Equities

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Chart I-3B…But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Overweight We recommend investors continue to take refuge in health care stocks within the defensive universe as the coronavirus pandemic unfolds. If severe government measures are a prerequisite to stop the spread of the virus then growth will suffer a massive setback. Were President Trump to eventually take draconian measures similar to what the Italian Prime Minister imposed recently, and to effectively shut down the country, then PCE will collapse. In fact, PCE excluding health care will take a beating. Health care outlays will rise both in absolute terms and relative to overall spending (see chart, second & third panels). Given the safe haven status of the S&P health care index and the stable cash flows these businesses command, when growth is scarce, investors flock to any source of growth they can come by and health care stocks definitely fit that bill. The implication is an earnings-led durable health care sector outperformance phase, a message that our relative macro EPS growth model is forecasting for the rest of the year (see chart, bottom panel). Bottom Line: We reiterate our overweight recommendation in the largest market capitalization weighted defensive sector in the SPX, the S&P health care sector. For more details, please refer to this Monday’s Weekly Report.  

The coronavirus has served as a catalyst for a bear market in the SPX, the first since the GFC. We have been bearish up until this past Monday but given that we do not expect a GFC repeat we recommended investors with higher risk tolerance to dip their toes into the recent equity market weakness and deploy long-term capital.  Today we introduce US Equity Strategy’s Corona Virus Proof Equity Basket, a portfolio of 15 stocks that we think can rise in absolute terms and continue to defy gravity compared with the broad market as it is rather insulated from the COVID-19 pandemic. This basket includes a bankruptcy consultant, an e-learning company on the cloud, a software company that enables remote access, three grocers, a tele-medicine company, two biotech giants, a Big Pharma company, the biggest online store in the US, an online streaming service company, a teleconferencing company, and finally two household/cleaning products leaders. Moreover, this basket can also serve as a signpost that the worse is behind us, and that the fear from the pandemic is dissipating. We will be closely monitoring this relative share price ratio for any weakness in order to gauge if such a turnaround is evident. Bottom Line: We would buy this US Equity Strategy Corona Virus Proof portfolio in order to ride out extreme volatility in the coming months. Stay tuned. The ticker symbols for the stocks in the US Equity Strategy Corona Virus Proof Equity Basket are: TDOC, INST, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN.  

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

Equities were unhinged last week, as the trifecta of the corona virus becoming a pandemic, Saudi ripping the cord out of crude oil and the convulsing bond markets made for an explosive equity market cocktail. The result was two circuit breaker triggers last week and one yesterday near the -7% mark that (thankfully) worked as planned and brought some liquidity back into the markets. Our Complacency-Anxiety index plunged to a panic level that has marked previous equity market troughs (see chart). In yesterday’s Weekly Report, we also highlighted our capitulation index that is close to levels that have marked previous equity market troughs. We deem that a prolonged troughing phase will ensue leaving ample time for long-term investors to deploy capital. A retest near last Thursday’s and yesterday’s lows is a high probability event, at which point we think the market will likely hold those lows. Our bottoming out equity market roadmap is the 1987, 2011, 2015/16 and early 2018 drawdowns. Consolidation around recently depressed levels will serve as a signal to definitively put cyclical-oriented capital to work. Bottom Line: Investors with higher risk tolerance should be dipping their toes into market weakness and start to deploy long-term oriented capital.