medium term. Chart I-21War Spending Is Always Inflationary COVID-19 has generated an inflationary shock in the medium term. Governments have suddenly abandoned their preferences for fiscal rectitude. The US deficit will reach a peacetime record of 15% of GDP. These are war-like spending measures. In history, gold standard or not, wars were the main reason for inflationary outbreaks as they involved massive budgetary expansions (Chart I-21). The large monetary easing accompanying the current fiscal expansion will only add to this inflationary impulse. Many of the proposals discussed by governments involve funneling cash directly to households, while central banks buy bonds issued by the same government. This is very close to helicopter money. These policies will increase the velocity of money, which is structurally inflationary (Chart I-22). Naysayers may point to the lack of inflation created by QE programs in the direct aftermath of the GFC. However, at that time, households and commercial banks were much sicker. Today, capital ratios in the US and the Eurozone are 60% and 33% higher than in 2007, respectively (Chart I-23). Thus, banks are much more likely to add to money creation instead of retracting from it as they did in the last cycle. Chart I-22If Velocity Rises, So Will Inflation Chart I-23Banks Are Much Healthier Than In 2008   Chart I-24Financial Assets Have No Inflation Cushion Markets are not ready for higher inflation. The 5-year/5-year forward CPI swaps in the US and the euro area stand at only 1.6% and 0.7%, respectively. Household long-term inflation expectations are also at all-time lows (Chart I-24). Therefore, an increase in inflation will have a deep impact on asset prices. The first implication is that gold prices have probably begun a new structural bull market. Inflation will surprise on the upside and keep real interest rates lower. Both these factors are highly bullish for the yellow metal. Additionally, easy fiscal policy and money printing will devalue currencies versus hard assets, which will benefit all precious metals, including gold. EM central banks have recently been diversifying aggressively in gold, which will add another impetuous to its rally. The second implication is that the stock-to-bond ratio has structural upside. Equities are not a perfect inflation hedge, but their profits can rise when selling prices accelerate. However, bonds display rock bottom real yields, inflation protection and term premia. Moreover, their low-running yields are below the dividend yields of equities, which has also boosted bond duration to record levels. Therefore, bonds offer even less protection against higher inflation. Hence, the stock-to-bond ratio will probably follow the historical experience of the 20th century structural bull market and inflect higher (Chart I-25). However, this outperformance will not stem from the superior performance of stocks in real terms; rather, it will emerge from a very poor performance by bonds. Chart I-25The Stock-To-Bond Ratio Will Follow The 20th Century Road Map Thirdly, the structural relative bear market in EM equities will likely end soon. EM equities will enjoy strong real asset prices and EM assets have much more appealing valuations than DM stocks. This is an imbedded inflation protection. The world is witnessing a fiscal and monetary push that will result in lower productivity growth and profit margins, along with feared inflation. The next decade could increasingly look like the stagflationary 1970s. Mathieu Savary Vice President The Bank Credit Analyst March 26, 2020 Next Report: April 30, 2020   II. Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to the only available real time estimate of the real neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even once economic recovery takes hold unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). This report revisits the “LW” R-star estimate in detail, and demonstrates why the estimation is almost certainly wrong, at least over the past two decades. We also outline an inferential approach that investors can use to monitor where the neutral rate is in real time and whether it is rising or falling. The core conclusion for investors is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, investors should avoid dogmatic medium-to-longer term views about yields as they may rise meaningfully over a cyclical and secular horizon once a post-COVID-19 expansion takes hold. Over the past several weeks financial markets have moved rapidly to price in a global recession stemming from the COVID-19 outbreak. As financial market participants began to turn to policy makers for support, eyes focused first on the Federal Reserve, and then fiscal authorities. Earlier this week, the ECB joined the party and announced aggressive further measures of its own. When responding to the Fed’s return to the lower bound and its other recent monetary policy decisions, many market participants have expressed the view that the Fed is largely impotent to deal with a global pandemic. There are three elements to this view. The first is that interest rate cuts are ill equipped to stimulate domestic demand if quarantine measures or other forms of “social distancing” are in effect. The second element is that the Fed has only been capable of delivering a fraction of the reduction in interest rates compared to what has occurred in response to previous contractions. The third aspect of this view is that because the neutral rate of interest is so much lower now than it was in the past, Fed rate cuts will not be as stimulative as they were before. Chart II-1Monetary Policy Ceased To Be Stimulative Last Year, According To The LW R-star Estimate While we at least partly agree with the first and second elements of this view, we feel strongly that the third is flawed. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013,6 and have gravitated to the only available real time estimate of the neutral rate of interest: the Laubach & Williams (“LW”) “R-star” estimate. This time series, which is regularly updated by the New York Fed,7 suggests that the real fed funds rate reached neutral territory in the first quarter of 2019 (Chart II-1). With this apparent visualization of secular stagnation as a guide, many investors have concluded that monetary policy ceased to be stimulative last year and that recent Fed rate cuts will be of limited benefit to economic activity even beyond the near term unless inflation meaningfully accelerates (thus pushing real rates lower for any given nominal Fed funds rate). In this Special Report we revisit the “LW” R-star estimate in detail, and demonstrate why the estimation is almost certainly wrong, at least over the past two decades. Our analysis does not reveal a precise alternative estimate of the neutral rate, although we do provide some inferential perspective on how investors may be able to monitor where the neutral rate is in real time and whether it is rising or falling. However, the core insight emanating from our report, particularly for US fixed income investors, is that US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. While bond yields may not rise significantly in the near-term, this underscores that they have the potential to rise meaningfully over a cyclical and secular horizon once economic activity recovers. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise may be larger than many investors currently expect. Demystifying The LW R-star Estimate The LW estimate of the neutral rate of interest has gained credibility for three reasons. First, as noted above, the evolution of the series fits with the secular stagnation narrative re-popularized by Larry Summers. Second, the series is essentially sponsored by the Federal Reserve even if it is not officially part of the Fed’s forecasting framework, as its two creators are long-time Fed employees (Thomas Laubach is a director of the Fed’s Board of Governors, and John Williams is the current President of the New York Fed). But, in our view, there is a third important reason that global investors have accepted the LW R-star estimate of the neutral rate of interest: the methodology used to generate the estimate is extremely technically complex, and thus is difficult for most investors to penetrate. Much of the technical complexity of the LW estimate is centered around the use of a statistical procedure called a Kalman filter (“KF”). Simply described, the KF is an algorithm that tries to estimate an unobservable variable based on 1) an idea of how the unobservable variable might relate to an observable variable (the “measurement equation”), and 2) an idea of how the unobservable variable might change through time (the “transition equation”). Through a repeated process of simulating the unobserved variable based on a set of assumptions, the KF is able to compare predicted results to actual results on an observation-by-observation basis, and use that information to generate ever more reliable future estimates of the unobserved variable (Chart II-2). Chart II-2A Very Simplified Overview Of The Kalman Filter Algorithm We acknowledge that a full technical treatment of the Kalman Filter as it relates to the LW estimate of the neutral rate of interest is beyond the scope of this report, and we provide a more technical overview in Box II-1. But what emerges from a detailed analysis of the model is that the Kalman Filter jointly estimates R-star, potential GDP growth, potential GDP, and the variable “z”, the determinants of R-star that are not explained by potential GDP growth. As we will highlight in the next section, this joint estimation of these four variables is a crucial aspect of the model, because a valid estimate of R-star necessitates a valid estimate of the remaining variables. BOX II-1 A Technical Overview Of The Laubach & Williams R-star Model Chart Box II-1 shows that there are three sets of formulas involved in the LW estimation: the “law of motion” for the neutral rate of interest, two measurement equations, and three transition equations. The law of motion for the neutral rate is fairly simple: R-star is a function of trend real GDP growth, as well as “other factors” represented by the variable “z”. Laubach & Williams note that z “captures factors such as households’ rate of time preference”. The measurement equations are also fairly straightforward. First, the (unobservable) output gap is a function of lagged values of itself as well as the lagged real Fed funds rate gap (relative to the unobservable neutral rate). Second, inflation is a function of lagged values of itself, past values of the output gap, relative core import prices, and lagged relative imported oil prices (the latter two variables are included to capture potential supply shocks to inflation). Note that this second measurement equation is required for the model to work, as it relates the unobservable output gap to observable inflation. As presented in Chart II-2, the three transition equations are present to simulate how the unobservable variables might move through time. Potential growth and potential output are a random walk, and “z” from the law of motion follows either a random walk or an autoregressive process. Chart Box II-1The Laubach & Williams R-star Model Debunking The LW R-star Estimate Before criticizing the LW estimate of the neutral rate of interest, it is important for us to note that we have the utmost respect for the Federal Reserve and its research methods. We fully acknowledge that the LW R-star estimation is rooted in solid economic theory, and we have identified no technical errors in the setup of the LW model. Nevertheless, valid analytical efforts sometimes lead to problematic real-world results, and there are two key reasons to believe that the Kalman filter in the LW model is almost certainly misspecifying R-star, at least in terms of its estimate over the past two decades. The first reason relates to the sensitivity of the model to the interval of estimation (the period over which R-star is estimated). Chart II-3 presents the range of quarterly estimates of R-star since 2005, along with the difference between the high and low end of the range in the second panel. The chart shows that while previous estimates of R-star have generally been stable for values ranging between the early-1980s and 2006/2007, pre-1980 estimates have varied quite substantially and we have seen material revisions to the estimates over the past decade. Q1 2018 serves as an excellent example: in that quarter R-star was estimated to be 0.14%; today, the Q1 2018 R-star estimate sits at 0.92%. Chart II-3Since 2005, There Has Been Some Instability In The LW R-star Estimates However, Table II-1 and Chart II-4 highlight the real instability of the Kalman filter estimation by demonstrating the effect of varying the starting point of the model (please see Box II-2 for a brief description of how our estimation of R-star using the LW approach differs slightly from the original procedure). Laubach & Williams originally estimated R-star beginning in Q1 1961; Table II-1 shows what happens to today’s estimate of R-star simply by incrementally varying the starting point of the model from Q1 1958 to Q4 1979. Table II-1Alternative Current LW Estimates Of R-star By Model Starting Point Chart II-4Alternative Starting Points Produce Wildly Different Estimates Of R-star Today BOX II-2 The Laubach & Williams R-star Model With Simplified Inflation Expectations To proxy inflation expectations in their model, Laubach & Williams use a “forecast of the four-quarter-ahead percentage change in the price index for personal consumption expenditures excluding food and energy (“core PCE prices”) generated from a univariate AR(3) of inflation estimated over the prior 40 quarters”. The authors note that a simplified measure of expectations, a 4-quarter moving average of quarterly annualized core inflation, does not materially alter their results. For the sake of parsimony we use this simplified measure in our analysis. We find that the effect shifts the current estimate of R-star only slightly (+10 basis points), and that the historical differences between our version of the 1961 estimation and the official series are indeed minor. The table highlights that the model fails to even generate a result in a majority of the cases (only 39 out of 88 of the model runs were error-free). In addition, Chart II-4 shows that of the successful estimates of R-star using the LW procedure and alternate starting dates of the model, the estimate of R-star today varies from -2% (in one case) to +2%. Excluding the one extremely negative outlier results in an effective estimate range of 0% to 2%, but the key point for investors is that this range is massive and underscores that the original model’s estimate of R-star today is heavily and unduly influenced by the interval of estimation. Investors should also note that of all of the alternative estimates of R-star today shown in Chart II-4, the estimate using the original interval is very much on the low end of the distribution. The second (and most important) reason to believe that the LW estimate is misspecifying R-star is that the output gap estimate generated by the model is almost certainly invalid, at least over the past two decades. Chart II-5presents the LW output gap estimate alongside an average of the CBO, OECD, and IMF estimates of the gap; panel 1 shows the official current LW output gap estimate, whereas panel 2 shows the range of output gap estimates that are generated using the different estimation intervals highlighted in Table II-1 and Chart II-4. Chart II-5The LW Output Gap Estimates, Upon Which R-star Depends, Have Been Wrong For Two Decades Given that the Kalman filter in the LW model jointly determines R-star and the output gap (by way of estimating potential output via estimating potential GDP growth) and that these estimates are dependent on each other, Chart II-5 highlights that in order to believe the LW R-star estimate investors must believe three things: That the US economy was chronically below potential in the late-1990s when the unemployment rate was below 5%, real GDP growth averaged nearly 5%, and the equity market was booming, That output exceeded potential in 2004/2005 by a magnitude not seen since the late-1970s / early-1980s despite an average unemployment rate, That the 2008/2009 US recession was not particularly noteworthy in terms of its deviation from potential output, and that the economy had returned to potential output by 2010/2011 when the unemployment rate was in the range of 8-9%. Chart II-6The US Economy Was Definitely Not At Full Employment In 2010 While we do not believe any of these three statements, the third is especially unlikely. Chart II-6 highlights that the economic expansion from 2009 – 2020 was the weakest on record in the post-war era in terms of average annual real per capita GDP growth. To us, this is a clear symptom of a chronic deficiency in aggregate demand, and that it is essentially unreasonable to argue that the economy was operating at full employment prior to 2014/2015. This means that the Kalman filter is generating incorrect and unreliable estimates of the output gap, which means in turn that the filter’s estimation of R-star is almost assuredly wrong. How Can Investors Tell What The Neutral Rate Is? An Inferential Approach Table II-2 presents the sensitivity of the original Q1 1961 LW estimate of R-star to a series of counterfactual scenarios for inflation, real GDP growth, nominal interest rates, and import and oil prices since mid-2009. While these scenarios do not in any way improve the validity of the LW R-star estimate, they do help clarify the theoretical basis of the model and they help reveal how investors may infer whether the neutral rate of interest is higher or lower than prevailing market rates, and whether it is rising or falling. Table II-2Sensitivity Of Current LW R-star Estimate To Counterfactual Scenarios (2009 - Present) Chart II-7Core Import Price Growth Has Been Weak On Average During This Expansion Table II-2 highlights that today’s estimate of R-star using the original LW approach is mostly sensitive to our counterfactual scenarios for growth and interest rates, but not inflation or oil prices. Shifting down import price growth also has a meaningful effect on R-star, but since core import price growth has been particularly weak over the past several years (Chart II-7), it seems unreasonable to suggest that they have been abnormally high and thus “explain” a low R-star estimate today. Table II-2 essentially highlights that the entire question of the neutral rate of interest over the past decade, and the core contradiction that led to the re-emergence of the secular stagnation thesis, can effectively be boiled down to the following simple question: “Why hasn’t US economic growth been stronger this cycle, given that interest rates have been so low?” Based on the (hopefully uncontroversial) view that interest rates influence economic activity and that economic activity influences inflation, we propose the following checklist for investors to ask themselves in order to not only determine the answer to this important question, but to help identify whether R-star in any given country is likely higher or lower than existing policy rates at any given point in time. Are interest rates above or below the prevailing level of economic growth? Are interest rates rising or falling, and how intensely? Are there identifiable non-monetary shocks (positive or negative) that appear to be influencing economic activity? Is private sector credit growth keeping pace with economic growth? Are debt service burdens in the economy high or low? The first question reflects the most basic view of R-star, which is that the real neutral rate of interest should be equal to, or at least closely related to, the potential growth rate of the economy, ceteris paribus. Questions 2 through 5 attempt to determine whether ceteris paribus holds. In terms of how the answers to these questions relate to identifying the neutral rate, consider two economies, “Economy A” and “Economy B” (Chart II-8). Economy A has broadly stable or slightly rising interest rates that are well below prevailing rates of economic growth (questions 1 & 2), no obvious beneficial shocks to domestic demand from fiscal policy or other factors (question 3), and strong private sector credit growth that is perhaps above or strongly above the current pace of GDP growth (question 4). Chart II-8'Economy A', Versus 'Economy B' Inferentially, it would seem that interest rates in this hypothetical economy are below R-star today. Question 5 is in our list because the more that active private sector leveraging occurs (thus pushing up debt burdens), the more that we would expect R-star in the future to fall. This is because debt payments as a share of income cannot rise forever, and we would expect that the capacity of economy A’s central bank to raise interest rates in the future are negatively related to economy A’s private sector debt service burden today. Now, imagine another economy (“Economy B”) with interest rates well below average rates of economic growth, an interest rate trend that is flat-to-down, no identifiable non-monetary policy shocks that are restricting aggregate demand, persistently sluggish credit growth, and high private sector debt service burdens in the past. If economy B is growing (even sluggishly) and not in the middle of a recession, it would seem that prevailing interest rates are below R-star, but not significantly so. In this scenario it would seem reasonable to conclude that R-star in economy B has fallen non-trivially below its potential growth rate, and that interest rate increases are likely to move monetary policy into restrictive territory earlier than otherwise would be the case. Is The United States “Economy B”? From the perspective of some investors, our description of economy B above perfectly captures the experience of the US over the past decade: an extremely low Fed funds rate, sluggish to weak growth and inflation, all the result of a huge build-up in leverage and debt service burdens during the last economic cycle. We do not doubt that R-star fell in the US for some period of time during the global financial crisis and in the early phase of the economic recovery. But we doubt that it is as low today as the secular stagnation narrative would imply, in large part because it ignores several important aspects concerning questions 2 through 5 noted above. Chart II-9Fiscal Austerity Has Been A Serious Non-Monetary Shock To Aggregate Demand Non-monetary shocks to the US and global economies: Over the past 12 years, there have been at least five deeply impactful non-monetary shocks to both the US and global economies that have contributed to the disconnect between growth and interest rates: 1) a prolonged period of US household deleveraging from 2008-2014, 2) the euro area sovereign debt crisis, 3) fiscal austerity in the US, UK, and euro area from 2010 – 2012/2014 (Chart II-9), 4) the US dollar / oil price shock of 2014, and 5) the recent trade war between the US and China. Several of these shocks have been policy-driven, and in the case of austerity the negative consequences of that policy has led to a lasting change in thinking among fiscal authorities (outside of Japan) that is unlikely to reverse in the near-future. Chart II-10Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Private sector credit growth: Chart II-10 highlights the extent of household deleveraging noted above by showing the growth in total household liabilities over the past decade alongside income growth. Panel 2 shows the leveraging trend of firms, as represented by the nonfinancial corporate sector debt-to-GDP ratio. Chart II-10 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it is now growing again and has largely closed the gap with income growth. The second point is that the nonfinancial corporate sector has clearly leveraged itself over the course of the expansion, arguing that interest rates have not in any way been restrictive for businesses. While it is true that firms have largely leveraged themselves to buy back stock instead of significantly increasing capital expenditures, in our view this reflects the fact that US consumer demand was impaired for several years due to deleveraging. We doubt that firms would have altered their capital structures to this degree if they did not view interest rates as extremely low. Debt service burdens: Chart II-11 highlights that US household debt service burdens were at very elevated levels prior to the financial crisis, suggesting that the neutral rate did fall for some time following the recession. But today, the debt burden facing households is the lowest it has been in the past 40 years due to both rate reductions and deleveraging, arguing against the view that household debt levels will structurally weigh on interest rates in the years to come. Chart II-12 shows that the picture is different for nonfinancial corporations, as the substantial leveraging noted above has indeed raised debt service burdens for firms. However, the nonfinancial corporate sector debt service ratio remains 400 basis points below early-2000 levels when excess corporate sector liabilities had a clear impact on the economy, suggesting that the Fed’s capacity to raise interest rates still exists following the onset of economic recovery if corporate sector credit growth does not rise sharply relative to GDP over the coming 6-12 months. Chart II-11The Debt Burden Facing US Households Is At A Record Low Chart II-12Businesses Have Levered Up Their Balance Sheets, But There Is Still Room For Rates To Rise   The intensity of recent interest rate changes: Finally, many investors have pointed to sluggish housing activity over the past three years as evidence of a low neutral rate. However, Chart II-13 highlights that the rise in the 30-year US mortgage rate from late-2016 to late-2018 was one of the largest two-year changes in US history, and Chart II-14 shows that the growth in household mortgage credit did not fall below its trend during this period until Q4 2018, when the US stock market fell 20% from its high in response to the economic consequences of the US/China trade war. Chart II-14 also shows that mortgage credit growth responded sharply to a recent reduction in interest rates. All in all, Charts II-13 & II-14 cast doubt on the notion that the level of mortgage rates over the past three years reached restrictive territory. Chart II-13Mortgage Rates Rose Very Significantly From Late-2016 To Late-2018 Chart II-14A Record Rise In Mortgage Rates Did Not Crack The Housing Market   Investment Conclusions In the face of a global pandemic and an attendant global recession this year, the idea of eventual Fed rate hikes and the notion that the US economy will be able to tolerate them likely seems preposterous to many investors. We agree that over the coming 6-12 months US Treasury yields are unlikely to rise; even at current levels of the 10-year Treasury yield, we are reluctant to call a trough. Chart II-15US 10-Year Treasurys Are Mostly Priced For A Repeat Of The Past Decade However, Chart II-15highlights that over a long-term time horizon, the bond market is now essentially priced for a repeat of the ten-year path of the Fed funds rate following the global financial crisis. While some investors will view this as a reasonable expectation in the face of what they see as a persistent and unexplainable gap between growth and interest rates over the past decade, we think this gap is explainable and we highly doubt that a pandemic with minimal mortality risk to the working age population and the young will cause the US economy to be afflicted with active consumer deleveraging lasting 4 to 6-years, substantial and wide-ranging fiscal austerity, persistently rising trade tariffs, and sharply lower oil prices. So while we agree that the US economy will be substantially cyclically affected by COVID-19, US Treasury yields reflect a “low rates forever” view with much higher certainty than is analytically warranted and thus appear to be anchored by a false narrative. As such, we caution fixed-income investors against dogmatic medium-to-longer term views about bond yields, as their potential to rise following the upcoming recession may be larger than many investors currently believe.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com III. Indicators And Reference Charts Last month, we continued to strike a cautious tactical tone. Valuations were not depressed enough to compensate investors for the lack of clarity around the path of COVID-19. In other words, there was not enough of a risk premium imbedded in asset prices if COVID-19 cases were to spread around the world. Now that COVID-19 has spread around the planet, asset valuations have adjusted massively. The BCA Valuation Indicator for the S&P 500 is now in undervalued territory, thanks to both lower prices and interest rates. Meanwhile, the BCA Monetary Indicator has never been more accommodative than it is today. Together, these two indicators suggest that twelve months from now, equities will stand at higher levels than they do today. Tactically, equities have most probably found their floor. Both our Composite Sentiment Indicator and the VIX are consistent with a capitulation. Anecdotal evidences also point to a capitulation by retail investors. Additionally, Our RPI indicator is finally starting to try to turn up. Nonetheless, equities will likely re-test their Monday March 23rd floor as the length of US and global quarantines that are so damaging to growth (but for now, necessary) remain uncertain. The cleanest way to express a positive 12-month outlook on equities is to bet on a rise in the stock-to-bond ratio. 10-year Treasurys are as expensive as they were in late 2008 and early 1986, two periods followed by rapid rises in yields. Moreover, our Composite Technical Indicators is 2.5 sigma overbought. The yield curve is steepening anew, which confirms the intuition that yields will experience significant upside over the coming 12 months. On a longer-term basis, inflation expectations are too low to compensate investors for the inflation risk created by a larger monetary and fiscal expansion than the one witnessed in 2008. That being said, EM sovereigns are getting attractive for long-term investors.  Following the surge in the dollar that accompanied the liquidity crunch that surrounded the COVID-19 panic, the dollar is now trading at its most expensive level since 1985. The large liquidity injections by the Fed should cap the dollar for now, but the greenback will need more clarity on the end of global quarantines before it can fall decisively. Nonetheless, it will depreciate significantly once the global economy rebounds due to the powerful reflationary impulse building up around the world. Finally, commodity prices are retesting their 2008 lows. They are not as oversold as they were then, but this is good sign as the advance/decline line of our Continuous Commodity Index continues to trend higher. Thus, if as we expect, the dollar’s surge is ending, commodities are likely to be in the process of finding a floor right now. Once investors become more optimistic about the outlook for global growth, commodities will likely rebound sharply, maybe even more so than stocks. Therefore, it is a good time to begin accumulating metals, energy and equities as well as FX linked to natural resources prices. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "March 2020," dated February 27, 2020, available at bca.bcaresearch.com 2  Chwieroth, Jeffrey M., Walter, Andrew, The Wealth Effect: How the Great Expectations of the Middle Class Have Changed the Politics of Banking Crises, 2019. 3  A relaxation of social-distancing measures would likely mean that large-scale gatherings are still prohibited, and life would not return to normal for a long time. 4  Please see US Equity Strategy "The Darkest Hour Is Just Before The Dawn," dated March 23, 2020, available at uses.bcaresearch.com 5  Please see Commodity & Energy Strategy "KSA, Russia Will Be Forced To Quit Market-Share War," dated March 19, 2020, available at ces.bcaresearch.com 6  "IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer," Washington DC, November 8, 2013. 7  "Measuring the Natural Rate of Interest," Federal Reserve Bank of New York.

Special Report

Highlights China’s capital spending is likely to gradually recover in the second half of 2020. We project 6-8% growth in Chinese traditional infrastructure investment and a 30-50% increase in tech-related infrastructure investment by the end of 2020. There will not be much stimulus to boost housing demand. Commodities and related global equity sectors as well as global industrial stocks are approaching buy territory in absolute terms. Semiconductor stocks are attractive on a 12-month time horizon but still face near-term risks. Chinese property developer stocks remain at risk. Feature Chart I-1Chinese Growth Is Worse Now Than In 2008 Lockdowns during the Covid-19 outbreak have already caused much larger and more widespread damage to the Chinese economy than what occurred both in 2008 and in 2015 (Chart 1). Even though the spread of Covid-19 looks to be largely under control, China’s domestic economy is only in gradual recovery mode, and Chinese authorities are preparing to inject more stimulus to reinvigorate growth. The important questions are where and how large the stimulus will likely be. Infrastructure development will be the major focus this year, including both traditional and tech-related infrastructure. The former includes three categories: (1) Transport, Storage and Postal Services, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas and Water Production and Supply. The latter encompasses Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet, and data centers. The current emphasis of stimulus differs from the 2009 one which was more broad-based and spanned across not only infrastructure but also the property and auto sectors. It also differs from the 2016 stimulus measures, which had a heavy emphasis on the property market. Overall, the scale of combined traditional infrastructure and property market stimulus in 2020 will be smaller than what was put forward in 2009, 2012 and 2015-‘16. We estimate Chinese traditional infrastructure investment will increase by about RMB1 trillion to RMB1.5 trillion (6-8% year-on-year), while tech-related new infrastructure investment will be boosted by RMB 240 billion to RMB400 billion (30-50% year-on-year) (Chart 2).  Together, the infrastructure stimulus will be about RMB1.3 trillion to 1.9 trillion, amounting to 3.2-4.5% of nominal gross fixed capital formation (GFCF) and 1.3-1.9% of nominal GDP (Table 1). The Chinese property market is unlikely to receive much stimulus on the demand side this time as, “houses are for living in, not for speculation,” will remain the main policy mantra. That said, there will be some support for developers, helping somewhat ease extremely tight financing conditions. Chart 2Chinese Infrastructure Investment: A Boost Ahead Table 1Projections Of Traditional And Tech Infrastructure Investment In 2020 Restarting The Infrastructure Engine Tech Infrastructure: The authorities recently repeatedly emphasized the importance of “new infrastructure”1 development. This includes 5G networks, the industrial internet, inter-city transit systems, vehicle charging stations, and data centers. Strategic investment in indigenously produced leading technologies, the ongoing geopolitical confrontation with the US and the need to boost growth are behind the government’s aim for an acceleration in “new infrastructure” investment this year. China will significantly boost the pace of its strategic 5G network deployment as well as other tech-related investment. The growth of total tech infrastructure investment was 30-40% during the 4G-network development ramp-up in 2014. As the 5G network is much more costly to build than 4G, we expect growth within tech infrastructure investment to be 30-50% this year. This translates to an increase of RMB 240 billion to RMB400 billion in tech infrastructure investment in 2020, equaling around 0.2% to 0.4% of the country’s 2019 GDP (Table 1 on page 3). Chart 3Components Of Traditional Infrastructure Investment Traditional Infrastructure: Growth in traditional infrastructure has been weak at around 3% year-on-year in 2019, in line with our analysis last August. However, we are now expecting growth to accelerate to 6-8% by the end of this year, across all three categories of traditional infrastructure (Chart 3). In the past two months, the central government has clearly sped up the pace in reviewing and approving infrastructure projects related to power generation and distribution, transportation (railways, highways, waterways, airports, subways, etc.), and new energy. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management is likely to accelerate. Public utility management investment, which accounts for a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels. As the country’s urbanization process continues and more townships and city suburbs are developed, public utility management investment will register solid growth. The 6-8% year-on-year growth in traditional infrastructure investments by the end of this year equals to an increase of RMB1 trillion to RMB1.5 trillion in 2020. Adding up the increase of RMB 240 billion to RMB400 billion for tech-related infrastructure investment, total infrastructure spending will be RMB1.3 trillion to RMB1.9 trillion, or 1.3-1.9% of GDP (Table 1 on page 3). Bottom Line: We project 6-8% year-on-year growth in Chinese traditional infrastructure investment and a 30-50% year-on-year increase in tech-related infrastructure investment. Sources Of Infrastructure Financing Significant increases in special bond issuance, loosening public-private-partnerships (PPP) restrictions and possible Pledged Supplementary Lending (PSL) injections should enable local governments to provide sufficient funding for planned infrastructure investment projects. Net Special Bond Issuance Local government net special bond issuance, which is mainly used to fund infrastructure projects, has been one main source of financing. Last year, the amount of net special bond issuance was about RMB 2 trillion,2 accounting for about 11% of total infrastructure investment (both tech-related and traditional).  This year, the annual quota on local government special bonds is still unknown, as the NPC meeting has been postponed due to the Covid-19 outbreak. Given that last year’s quota was RMB2.15 trillion, RMB 800 billion higher than in the previous year (25% growth over 2018), it is reasonable to expect the quota for 2020 will be set at RMB 3.15-3.65 trillion, a 30-35% increase from 2019. This increase alone will be able to finance 70-80% of the RMB1.3 trillion to RMB1.9 trillion additional funding required for the infrastructure investments planned for this year. Consequently, the share of special bonds in total infrastructure spending in 2020, if these projections materialize, will rise to 15-17% from 11% in 2019. Chart 4Public-Private-Partnerships Financing Will Recover This Year   Public-Private-Partnerships (PPP) PPPs involve a collaboration between local governments and private companies. The PPP establishment can allow the local governments to reduce local governments’ burden of financing infrastructure. Due to tightened regulations on PPP projects since late 2017, PPP financing plunged 75% from about RMB 5 trillion in 2017 to RMB 1.2 trillion in 2019. Its share of total infrastructure investment had also tumbled from nearly 30% in early 2017 to 6% in 2019 (Chart 4). However, in recent months, the Chinese government has started to loosen up the restrictions on PPP projects, by releasing three announcements within a month (Box 1). We believe recent government actions will lead to a pickup in PPP financing.             Box 1 The Authorities: Loosening Up of PPP-Related Policies On February 12, the Finance Ministry released a notice demanding local governments “accelerate and strengthen PPP projects’ reserve management.” On February 28, the Finance Ministry released a contract sample of sewage water and garbage disposal projects, aiming to help local governments to more effectively proceed with such projects. On March 10, the website of the National Development and Reform Commission demanded local governments utilize the national PPP project information management and monitoring platform, actively attracting private capital and starting the projects as soon as possible. In addition, the government will likely make efforts to reduce financial and operating costs of some infrastructure projects in order to increase the risk-to-return attractiveness of such projects for private investors. The authorities may order both policy banks and commercial banks to give preferential loans to certain infrastructure projects (i.e., low-interest and long-term loans from policy banks). Moreover, the government can also provide tax breaks, offer land at a reduced cost,  and other supportive policies to certain infrastructure projects. Putting it all together, we expect PPP financing to grow 10-20% and provide additional funding of RMB120 billion to RMB240 billion to China’s infrastructure development in 2020. Pledged Supplementary Lending Chart 5Possible Pledged Supplementary Lending Injections In Infrastructure Projects Some Chinese government officials have hinted that policy banks may start using PSL injections to boost domestic infrastructure investment.3  Speculation among China watchers is that the scale of PSL injections will be RMB600 billion this year (Chart 5). In comparison, PSL net lending for the property market ranged from RMB 630 to 980 billion in the years 2015-2018. Bottom Line: Odds are that a significant increase in special bond issuance, loosening PPP restrictions and possible PSL injections will be sufficient to offset the decline in other funding sources. Consequently, a moderate acceleration in traditional infrastructure investment and very strong growth in tech-related infrastructure expenditures is likely. What About Stimulus In The Property Sector? Stimulus for the property sector this time will be less forceful than the ones in both 2009 and 2016. In addition, structural property demand in China has already entered a saturation phase, drastically different from previous episodes when demand still had strong underlying growth. Altogether, the outlook for property sales in China is not promising.  “Houses are for living in, not for speculation” will remain the main policy focus in the Chinese property market. That said, authorities will help ease developers’ extremely tight financing conditions. No stimulus on demand: Three cities (Zhumadian, Baoji, Guangzhou) that had released policies to loosen up restrictions on the demand side (e.g., cutting down payment from 30% to 20%, allowing larger amounts of borrowing for homebuyers) were ordered to retract their announcements within a week. There will be very little PSL lending into the property market in 2020, in line with the government’s goal of curbing speculation in the property market. Some supportive polices for developers: Over 60 cities have released policies on the supply side (e.g., delaying developers’ land transaction payments, waiving fines for breaches of start and completion dates, etc.), mainly helping property developers overcome their extreme funding shortages. Given housing unaffordability and lack of demand, we expect floor space sold to contract slightly in 2020 (Chart 6, top panel). In the meantime, we expect a slight pickup in property starts (Chart 6, middle panel). In order to stay afloat, property developers have to maintain rising floor space starts for presales to gain some funding – a fund-raising scheme for Chinese real estate developers that we discussed in detail in prior reports. In addition, we also expect moderate growth in property completions in the commodity buildings market (Chart 6, bottom panel). The pace of property completion has to be accelerated as property developers are currently under increased pressure to deliver units that were pre-sold about two years ago. This will lift construction activity in the commodity buildings market (Chart 7). Chart 6Commodity Buildings: Divergences Among Sales, Starts And Completions Chart 7Commodity Buildings: Construction Activities Please note that commodity buildings are a small subset of total constructed buildings in China, and as a subset do not provide a full picture of construction activity. The official data show that commodity buildings account for only 24% of total constructed buildings in terms of floor space area completed. In terms of a broader measure of the Chinese property market, we still expect a continuing contraction – albeit less than last year – in “building construction” floor area started and completed (Chart 8). Bottom Line: There will not be much stimulus to boost housing demand. Yet authorities will ease financial constraints on property developers that will allow them to complete housing currently under construction. Chart 8Building Construction Versus Commodity Housing Chart 9Commodities And Related Equity Sectors Are Approaching A Bottom Investment Implications Traditional infrastructure spending in China will post a moderate recovery in 2020, with most gains occurring in the second half of the year. Consistently, we believe the segments of Chinese and global markets leveraged to the infrastructure cycle – commodities and related equity sectors as well as industrial stocks – are approaching buying territory in absolute terms. Prices of segments have collapsed, creating a good entry point in the coming weeks (Chart 9, 10 and 11). Chart 10A Buying Time May Be Not Far For Industrial Stocks… Chart 11…And Machinery Stocks China’s spending on itech-related infrastructure will post very strong growth in 2020. Even though global semiconductor stocks have sold off considerably, they have not underperformed the global equity benchmark. In the near term, we believe risks are still to the downside for technology and semi stocks (Chart 12). However, this down-leg will create a good buying opportunity. We are watching for signs of capitulation in this sector to buy. Finally, concerning Chinese property developers, their share prices will likely underperform their respective Chinese equity benchmarks in the next nine months (Chart 13). Meanwhile, the absolute performance of property stocks listed on the domestic A-share market remains at risk (Chart 13, bottom panel). Chart 12Semi Stocks: Final Down-leg Is Possible Chart 13Chinese Property Developers Are Still At Risk  Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes   1    To gauge the scale of the “new infrastructure”, we are using the National Bureau of Statistics data of “investment in information transmission, software and information technology service”. This tech-related infrastructure investment measure includes 5G networks, industrial internet, and data centers, while inter-city transit systems and vehicle charging stations may be included in the transportation investment. 2   Please note that the amount of net special bond issuance was the actual amount of funding used in infrastructure projects. It was smaller than the RMB 2.15 trillion quota because a small proportion of issuance were used to repay some existing special bonds due in the year. 3   http://www.xinhuanet.com/money/2020-02/19/c_1125593807.htm

Special Report

Highlights The global pandemic is quickening the decline in globalization. Democracies can manage the virus, but it will be painful. European integration just got a major boost from Germany’s fiscal turn. Stay long the German consumer relative to the exporter. The US and UK are shifting to a “big government” approach for the first time in forty years. Go long TIPS versus equivalent-maturity nominal Treasuries. The US-China cold war is back on, after a fleeting hiatus. Stay short CNY-USD. Stay strategically long gold but go tactically long Brent crude oil relative to gold. Feature The global pandemic blindsided us this year, but it is catalyzing the past decade’s worth of Geopolitical Strategy’s themes. This week’s report is dedicated to our founder and consulting editor, Marko Papic, who spearheaded the following themes, which should be considered in light of this month’s extraordinary developments: The Apex Of Globalization: Borders are closing and the US is quarreling with both Europe and China over vulnerabilities in its medical supply chain. European Integration: Germany is embracing expansive fiscal policy and is softening its line on euro bonds. The End of Anglo-Saxon Laissez-Faire: Senate Republicans in the US are considering “helicopter money” – deficit-financed cash handouts to the public. US-China Conflict: Pandemic, recession, and the US election are combining to make a dangerous geopolitical cocktail. In this report we discuss how the coronavirus crisis is supercharging these themes, making them salient for investors in the near term. New themes will also develop from the crucible of this pandemic and global recession. Households Can’t Spend Helicopter Money Under Quarantine The global financial meltdown continues despite massive monetary and fiscal stimulus by governments across the world (Chart 1). The reason is intuitive: putting cash in people’s hands offers little solace if people are in quarantine or self-isolation and can’t spend it. Stimulus is essential and necessary to defray the costs of a collapsing economy, but doesn’t give any certainty regarding the depth and duration of the recession or the outlook for corporate earnings. Government health policy, rather than fiscal or monetary policy, will provide the critical signals in the near term. Once the market is satisfied that the West is capable of managing the pandemic, then the unprecedented stimulus has the potential to supercharge the rebound. The most important measure is still the number of new daily cases of the novel coronavirus across the world (Chart 2). Once this number peaks and descends, investors will believe the global pandemic is getting under control. It will herald a moment when consumers can emerge from their hovels and begin spending again. Chart 1Monetary/Fiscal Stimulus Not Enough To Calm Markets Chart 2Keep Watching New Daily Cases Of COVID-19 It is critical to see this number fall in Italy, proving that even in cases of government failure, the contagion will eventually calm down (Chart 3). This is essential because it is possible that an Italian-sized crisis could develop in the US or another European country, especially given that unlike Iran, these countries have large elderly populations highly susceptible to the virus. Financial markets are susceptible to more panic until the US and EU show the virus is under control. At the same time the other western democracies still need to prove they are capable of delaying and mitigating the virus now that they are fully mobilized. They should be able to – social distancing works. The province of Lodi, Italy offers an example of successful non-pharmaceutical measures (isolation). It enacted stricter policies earlier than its neighbors and succeeded in turning down the number of daily new cases (Chart 4).1 But it may also be testing less than its wealthier neighbor Bergamo, where the military has recently been deployed to remove corpses. Chart 3Market Needs Italy Contagion To Subside Chart 4Lodi Suggests Social Distancing Works More stringent measures, including lockdowns, are necessary in “hot zones” where the outbreak gets out of control. It is typical of democracies to mobilize slowly, in war or other crises. Italy brought the crisis home for the G7 nations, jolting them into unified action under Mario Draghi’s debt-crisis slogan of “whatever it takes.” Borders are now closed, schools and gatherings are canceled, policy and military forces are deploying, and emergency production of supplies is under way. Populations are responding to their leaders. Self-preservation is a powerful motivator once the danger is clearly demonstrated. Still, in the near term, Spain, Germany, France, the UK, and the United States have painful battles to fight to ensure they do not become the next Italy, with an overloaded medical system leading to a vicious spiral of infections and deaths (Chart 5). Chart 5Painful Battles Ahead For US And EU Until financial markets verify that current measures are working, they are susceptible to panics and selling. In the United States, testing kits were delayed by more than a month because the Center for Disease Control bungled the process and failed to adopt the successful World Health Organization protocol. Some materials for testing kits are still missing. Many states will not begin testing en masse for another two weeks. This means that big spikes in new cases will occur not only now but in subsequent weeks as testing exposes more infections. Over the next month there are numerous such trigger points for markets to panic and give away whatever gains they may have made from previous attempts at a rally. Pure geopolitical risks, outlined below, reinforce this reasoning. Volatility will continue to be the dominant theme. Governments must demonstrate successes in health crisis management before monetary and fiscal measures can have their full effect. There is no amount of stimulus that can compensate for the collapse of consumer spending in advanced consumer societies (Chart 6), so consumers’ health must be put on a better trajectory first. Thus in place of economic and financial data streams, we are watching our Health Policy Checklist (Table 1) to determine if policy measures can provide reassurance to the economy and financial markets. Chart 6No Stimulus Can Offset Collapse Of Consumer Table 1Markets Need To See Health Policy Succeeding Bottom Line: For financial markets to regain confidence durably, governments must show they can manage the outbreak. This can be done but the worst is yet to come and markets will not be able to recover sustainably over the next month or two during that process. There is more upside for the US dollar and more downside for global equities ahead. The Great Fiscal Blowout Global central banks were not entirely out of options when this crisis hit – the Fed has cut rates to zero, increased asset purchases, and extended US dollar swap lines, while central banks already at the zero bound, like the ECB, have still been able to expand asset purchases radically (Table 2). Table 2Central Banks Still Had Some Options When Crisis Hit Chart 7ECB Still The Lender Of Last Resort The ECB’s new 750 billion euro Pandemic Emergency Purchase Program (PEPP) has led to a marked improvement in peripheral bond spreads which were blowing out, guaranteeing that the lender of last resort function remains in place even in the face of a collapse of the Italian economy that will require a massive fiscal response in the future (Chart 7). Nevertheless with rates so low, and government bond yields and yield curves heavily suppressed, investors do not have faith in monetary policy to make a drastic change to the macro backdrop for developed market economies. Fiscal policy was the missing piece. It has remained restrained due to government concerns about excessive public debt. Now the “fiscal turn” in policy has arrived with the pandemic and massive stimulus responses (Table 3). Table 3Massive Stimulus In Response To Pandemic The Anglo-Saxon world had already rejected budgetary “austerity” in 2016 with Brexit and Trump. Few Republicans dare oppose spending measures to combat a pandemic and deep recession after having voted to slash corporate taxes at the height of the business cycle in 2017.2 The Trump administration is currently vying with the Democratic leadership to see who can propose a bigger third and fourth phase to the current spending plans – $750 billion versus $1.2 trillion? Both presidential candidates are proposing $1 trillion-plus infrastructure plans that are not yet being put to Congress to consider. The Trump administration agrees with its chief Republican enemy, Mitt Romney, as well as former Obama administration adviser Jason Furman, in proposing direct cash handouts to households (“helicopter money”). The size of the US stimulus is at 7% of GDP and rising, larger than in 2008- 10. In the UK, the Conservative Party has changed fiscal course since the EU referendum. Prime Minister Boris Johnson's government had proposed an “infrastructure revolution” and the most expansive British budget in decades – and that was before the virus outbreak. Robert Chote, the head of the Office for Budget Responsibility, captured the zeitgeist by saying, “Now is not a time to be squeamish about public sector debt. We ran during the Second World War budget deficits in excess of 20% of GDP five years on the trot and that was the right thing to do.”3 Now Germany and the EU are joining the ranks of the fiscally accommodative – and in a way that will have lasting effects beyond the virus crisis. Chart 8Coalition Loosened Belt Amid Succession Crisis On March 13 Germany pulled out a fiscal “bazooka” of government support. Finance Minister Olaf Scholz announced that the state bank, KfW, will be able to lend 550bn euros to any business, great or small, suffering amid the pandemic. KfW’s lending capacity was increased from 12% to 15% of GDP. But Scholz, of the SPD, and Economy Minister Peter Altmaier, of the CDU, both insist that there is “no upward limit.” This shift in German policy was the next logical step in a policy evolution that began with the European sovereign debt crisis and took several strides over the past year. The German public, battered by the Syrian refugee crisis, China’s slowdown, and the trade war, voted against the traditional ruling parties, the Christian Democratic Union (CDU) and the Social Democratic Party (SPD). Smaller parties have been stealing their votes, namely the Greens but also (less so) the right-wing populist Alternative for Germany (Chart 8). This competition has thrown the traditional parties into crisis, as it is entirely unclear how they will fare in the federal election in 2021 when long-ruling Chancellor Angela Merkel passes the baton to her as yet unknown successor. To counteract this trend, the ruling coalition began loosening its belt last year with a small stimulus package. But a true game changer always required a crisis or impetus – and the coronavirus has provided that. Germany’s shift is ultimately rooted in geopolitical constraints: Germany is a net beneficiary of the European single market and stands to suffer both economically and strategically if it breaks apart. Integration requires not only the ECB as lender of last resort but also, ultimately, fiscal transfers to keep weaker, less productive peripheral economies from abandoning the euro and devaluing their national currencies. When Germany loosens its belt, it gives license to the rest of Europe to do the same: The European Commission was obviously going to be extremely permissive toward deficits, but it has now made this explicit. Spain announced a massive 20% of GDP stimulus package, half of which is new spending, and is now rolling back the austere structural reforms of 2012. Italy is devastated by the health crisis and is rolling out new spending measures. The right-wing, big spending populist Matteo Salvini is waiting in the wings, having clashed with Brussels over deficits repeatedly in 2018-19 only to see Brussels now coming around to the need for more fiscal action. In addition to spending more, Germany is also sounding more supportive toward the idea of issuing emergency “pandemic bonds” and “euro bonds,” opening the door for a new source of EMU-wide financing. True, the crisis will bring out the self-interest of the various EU member states. For example, Germany initially imposed a cap on medical exports so that critical items would be reserved for Germans, while Italy would be deprived of badly needed supplies. But European Commission President Ursula von der Leyen promptly put a stop to this, declaring, “We are all Italians now.” Fiscal policy is now a tailwind instead of a headwind. Von der Leyen is representative of the German ruling elite, but her position is in line with the median German voter, who approves of the European project and an ever closer union. Chart 9DM Budget Deficits Set To Widen Separately, it should be pointed that Japan is also going to loosen fiscal policy further. Prime Minister Shinzo Abe was supposed to have already done this according to his reflationary economic policy. His decision to hike the consumer tax in 2014-15 and 2019, despite global manufacturing recessions, ran against the aim of whipping the country’s deflationary mindset. While Abe’s term will end in 2021, Abenomics will continue and evolve by a different name. His successor is much more likely now to follow through with the “second arrow” of Abenomics, government spending. Across the developed markets budget deficits are set to widen and public debt to rise, enabled by low interest rates, surging output gaps, and radical policy shifts that were long in coming (Chart 9). Bottom Line: Ultra-dovish fiscal policy is now complementing ultra-dovish monetary policy throughout the West. This was clear in the US and UK, but now Europe has joined in. Germany’s “bazooka” is the culmination of a policy evolution that began with the European debt crisis. This is an essential step to ensuring that Germany rebalances its economy and that Europe sticks together during and after the pandemic. Europe still faces enormous challenges, but now fiscal policy is a tailwind instead of a headwind. US-China: The Cold War Is Back On US-China tensions are heating back up and could provide the source of another crisis event that exacerbates the “risk off” mode in global financial markets. The underlying strategic conflict never went away – it is rooted in China’s rising geopolitical power relative to the United States. The “phase one” trade deal agreed last fall was a manifestly short-term, superficial deal meant to staunch the bleeding in China’s manufacturing sector and deliver President Trump a victory to take to the 2020 election. Beijing was never going to deliver the exorbitant promises of imports and was not likely to implement the difficult structural provisions until Trump achieved a second electoral mandate. Trump always had the option of accusing China of insufficient compliance, particularly if he won re-election. Now, however, both governments are faced with a global recession and are seeking scapegoats for the COVID-19 crisis. Xi Jinping doesn’t have an electoral constraint but he does have to maintain control of the party and rebuild popular confidence and legitimacy in the wake of the crisis. China’s private sector has suffered a series of blows since Xi took power. China’s trend growth is slowing, it is sitting on an historic debt pile, and it is now facing the deepest recession in modern memory. The protectionist threat from the United States and other nations is likely to intensify amid a global recession. Former Vice President Joe Biden has clinched the Democratic nomination and does not offer a more attractive option for China than President Trump. On the US side, Trump’s economic-electoral constraint is vanishing. Trump’s chances of reelection have been obliterated unless he manages to recreate himself as a successful “crisis president” and convince Americans not to change horses in mid-stream. Primarily this means he will focus on managing the pandemic. Yet it also gives Trump reason to try to change the subject and adopt an aggressive foreign or trade policy, particularly if the virus panic subsides. The economic downside has been removed but there could be political upside to a confrontation with China. The US public increasingly views China unfavorably and is now particularly concerned about medical supply chain vulnerabilities. A diplomatic crisis is already unfolding. China’s propaganda machine has gone into overdrive to distract its populace from the health crisis and recession. The main thrust of this campaign is to praise China’s success in halting the virus’s spread through draconian measures while criticizing the West’s ineffectual response, symbolized by Italy and the United States. This disinformation campaign escalated when Zhao Lijian, spokesman for the Ministry of Foreign Affairs, tweeted that COVID-19 originated in the United States. The conspiracy theory holds that it brought or deployed the coronavirus in China while a military unit visited for a friendly competition in Wuhan in October. A Hong Kong doctor who wrote an editorial exposing this thesis was forced to retract the article. President Trump responded by deliberately referring to COVID-19 as the “Chinese virus.” He defended these comments as a way of emphasizing the origin although China and others have criticized the president for dog-whistle racism. Secretary of State Mike Pompeo and Yang Jiechi, a top Chinese diplomat, met to address the dispute, but relations have only gotten worse. After the meeting China revoked the licenses of several prominent American journalists.4 The fact that conspiracy theories are being spouted by official and semi-official sources in the US and China reflects the dangerous combination of populism, nationalism, and jingoism flaring up in both countries – and the global recession has hardly begun.5 The phase one trade deal may collapse. Investors must now take seriously the possibility that the phase one trade deal will collapse. While China obviously will not meet its promised purchases for the year due to the recession, neither side has abandoned the deal. The CNY-USD exchange rate is still rising (Chart 10). President Trump presumably wants to maintain the deal as a feather in his cap for the election. This means that any failure would come from the China side, as an attack on Trump, or from Trump deciding he is a lame duck and has nothing to lose. These are substantial risks that would blindside the market and trigger more selling. Chart 10US And China Could Abandon Trade Deal Military and strategic tensions could also flare up in the South and East China Seas, the Korean peninsula, or the Taiwan Strait. While we have argued that Korea is an overstated geopolitical risk while Taiwan is understated, at this point both risks are completely off the radar and therefore vastly understated by financial markets. A “fourth Taiwan Strait crisis” could emerge from American deterrence or from Chinese encroachments on Taiwanese security. What is clear is that the US and China are growing more competitive, not more cooperative, as a result of the global pandemic. This is not a “G2” arrangement of global governance but a clash of nationalisms. Another risk is that President Trump would look elsewhere when he looks abroad: conflict with Iran-backed militias in Iraq is ongoing, and both Iran and Venezuela are on the verge of collapse, which could invite American action. A conflict or revolution in Iran would push up the oil price due to regional instability and would have major market-negative implications for Europe. Bottom Line: The US-China trade conflict had only been suspended momentarily. The economic collapse removes the primary constraint on conflict, and the US election is hanging in the balance, so Trump could try to cement his legacy as the president who confronted China. This is a major downside risk for markets even at current crisis lows. Investment Implications What are the market implications of the themes reviewed in this report? First, the virus will precipitate another leg down in globalization, which was already collapsing (Chart 11). Chart 11Globalization Has Peaked The US dollar will remain strong in the near term. It is too soon to go long commodities and emerging market currencies and risk assets, though it is notable that our Emerging Markets Strategy has booked profits on its short emerging market equity trade (Chart 12). Chart 12Too Soon To Go Long EM/Commodities Second, the Anglo-Saxon shift away from laissez faire leads toward dirigisme, an active state role in the economy. US stocks can outperform global stocks amid the global recession, but the rising odds that Trump will lose the election herald a generational anti-corporate turn in US policy. We are strategically long international stocks, which are far more heavily discounted. The combination of de-globalization and dirigisme is ultimately inflationary so we recommend that investors with a long-term horizon go long TIPS versus equivalent-maturity nominal Treasuries, following our US Bond Strategy. Third, Germany, the EU, and the ECB are taking dramatic steps to reinforce our theme of continued European integration. We are strategically long German consumers versus exporters and believe that recommendation should benefit once the virus outbreak is brought under control. There is more downside for EUR-USD in the near term although we remain long on a strategic (one-to-three year) horizon. Fourth, China will not come out the “winner” from the pandemic. It is suffering the first recession in modern memory and is beset by simultaneous internal and external economic challenges. It is also becoming the focus of negative attention globally due to its lack of integration into global standards. Economic decoupling is back on the table as the US may take advantage of the downturn to take protective actions. The US stimulus package in the works should be watched closely for “buy America” provisions and requirements for companies to move onshore. A Biden victory will not remove American “containment policy” directed toward China. Stay strategically long USD-CNY. The chief geopolitical insight from all of the above is that the market turmoil can be prolonged by geopolitical conflict, especially with Trump likely to be a lame duck president. With nations under extreme stress, and every nation fending for itself, the probability of conflicts is rising. We do however see the potential for collapsing oil prices to force Russia and Saudi Arabia back to the negotiating table, so we are initiating a tactical long Brent crude oil / short gold trade. Moreover we remain skeptical toward companies and assets exposed to the US-China relationship, particularly Chinese tech.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Margherita Stancati, "Lockdown of Recovering Italian Town Shows Effectiveness of Early Action," Wall Street Journal, March 16, 2020. 2 The conservatives Stephen Moore, Art Laffer, and Steve Forbes are virtually isolated in opposing the emergency fiscal measures – and will live in infamy for this, their “Mellon Doctrine” moment. 3 Costas Pitas and Andy Bruce, “UK unveils $420 billion lifeline for firms hit by coronavirus,” Reuters, March 17, 2020. 4 China retaliated against The Wall Street Journal for calling China “the sick man of Asia.” The United States responded by reducing the number of Chinese journalists licensed in the US. (Washington had earlier designated China state press as foreign government actors, which limited their permissible actions.) Beijing then ordered reporters from The Wall Street Journal, New York Times, and Washington Post whose licenses were set to expire in 2020 not to return. 5 Inflicting an epidemic on one’s own people is a very roundabout way to cause a global pandemic and harm the United States – obviously that is not what happened in China. It is also absurd to think that the US has essentially initiated World War III by committing an act of bioterrorism against China.

Special Report

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

Risk Of Debt Deflation… Chart II-1Singapore: Deflation Is At The Door Singaporean businesses and consumers have been deleveraging in the past six years. That, along with the ongoing export slump1  and collapse in tourism revenues – 50% and 5% of GDP, respectively – have likely pushed real and nominal GDP into contraction in Q1 2020. Negative income growth risks turning this gradual deleveraging into debt deflation. Debt deflation occurs when prices fall and the real value of debt rises. Given the private sector is still heavily leveraged, deflation will trigger defaults. This scenario would be disastrous for Singapore’s credit sensitive property and banking sectors – the two key pillars of this economy. Singapore is not far from this tipping point as core and trimmed-mean consumer prices inflation measures as well as GDP deflator are flirting with deflation (Chart II-1). In order to ensure that this ongoing deleveraging does not enter a debt deflation spiral, both monetary and fiscal authorities need to stimulate more aggressively than they already have. Specifically, they should reduce interest rates to zero and provide substantial fiscal stimulus. … Warrants Zero Interest Rates Even though Singapore households and companies have been deleveraging, they remain highly indebted - total non-financial private sector credit stands at 173% of GDP (Chart II-2, top panel). The middle and bottom panels on Chart II-2 illustrate company and household leverage, defined as the ratio of Singaporean banks domestic loans to non-financial businesses and households relative to corporate profits and employee compensation, respectively. Corporate profits and employee compensation are better measures because they are incomes available to corporates and households, while nominal GDP is not.  In brief, these measures gauge companies and households liabilities relative to their proper income. Critically, nominal GDP growth has dropped well below prime lending rates which stand at 5.25%. Besides, the prime lending rate in real (in inflation-adjusted) terms has risen as inflation dropped (Chart II-3). Chart II-2Singapore: Companies & Households Are Deleveraging Chart II-3Singapore: Interest Payments Are Elevated   This is dangerous and nominal income growth is falling below the nominal interest rate, worsening borrowers’ ability to service their debt. Chart II-4 shows that the private sector’s interest rate payments on debt are elevated relative to GDP. This risks pushing the level of non-performing loans (NPLs) at commercial banks much higher. The non-performing loan (NPL) ratio at Singaporean commercials banks is bound to rise from the low NPL ratio of 2%. Moreover, the ratio of special-mention loans - loans that are stressed but are not yet officially recognized as non-preforming - are also set to climb meaningfully from 2%. Furthermore, Singaporean banks have extended a non-negligible amount of loans to Chinese and ASEAN businesses. With the indebted mainland economy struggling following the COVID-19 epidemics and ASEAN companies strained by weakness in their domestic demand, Singaporean banks will have to deal with rising NPLs emanating from China and ASEAN. Singapore’s commercial banks will be forced to raise their provisioning levels significantly, which will hurt their profits. Provisions of the three large MSCI-listed commercial banks  have been already rising. This has been historically negative for bank share prices2 (Chart II-5). Chart II-4Singapore: NPL Provisions And Bank Stocks Chart II-5Singapore: Rates Are Heading To New Lows As banks boost their provisioning, shareholders will push them to curtail credit origination to control risks. This will dampen economic and income growth. Without bold actions by the authorities, the banking sector and the real economy are facing a dire outlook. Interest Rates Are Heading To Zero Although the monetary and fiscal authorities have provided stimulus, it remains inadequate to fend off rising risks of debt deflation. The MAS (Monetary Authority of Singapore) conducts monetary policy by guiding the trade-weighted exchange rate. The MAS depreciates the trade-weighted SGD when it wants to ease and vice versa. Given the economy has become much more leveraged and, thereby, more sensitive to credit and interest rates, depreciating currency is not always sufficient to create a swift turnaround in domestic demand. This is especially true when global trade is shrinking, as it is today. In brief, currency depreciation will only augment the market share of exporters in world trade even though their exports will continue shrinking in absolute terms. Hence, currency depreciation will not promptly boost income and employment in the export industries amid the ongoing global trade contraction. At the current juncture, currency depreciation without a substantial decline in borrowing costs will have little spillover to domestic demand. Chart II-6 illustrates that Singapore’s central bank has already been injecting liquidity in the banking system in order to bring interbank/money market rates lower. However, interest rates remain relatively elevated compared with the US, the euro area and Japan (Chart II-7), as well as relative to what this indebted economy needs. Chart II-6Singapore: Real Lending Rates Are High Chart II-7Singapore Interest Rates Are Above G3     On the fiscal side, the government budget will barely turn expansionary this year: expenditures will rise from 3% currently to just 7%, which translates to a 1% rise relative to GDP. This will not do much to boost overall growth. If the pace of domestic loan growth drops from 2.4% to 1.4% (by 100 basis points), that would generate a negative 1.8% credit impulse of GDP, more than offsetting the rise in the fiscal spending impulse. Chart II-8Singapore: Cyclical Sectors Are Contracting Confirming the lingering growth downtrend, economic conditions were dire even before the COVID-19 outbreak. Manufacturing production volume is shrinking and sea cargo handled has been dropping (Chart II-8). Electronic exports are contracting from a year ago (Chart II-8, bottom panel). Finally, corporate profits are not growing. Consumer spending is extremely weak. Retail volume sales excluding vehicle sales are contracting 2% from last year (Chart II-9). The excess-mired property sector is slowing down anew. Housing loans are contracting which will trigger a material drop in residential property sales (Chart II-10, top panel). As the latter transpires, construction activity will also shrink (Chart II-10, bottom panel). Chart II-9Singapore: Consumer Are Not Spending Chart II-10Singapore Property Sector Is Struggling Bottom Line: The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. Investment Recommendations The MAS will continue injecting more liquidity into the banking system to bring down interest rates further and devalue the currency. Exactly for these reasons, since June 8, 2018 we have been recommending shorting the SGD versus the JPY. This trade has so far produced a 7.3% gain with very low volatility (Chart II-11). Our target for this SGDJPY position is 70. Today we are booking profits on the short Hong Kong property developers / long Singapore property developers position because the Fed is about to cut rates to zero, which will reduce downside potential in Hong Kong real estate stocks. This recommendation has produced 21.5% profit since March 22, 2017 (Chart II-12). Chart II-11Stay With Short SGD / Long JPY Trade Chart II-12Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position   As to the overall stock market, we continue recommending a neutral allocation to Singapore within an EM dedicated equity portfolio. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Feature An analysis on Singapore is available below. The plunge in global risk assets is occurring at such a breathtaking pace that any economic analysis is pointless at this time. Economic growth forecasts have been reduced to moving targets. In our latest report published two days ago, we argued that we are witnessing the unravelling of the policy put. For now, monetary stimulus – both rate cuts and QE programs – are unlikely to halt the market riot. Fiscal stimulus is forthcoming but its actual impact on the real economy will not materialize until another several months. The only thing that investors can use to gauge market downside as of now are valuations and market technicals. This report presents the most important technical and valuations indicators that we are currently monitoring. All market prices are updated as of the close of Thursday, March 12, 2020. We are in a liquidation phase where fundamentals do not matter and markets often undershoot. Such indiscriminate liquidation also leads to major buying opportunities. We will book profits on the short EM stocks position when the MSCI EM equity index in USD hits 800. On Thursday March 12, the MSCI EM equity index closed at 880. Possibly, we will recommend accumulating EM stocks and will reverse our bearish bias on EM currencies and fixed-income markets if the EM MSCI Index reaches this level. Remarkably, the top chart on page 2 shows that major EM bear markets – in 1998, 2002, 2008 and 2015-16 – all bottomed when EM share prices hit their 24-year exponential moving average. This technical support for the MSCI EM stock index is currently 780, about 10% below yesterday’s close. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com EM Stocks Are Approaching A Major Defense Line Global Material Stocks Are At A Long-Term Technical Support Line A Long-Term Perspective On Brazilian Stocks The Brazilian Real Is Not Yet Very Cheap Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E (CAPE) Ratio For US Stocks Three Technical Support Levels For S&P 500 An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft Is FAANGM A Bubble That Has Reached A Top? US Market Cap As % Of GDP Was Record High Last Month Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies   Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies   Singapore: Zero Interest Rates Ahead   Risk Of Debt Deflation… Singaporean businesses and consumers have been deleveraging in the past six years. That, along with the ongoing export slump1  and collapse in tourism revenues – 50% and 5% of GDP, respectively – have likely pushed real and nominal GDP into contraction in Q1 2020. Negative income growth risks turning this gradual deleveraging into debt deflation. Debt deflation occurs when prices fall and the real value of debt rises. Given the private sector is still heavily leveraged, deflation will trigger defaults. This scenario would be disastrous for Singapore’s credit sensitive property and banking sectors – the two key pillars of this economy. Singapore is not far from this tipping point as core and trimmed-mean consumer prices inflation measures as well as GDP deflator are flirting with deflation (Chart II-1). In order to ensure that this ongoing deleveraging does not enter a debt deflation spiral, both monetary and fiscal authorities need to stimulate more aggressively than they already have. Specifically, they should reduce interest rates to zero and provide substantial fiscal stimulus. … Warrants Zero Interest Rates Even though Singapore households and companies have been deleveraging, they remain highly indebted - total non-financial private sector credit stands at 173% of GDP (Chart II-2, top panel). Chart II-1Singapore: Deflation Is At The Door Chart II-2Singapore: Companies & Households Are Deleveraging   The middle and bottom panels on Chart II-2 illustrate company and household leverage, defined as the ratio of Singaporean banks domestic loans to non-financial businesses and households relative to corporate profits and employee compensation, respectively. Corporate profits and employee compensation are better measures because they are incomes available to corporates and households, while nominal GDP is not.  In brief, these measures gauge companies and households liabilities relative to their proper income. Critically, nominal GDP growth has dropped well below prime lending rates which stand at 5.25%. Besides, the prime lending rate in real (in inflation-adjusted) terms has risen as inflation dropped (Chart II-3). This is dangerous and nominal income growth is falling below the nominal interest rate, worsening borrowers’ ability to service their debt. Chart II-4 shows that the private sector’s interest rate payments on debt are elevated relative to GDP. This risks pushing the level of non-performing loans (NPLs) at commercial banks much higher. Chart II-3Singapore: Real Lending Rates Are High Chart II-4Singapore: Interest Payments Are Elevated   The non-performing loan (NPL) ratio at Singaporean commercials banks is bound to rise from the low NPL ratio of 2%. Moreover, the ratio of special-mention loans - loans that are stressed but are not yet officially recognized as non-preforming - are also set to climb meaningfully from 2%. Chart II-5Singapore: NPL Provisions And Bank Stocks Furthermore, Singaporean banks have extended a non-negligible amount of loans to Chinese and ASEAN businesses. With the indebted mainland economy struggling following the COVID-19 epidemics and ASEAN companies strained by weakness in their domestic demand, Singaporean banks will have to deal with rising NPLs emanating from China and ASEAN. Singapore’s commercial banks will be forced to raise their provisioning levels significantly, which will hurt their profits. Provisions of the three large MSCI-listed commercial banks  have been already rising. This has been historically negative for bank share prices2 (Chart II-5). As banks boost their provisioning, shareholders will push them to curtail credit origination to control risks. This will dampen economic and income growth. Without bold actions by the authorities, the banking sector and the real economy are facing a dire outlook. Interest Rates Are Heading To Zero Although the monetary and fiscal authorities have provided stimulus, it remains inadequate to fend off rising risks of debt deflation. The MAS (Monetary Authority of Singapore) conducts monetary policy by guiding the trade-weighted exchange rate. The MAS depreciates the trade-weighted SGD when it wants to ease and vice versa. Given the economy has become much more leveraged and, thereby, more sensitive to credit and interest rates, depreciating currency is not always sufficient to create a swift turnaround in domestic demand. This is especially true when global trade is shrinking, as it is today. The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. In brief, currency depreciation will only augment the market share of exporters in world trade even though their exports will continue shrinking in absolute terms. Hence, currency depreciation will not promptly boost income and employment in the export industries amid the ongoing global trade contraction. At the current juncture, currency depreciation without a substantial decline in borrowing costs will have little spillover to domestic demand. Chart II-6 illustrates that Singapore’s central bank has already been injecting liquidity in the banking system in order to bring interbank/money market rates lower. However, interest rates remain relatively elevated compared with the US, the euro area and Japan (Chart II-7), as well as relative to what this indebted economy needs. Chart II-6Singapore: Rates Are Heading To New Lows Chart II-7Singapore Interest Rates Are Above G3     On the fiscal side, the government budget will barely turn expansionary this year: expenditures will rise from 3% currently to just 7%, which translates to a 1% rise relative to GDP. This will not do much to boost overall growth. If the pace of domestic loan growth drops from 2.4% to 1.4% (by 100 basis points), that would generate a negative 1.8% credit impulse of GDP, more than offsetting the rise in the fiscal spending impulse. Chart II-8Singapore: Cyclical Sectors Are Contracting Confirming the lingering growth downtrend, economic conditions were dire even before the COVID-19 outbreak. Manufacturing production volume is shrinking and sea cargo handled has been dropping (Chart II-8). Electronic exports are contracting from a year ago (Chart II-8, bottom panel). Finally, corporate profits are not growing. Consumer spending is extremely weak. Retail volume sales excluding vehicle sales are contracting 2% from last year (Chart II-9). The excess-mired property sector is slowing down anew. Housing loans are contracting which will trigger a material drop in residential property sales (Chart II-10, top panel). As the latter transpires, construction activity will also shrink (Chart II-10, bottom panel). Chart II-9Singapore: Consumer Are Not Spending Chart II-10Singapore Property Sector Is Struggling Bottom Line: The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. Investment Recommendations The MAS will continue injecting more liquidity into the banking system to bring down interest rates further and devalue the currency. Exactly for these reasons, since June 8, 2018 we have been recommending shorting the SGD versus the JPY. This trade has so far produced a 7.3% gain with very low volatility (Chart II-11). Our target for this SGDJPY position is 70. Today we are booking profits on the short Hong Kong property developers / long Singapore property developers position because the Fed is about to cut rates to zero, which will reduce downside potential in Hong Kong real estate stocks. This recommendation has produced 21.5% profit since March 22, 2017 (Chart II-12). Chart II-11Stay With Short SGD / Long JPY Trade Chart II-12Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position   As to the overall stock market, we continue recommending a neutral allocation to Singapore within an EM dedicated equity portfolio. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1   Domestic exports, excluding re-exports. 2   DBS Bank, Overseas-Chinese Banking, United Overseas Bank.

Highlights China is moving from virus containment to normalization and economic stimulus. The full weight of the virus panic is only now hitting the US public and has not yet peaked. The US – and western democracies in general – have the raw capabilities to manage the virus outbreak. The profile of global political risk is shifting as a result of the economic shock stemming from the virus. This implies that while equity markets are close to their bottom, they face more volatility. Feature Chart 1No Peak In New Cases Outside China China’s President Xi Jinping visited Wuhan, the epicenter of the coronavirus breakout that has triggered a global bear market, on March 10. While he did not declare outright victory over the virus, his symbolic visit reinforced the fact that China has drastically reduced the number of new daily cases both within and without Hubei province. Meanwhile the virus is spreading rapidly across the rest of the world (Chart 1). It is not clear if the outbreak and emergency response in the United States will follow the Italian or South Korean trajectory. The initial US response is not encouraging, but the US has latent institutional strengths. Either way the US is facing a tsunami of new cases in the very near term. Hence the panic among the American population can still escalate from here (Chart 2). Panic among households translates to a drop in economic activity that will ensure financial markets remain volatile, even if US equities are close to their bottom. Chart 2US Public Panic Has Not Peaked Yet Can Democracies Manage The Crisis? Chart 3Developed Economies Have Better Health The question has become salient because of the poorly managed cordon sanitaire in Italy and the slow and halting initial reaction of the United States. Moreover, to distract from China’s domestic crisis, the Communist Party has turned up the volume of its propaganda organs, advertising the success of China’s draconian containment measures and warning that the virus cannot be contained if the rest of the world does not follow suit. However, it is not the case that the pandemic can only be managed through absolutist policies. To date, developed economies and democracies – including westernized countries like Japan – have the best record in the world of improving public health and reducing mortality from infectious diseases. This is apparent simply by looking at life expectancy for those aged 60. Europe and Japan have the longest lives beyond 60, including extension of life when dealing with late-life health problems, while other regions lag, including Asia. The United States is on the low end of the developed countries but still considerably better than emerging market economies at prolonging life, even for unhealthy elderly folks (Chart 3). Chart 4US Has Reduced Flu/Pneumonia Deaths Dramatically The United States, like other countries, has done battle with a range of infectious diseases over the course of its history – in which it was the leader in economic, scientific, and technological advancement. These include cholera and viral epidemics like smallpox, Yellow Fever, the Spanish Flu, and SARS. The death rate for influenza and pneumonia has generally declined since the 1950s, although a counter-trend increase is conceivable given what occurred in the 1980s-90s (Chart 4).  The strategy that the US and developed economies have used, embodied in documents like the World Health Organization’s interim protocol for rapid operations to contain pandemics, is one of creating a containment zone with movement restrictions and a closely watched buffer zone in which a combination of anti-viral treatment and non-pharmaceutical treatment (e.g. social distancing) is employed. “Containment and isolation” strategies are generally successful even though they often fail to establish an impenetrable geographic cordon sanitaire, must rely on voluntary behavior, and will never receive total compliance. The survival instinct and social pressure are powerful enough to convince most individuals and households to keep their distance from others once they are informed of the risks. Targeted government measures by credible regimes with a monopoly on the use of force – in cases where strong restrictions are necessary – are effective. And in democracies they are kept in place only as long as necessary (the incubation period of the virus plus a few more weeks). Developed economies and democracies  have the best record of improving public health and reducing mortality from infectious diseases. The overall effect is to “flatten the curve,” e.g. to slow the spread of the virus, and delay and reduce the peak intensity of the number of cases and burden on hospitals and doctors.1 Of course, nations need institutional capacity and leadership to deal with a pandemic and the indirect impacts on their economies, trade, and supply chains. When businesses grind to a halt, will households be able to get what they need? If not, civic order could break down. Supply security is a fundamental national interest and governments that cannot provide it risk a loss of legitimacy and control. Major nations devote extensive resources to building and maintaining internal lines of communication so that neither natural nor man-made disasters can stop them from ensuring security and essential goods and services. Europe and North America will ultimately deal with the crisis successfully. A look at some basic indicators and indexes of national capabilities shows which nations are best and worst positioned to meet the logistical and supply challenges of the virus’s economic shock: The US ranks close to Japan in logistical capabilities, while Italy ranks between these two and Iran, which is woefully lacking (Chart 5). Chart 5Italy Suffers From Logistic Weaknesses Italy resembles China in having significant supply chain vulnerabilities (Chart 6), including quality of infrastructure (Chart 7). Obviously China has made leaps and bounds, but interior regions are still underserviced. Clearly China has benefited from greater government authority and capacity relative to Italy. Chart 6US Supply Chains Are Resilient Chart 7US Infrastructure Is High-Quality Even when it comes to basic food security, Italy and China are more vulnerable than others (Chart 8). Yet China has kept food shortages to a minimum throughout the crisis. The US is large enough that different regions will have greater vulnerabilities when it comes to the health crisis. The National Health Security Preparedness Index shows California, Florida, Georgia, Texas, and Michigan are below the national average in the ability to execute countermeasures to health crises (Chart 9).  Chart 8Food Security Risks Under Control In China Chart 9US: Regional Differences In Health Preparedness​​​​​​​ These institutional factors suggest that Europe and North America will ultimately deal with the crisis successfully, although in the near term the consequences are unpredictable. Italy’s experience has made it apparent to all nations that if the reproduction rate is not suppressed through containment and isolation, then the health system will be overwhelmed and the death rate will go up. But clearly this has nothing to do with Italy’s being a democracy, as neither Japan nor South Korea have had the same experience. Investment Conclusions The United States is moving more aggressively to mitigate the problem, beginning with President Trump’s ban on travel with continental Europe and declaration of a national emergency. With a bear market having occurred, and a recession likely, President Trump is losing the primary pillar of his reelection campaign. He will continue to make reflationary efforts to salvage the economy. He has announced $50 billion in emergency spending and a waiver on student debt loan payments worth as much as $85 billion. But he has also become a “crisis president.” This means that he may take dramatic, surprise actions that are market-negative in the short term in order to delay the spread of the virus. Emergency powers are extensive and he will utilize them not only to combat the pandemic but also to double down on the narrative that got him elected: closing off America’s borders and reducing its exposure to the risks of globalization. This can include the movement of people, from places other than China and continental Europe (already halted), and even capital flows.  This is another reason to expect greater volatility in the near term despite the huge discounts on offer. We are not bottom-feeding yet. The profile of global political risk is shifting as a result of the virus and its economic shock. If Trump is seen as having mishandled the health and wellbeing of the nation, then he loses the election regardless of whether stimulus measures help the economy rebound by November. Whereas if he takes drastic, economically painful measures now to control the virus, and ultimately the virus subsides, there is still a slim chance he can win election. His approval rating, at an average of 45%, has lost its upward momentum but has not yet collapsed. Regardless of the election, the financial bloodbath should not obfuscate for investors the fact that the US is the world’s most advanced economy and longest continuously running constitutional republic. It has survived a total Civil War, two World Wars, a Great Depression, and countless outbreaks of disease. It has the ability to take emergency action and mitigate pandemics. This means that a great buying opportunity is just around the corner. The profile of global political risk is shifting as a result of the virus and its economic shock. The above should make it clear that the US and Italy face the most immediate ramifications – both are much more likely to see changes in ruling party over the next year than they were. Policy, however, will remain counter-cyclical (reflationary) regardless.  Rogue regimes like Iran, Venezuela, and North Korea face renewed risks of regime failure and/or military confrontation with the US and its allies beginning in the immediate term, especially if President Trump becomes a clear “lame duck” in the coming months. Down the line, the Japanese, German, and French elections will be affected by the economic fallout of the virus scare. China and Russia face medium-term risks due to new difficulties in improving their populations’ quality of life. Their leaders and ruling parties have an authoritarian grip, but political risk will increase as a result of slower growth. China retains the ability to stimulate aggressively – which it is doing – but that will slow the reform and rebalancing process.   Russia, meanwhile, faces another wave of internal devaluation if it does not call off its emerging market-share war with Saudi Arabia. Presidents Vladimir Putin and Xi Jinping are likely to re-consolidate power by 2022, but they face much greater risks of domestic instability than they did before this year’s turmoil. Matt Gertken   Vice President Geopolitical Strategist  mattg@bcaresearch.com   Footnotes 1    Martin S. Cetron, “Quarantine, Isolation and Community Mitigation: Battling 21st Century Pandemics with a 14th Century Toolbox,” September 20, 2006, available at nationalacademies.org.