Equities

We have been cyclically bearish the broad equity market and vindicated, especially given yesterday's circuit breaker drawdown in the SPX, heeding the messages of our EPS profit model, that had no pulse, and of the bond markets, with the 10/2 yield curve inversion last summer forewarning of recession. As a reminder, we have been a proponent that "it will not be different this time" and a recession would ensue, and there is little doubt we are in recession now. We believe the only sustainable way out of this mess is a big fiscal package as the Fed's easing via ZIRP and QE5 are given. With regard to a fiscal package we are looking for something similar to TARP in magnitude in order to stem the equity market hemorrhaging and instill some confidence that there is plenty of money available to deal with the fallout of the coronavirus. Q1 earnings season will be a kitchen sink quarter similar to Q4/2018 as CEOs have an opportunity to flush all the bad news in one shot. What worries us most is a doubling in the junk spread near the 2016 peak that will further tighten financial conditions and the looming bankruptcies that would push the default rate higher as the VIX has been forecasting (see chart). Counter-party risk is also on our radar screens as these violent moves in FX, fixed income, vol and equity markets will leave a visible mark. Bottom Line: With regard to equity market investment strategy, we would stay patient at the current juncture before deploying cyclically oriented capital and really hide in staples and health care stocks. Please look forward to the upcoming Monday's report for an update on our overweight recommendation in the health care sector and its key subcomponents.

Highlights Financial markets have experienced two weeks of wild swings: Following the negative 5-standard-deviation weekly move in the S&P 500 two weeks ago, the index moved at least 2.8% in each of last week’s first four sessions. 10- and 30-year Treasury yields made one all-time low after another. The coronavirus has arrived in the United States: It would appear inevitable that the coronavirus is going to spread across the US; the unknowns are how long it will spread, how deadly it will be, and how much it will impact the economy. Confronted with these unknowns, markets shot first and left asking questions for later. The selling may have gone a little far. The Fed and the Democratic candidates for president were in the news last week, … : The Fed made its first intra-meeting rate cut since the financial crisis was raging, cutting the fed funds rate by 50 basis points instead of waiting for its regularly scheduled March 17-18 gathering. Super Tuesday upended the chase for the Democratic presidential nomination, as our geopolitical strategists foresaw. … and we offer our quick read on their market impact: We expect that the Fed’s rate cut will be modestly positive for markets and the economy, while Joe Biden’s move to the head of the Democratic pack greatly diminished a risk that would otherwise have troubled investors all the way to November 3rd. Feature US equities have endured a rollercoaster ride over the last two-and-a-half weeks. From its all-time intraday high of 3,393.52 on February 19th, to the February 28th intraday low of 2,855.84, the S&P 500 corrected by 15.8% in just seven sessions. The brunt of the decline occurred two weeks ago, when the index lost 11.5% in its fourth worst week in the last six decades. The decline amounted to more than a negative 5-standard-deviation event, and took its place among what we now consider to be landmark episodes in US stock market history (Table 1). Table 1Socialism + Pandemic = History (But Not The Good Kind) The epic rout followed a weekend of distressing news. First, the coronavirus (COVID-19) slipped its Asian bonds, popping up fully formed in Italy and Iran in a sobering demonstration of its global reach. Second, Bernie Sanders had seemingly solidified his grip on the Democratic presidential nomination by trouncing the rest of the crowded field in the Nevada caucuses with nearly twice the share of the vote that he captured in his Iowa and New Hampshire wins. We therefore characterize the February 28th intraday low as the coronavirus/Sanders bottom. The former is still running around freely, but the latter has been largely contained. COVID-19 will surely be with us for a while longer, and may yet push the S&P 500 below its February 28th low, but it will have to do so without help from Bernie Sanders. Joe Biden reclaimed front-runner status following his tremendous Super Tuesday performance, and support for him coalesced with remarkable speed, relieving investors’ acute concern about a Sanders presidency. The primary campaign is still in its early stages, and the gaffe-prone Biden is capable of multiple stumbles between now and the nominating convention, but a general election without a self-declared socialist bent on ending health insurance as we know it will provoke considerably less market anxiety. The Rate Cut Equities had been pining for a rate cut, beginning last week’s surge upon the news that central bankers would be joining the G-7 Finance Ministers on their hastily arranged Tuesday morning conference call. After an immediate 2.5% pop upon the announcement of the intra-meeting cut, however, the S&P 500 sagged and wound up ending Tuesday’s session nearly 2% lower than its pre-cut level. The dismal market reception, and Powell’s own halting, tepid responses to questions at the press conference to discuss the rationale for the move left investors wondering if the Fed had made a mistake. We neither know nor care if it will turn out to be good policy, but we expect that the rate cut will lend support to risk assets over our 12-month investment horizon. Why would the Fed use monetary policy to try to combat a public health crisis, or any supply shock? Monetary policy tools were not made to fight public health crises. They will not speed the development of an antidote, make medical care more widely available, or make up for a lack of preparedness at the public health agencies leading the effort to blunt COVID-19’s spread. They also are not particularly well-suited to combat supply shocks. They cannot resolve global supply bottlenecks, put more people back to work in China, South Korea and Italy, or create and distribute all the test kits and protective clothing that medical professionals sorely need. It is within the Fed’s power, however, to try to keep COVID-19’s second-order economic consequences from taking root. Negative headlines, deserted shopping districts and runs on products like hand sanitizer and face masks can drag down business and consumer confidence. Falling confidence can weigh on consumption and investment, hobbling output, stifling employment growth, and raising the specter of a negatively self-reinforcing dynamic in which layoffs lead to less consumption, which feeds more layoffs, and less investment, etcetera. If the Fed can bolster the spirits of consumers and businesses, it can help to contain COVID-19’s adverse economic impact. Won’t this move leave the Fed with less ammunition down the road? Yes, it surely will, especially if the Fed would prefer to stick to conventional policy tools to combat the next recession. Last week’s cut may postpone the start date of that recession, however, affording the Fed a chance to execute a series of rate hikes before it arrives. For an investor with a timeframe that doesn’t exceed twelve months, it may not matter, provided the increased accommodation successfully reduces near-term recession risk. Do you think this move will be effective? At the margin, yes, we think it will. First of all, it will contribute to the mortgage-refinancing wave that has been building since the beginning of the year (Chart 1). With an average 3.45% 30-year fixed-rate mortgage rate, data provider Black Knight estimates 11 million borrowers could save at least 75 basis points by refinancing their existing loans.1 If the average rate were to fall to 3%, as it would if the spread between mortgage rates and Treasury yields simply eases back to the 2% neighborhood (Chart 2), the pool of potential refinancers would expand to 19 million. Reduced mortgage payments put more money in homeowners’ pockets and will help support consumption at the margin. Chart 1Mortgage Refis Were Already Ramping Up, ... Chart 2... And There Will Be Even More Activity Once Mortgage Spreads Normalize Lower rates will also increase demand for new-home purchases, which have positive multiplier effects, and other big-ticket consumer goods. They will also support investment at the margin, as hurdle rates fall, and more opportunities are projected to generate a positive net present value. Potential homebuyers may be less prone to attend open houses or conduct home searches if COVID-19 spreads, and skittish managers may be less prone to invest, but easier monetary conditions do promote economic activity. Finally, a Fed that is demonstrably committed to easing monetary conditions to mitigate COVID-19’s potential negative impacts may help shore up business and consumer confidence. It will take confidence to keep gloomy virus headlines from becoming a self-fulfilling recession prophecy. As Figure 1 illustrates, the Fed does have the means to boost demand in financial markets and the real economy. Figure 1Monetary Policy And The Economy What will it mean for markets? It may encourage investors to pay more for each dollar of a corporation’s earnings, helping to cushion equities from falling earnings projections (the Confidence/Risk Taking channel in Figure 1), though we think a surer outcome is that it will keep the search for yield at a fever pitch. Life insurers, pension funds and endowments can no longer rely on highly-rated sovereign bonds to deliver the income to meet their fixed obligations, but have very little leeway to allocate away from fixed income. They have therefore been forced to venture further and further out the risk curve (Figure 1’s Portfolio Balance Effect), which has had the effect of providing an ample supply of funds for less-than-pristine borrowers. Under zero- and negative-interest-rate policy (ZIRP and NIRP, respectively) just about any borrower aside from brick-and-mortar retailers and thinly capitalized oil drillers can attract a line of would-be lenders out the door and around the corner simply by offering an incremental 50-75 bps of yield. Since no borrower defaults, or goes bankrupt, as long as there is a lender willing to roll over its maturing obligations, extraordinarily accommodative monetary policy has had the effect of limiting default rates. We expect that the Fed’s move back in the direction of ZIRP will continue to squeeze spreads and ease financial conditions. That’s far from an ideal fundamental basis for owning spread product, and it won’t keep credit outperforming forever, but we expect it will allow spread product to continue to generate positive excess returns over Treasuries and cash over the next twelve months. Recession Prospects There is no doubt that the probability of a recession is rising. COVID-19 is already exerting intense pressure on the airline and hotel industries, and strapped small businesses will find themselves in its crosshairs soon. It is certainly possible that a recession could sneak up on us while we focus on our assessment of the monetary policy backdrop. But just as COVID-19 survival rates are heavily influenced by a patient’s intrinsic condition, the economy’s prognosis may be a function of its pre-outbreak status. To assess the economy’s vital signs, we begin with housing, the major economic segment with the greatest interest-rate sensitivity. If monetary policy is less accommodative than we’ve estimated, the housing market might be gasping for air, but it appears to be as fit as a fiddle. Permits and starts turned sharply higher in the middle of last year (Chart 3, top panel), following the sales component of the NAHB survey (Chart 3, bottom panel) and purchase mortgage applications (Chart 3, middle panel). Homes are already quite affordable, relative to history (Chart 4, top panel), and they’re bound to get even more affordable as mortgage rates fall. Chart 3Housing Charts Are Up And To The Right Across The Board Chart 4Homes Are Amply Affordable Nothing in the available data indicates that housing is running too hot. Residential investment’s contribution to GDP has flipped from barely negative to modestly positive (Chart 5), and there are no signs that its current course is unsustainable. Unsold inventories and the share of vacant homes are at 25-year lows (Chart 6), and starts and permits are only just catching up with the multi-year average of household formations, suggesting that the market has been undersupplied since the crisis excesses were worked off. The overall takeaway is that the housing market is in the early days of an overdue recovery that has plenty of room to run. Chart 5Residential Investment's Current Pace Is Easily Sustainable, ... Chart 6... And The Housing Market Still Looks Undersupplied Chart 7The Labor Market Is Strong Table 2No Sign Of Recession Here February’s employment situation report, ignored by markets in the throes of Friday's selloff, suggests that the labor market, and by extension the economy, was in fighting trim before COVID-19 took root in American soil (Chart 7). February’s net job additions far surpassed consensus estimates, and the figures for January and December were revised appreciably higher (Table 2). With the three-month moving average of net additions coming in one-third higher than expected, the report was nothing short of tremendous. The March release is sure to be worse, and the all-time record streak of expanding monthly payrolls may well come to an end, but the patient was in an awfully robust state before it encountered the virus, and that bodes well for its immediate future. The Democratic Primaries Super Tuesday turned out to be super for US financial markets. With all of the Democratic party’s machinery now at the service of Joe Biden, the probability that frightening left-tail outcomes might emerge from the general election has been dramatically reduced. Markets can live with a Biden-Trump contest no matter how it turns out. Although we thought that markets were exaggerating the potentially negative conditions that would ensue under President Sanders, they would have been subject to rolling bouts of angst every time his general election prospects rose. Though our geopolitical strategists unwaveringly saw the former vice president as the Democratic frontrunner, theirs was a decidedly minority view. Following the Nevada caucus, Sanders was viewed far and wide as the presumptive nominee. Although a Biden administration would presumably be less market-friendly than the current administration, he himself is a card-carrying member of the establishment and wouldn’t do anything that would upset the apple cart. From an investment perspective, Biden is the candidate that would Make America Predictable Again, and even if re-election is markets’ preferred outcome, the prospect of a Biden presidency is hardly frightening. Investment Implications Although our conviction level has fallen in the face of COVID-19 uncertainties, we hold to our view that a soft patch is more likely than a recession, and a correction is more likely than a bear market. We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. We think the most plausible worst-case scenario is a sharp but short recession, produced by a nasty supply shock that frightens households and businesses enough that they cease to consume or invest. The demand strike would imperil indebted businesses that suffered the biggest revenue declines: airlines, hotels, restaurants, retailers, thinly capitalized oil producers and a range of small businesses. They would shrink their workforces and many would default on their loans. That would be bad, as all recessions are bad, but it wouldn’t be a replay of the crisis. Credit extended to the sorts of borrowers listed above, ex-small businesses, is well-dispersed throughout the economy via corporate bonds and securitizations. The exposures the SIFI banks and their large- and mid-cap regional bank cousins have retained will be easily absorbed by the layers of additional capital mandated by Dodd-Frank and Basel 3. It seems to us that markets are pricing in a significant probability of something much worse than a run-of-the-mill recession, and we think that sets up an attractive risk-reward profile for investors in risk assets. We reiterate our risk-friendly recommendations, though we now recommend that fixed-income investors maintain benchmark duration positioning. We failed to appreciate the potential scope for a decline in long yields and are correcting course now.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Boston, Claire and Raimonde, Olivia, “A 30-Year Mortgage Below 3%? Treasury Rally Offers Bargain Loans,” Bloomberg, March 5, 2020.

The Fed’s inter meeting cut this week signals that the FOMC is panicky and has now acted a mere two days after the SPX fell 16% from the February 19 all-time highs. As a reminder, following the last 20% SPX correction in late 2018 it took the Fed seven months to cut rates! As the WSJ recently reported “Since 1998, the Fed has cut interest rates six other times between regularly scheduled meetings. Following each of those moves, the Fed has lowered rates again at its next policy meeting.” Thus, the fed funds rate is on the path to hitting the zero lower bound sooner rather than later, likely pulling longer term yields down with it. Tack on the safe haven flows the US Treasury market enjoys and the Treasury/Bund spread is also headed south. This spread has been an excellent leading indicator for the SPX over the past decades, as we have highlighted1 in the past, and warns that the S&P 500 will be lower in 9-12 months. Bottom Line: Stay cautious on the cyclical prospects of the broad equity market.   1    Please see U.S. Equity Strategy Insight Report, “Treasury/Bund Spread And The SPX,” dated April 18, 2019, available at uses.bcaresearch.com.

Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight1 and this Monday’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel). Tach on the coronavirus outbreak, and if supply chain breakdowns increase over the course of the next few weeks, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel). Bottom Line: We trimmed the S&P tech sector to underweight. For more details, please refer to this Monday’s Weekly Report. ​​​​​​​ Footnotes 1    Please see BCA US Equity Strategy Weekly Report, "Crosscurrents" dated February 3, 2020, available at uses.bcaresearch.com.

Highlights An analysis on Colombia is available below. If EM share prices hold at current levels, a major rally will likely unfold. If they are unable to hold, a substantial breakdown will likely ensue. The direction of EM US dollar and local currency bond yields will be the key to whether EM share prices break down or not. We expect continuous EM currency depreciation that will likely trigger foreign capital outflows from both EM credit markets and domestic bonds. This leads us to reiterate our short position in EM stocks. We are booking profits on the long implied EM equity volatility and the short Colombian peso/long Russian ruble positions. Feature The Federal Reserve’s intra-meeting rate cut this week might temporarily boost EM risk assets and currencies. However, it is also possible that investors might begin questioning the ability of policymakers in general and the Fed in particular to continuously boost risk assets. In recent years, investors have been operating under the implicit assumption that policymakers in the US, China and Europe have complete control over financial markets and global growth, and will not allow things to get out of hand. Investors have been ignoring contracting global ex-US profits as well as exceedingly high US equity multiples and extremely low corporate spreads worldwide. In the past 12 months, investors have been ignoring contracting global ex-US profits (Chart I-1) as well as exceedingly high US equity multiples. This has been occurring because of the infamous ‘policymakers put’ on risk assets. As doubts about policymakers’ ability to defend global growth and financial markets from COVID-19 heighten, investors will likely throw in the towel and trim risk exposure. A sudden stop in capital flows into EM is a distinct possibility. The Last Line Of Defense EM share prices are at a critical juncture (Chart I-2). If they hold at current levels, a major rally will likely unfold. If they are unable to hold at current levels, a substantial breakdown will likely ensue. Chart I-1Profitless Rally In 2019 Makes Stocks Vulnerable Chart I-2EM Share Prices Are At A Critical Juncture   What should investors be looking at to determine whether EM share prices will find a bottom close to current levels, or whether another major down-leg is in the cards? In our opinion, the direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Chart I-3 illustrates that EM equity prices move in tandem with EM corporate US dollar bond yields as well as EM local currency bond yields (bond yields are shown inverted on both panels). Falling EM fixed income yields have helped EM share prices tremendously in the past year. Chart I-3EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM corporate US dollar bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when EM credit spreads are widening more than Treasury yields are falling; or (3) when both US government bond yields and EM credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for US government bonds, presently EM corporate US dollar bond yields can only rise if their credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently rests with EM corporate spreads. EM corporate and sovereign credit spreads are breaking above a major technical resistance (Chart I-4). The direction of these credit spreads is contingent on EM exchange rates and commodities prices as demonstrated in Chart I-5. Credit spreads are shown inverted in both panels of this chart. Chart I-4A Breakout In EM Sovereign And Corporate Credit Spreads? Chart I-5Falling EM Currencies And Commodities Herald Wider EM Credit Spreads   EM exchange rates are also crucial for foreign investors’ in EM domestic bonds. The top panel of Chart I-6 demonstrates that even though the total return on the JP Morgan EM GBI domestic bond index has been surging in local currency terms, the same measure in US dollar terms is still below its 2012 level. The gap is due to EM exchange rates. EM local currency bond yields are at all-time lows (Chart I-6, bottom panel), reflecting very subdued nominal income growth and low inflation in many developing economies (Chart I-7). Chart I-6EM Currencies Are Key To EM Domestic Bonds Total Returns Chart I-7Inflation Is Undershooting In EM Ex-China   Hence, low EM domestic bond yields are justified by their fundamentals. Yet foreign investors are very large players in EM local bonds, and their willingness to hold these instruments is contingent on EM exchange rates’ outlook. The sensitivity of international capital flows into EM US dollar and local currency bonds to EM exchange rates has diminished in recent years because of global investors’ unrelenting search for yield. As QE policies by DM central banks have removed some $9 trillion in high-quality securities from circulation, the volume of fixed-income securities available in the markets has shrunk. This has led to unrelenting capital inflows into EM fixed-income markets, despite lingering weakness in their exchange rates. Nonetheless, sensitivity of fund flows into EM fixed-income markets to EM exchange rates has diminished but has not yet outright vanished. If EM currencies depreciate further, odds are that there will be a sudden stop in capital flows into EM fixed-income markets. Outside of some basket cases, we do not expect the majority of EM governments or corporations to default on their debt. Yet, we foresee further meaningful EM currency depreciation which will simply raise the cost of servicing foreign currency debt. It would be natural for sovereign and corporate credit spreads to widen as they begin pricing in diminished creditworthiness among EM debtors in foreign currency terms.     Bottom Line: Unlike EM equities, EM fixed-income markets are a crowded trade and are overbought. Hence, any selloff in these markets could trigger an exodus of capital pushing up their yields. Rising yields will in turn push EM equities over the cliff. EM Currencies: More Downside We expect EM currencies to continue depreciating. EM ex-China currencies’ total return index (including carry) versus the US dollar is breaking down (Chart I-8, top panel). This is occurring despite the plunge in US interest rates. Notably, as illustrated in the bottom panel of Chart I-8, EM ex-China currencies have not been correlated with US bond yields. The breakdown in correlation between EM exchange rates and US interest rates is not new. This means that the Fed's easing will not prevent EM currency depreciation. EM currencies correlate with commodities prices generally and industrial metals prices in particular (Chart I-9, top panel). The latter has formed a head-and-shoulders pattern and has broken down (Chart I-9, bottom panel). The path of least resistance for industrial metal prices is down. Chart I-8More downside In EM Ex-China Currencies Chart I-9A Breakdown In Commodities Points To A Relapse In EM Currencies Chart I-10Chinese Imports Are Key To EM Currencies EM currencies’ cyclical fluctuations occur in-sync with global trade and Chinese imports (Chart I-10). Both will stay very weak for now. Finally, China is stimulating, and we believe the pace of stimulus will accelerate. However, the measures announced by the authorities so far are insufficient to project a rapid and lasting growth recovery. In particular, the most prominent measure announced in China is the PBoC’s special re-lending quota of RMB 300 billion to enterprises fighting the coronavirus outbreak. However, this amount should be put into perspective. In 2019, private and public net credit flows were RMB 23.8 trillion, and net new broad money (M2) creation was RMB 16 trillion. Thus, this re-lending quota will boost aggregate public and private credit flow by only 1.2% and broad money flow by mere 2%. This is simply not sufficient to meaningfully boost growth in China. Notably, daily, commodities prices in China do not yet confirm any growth recovery (Chart I-11). Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Bottom Line: The selloff in EM exchange rates will persist. As discussed above, this will likely lead to outflows from both EM credit markets and domestic bonds. Reading Markets’ Tea Leaves It is impossible to forecast the pace and scope of the spread of COVID-19 as well as the precautionary actions taken by consumers and businesses around the world. In brief, it is unfeasible to assess the COVID-19’s impact on the global economy. The direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Rather than throwing darts with our eyes closed, we examine profiles of various financial markets with the goal of detecting subtle messages that financial markets often send: Aggregate EM small-cap and Chinese investable small-cap stocks seem to be breaking down (Chart I-12). Chart I-11Daily Commodities Prices In China: No Sign Of Revival Chart I-12Investable Small Cap Stocks Seem To Be Breaking Down   The technical profiles of various EM currencies versus the US dollar on a total return basis (including the carry) are consistent with a genuine bear market (Chart I-13). Hence, their weakness has further to go. Global industrial stocks’ relative performance against the global equity benchmark has broken below its previous technical support (Chart I-14). This is a bad omen for global growth. Chart I-13EM Currencies Are In A Genuine Bear Market Chart I-14A Breakdown In Global Industrials Relative Performance   Finally, Korean tech stocks as well as the Nikkei index seem to have formed a major top (Chart I-15). This technical configuration suggests that their relapse will very likely last longer and go further. Chart I-15A Major Top in Korean And Japanese Stocks? All these signposts relay a downbeat message on global growth and, consequently, EM risk assets and currencies. A pertinent question to ask is whether the currently extremely high level of the VIX is a contrarian signal to buy stocks? Investors often buy the VIX to hedge their underlying equity portfolios from short-term downside. However, when and as they begin to view the equity selloff as enduring, they close their long VIX positions and simultaneously sell stocks. In brief, the VIX’s current elevated levels are likely to be a sign that many investors are still long stocks. When investors trim their equity holdings, they will likely also liquidate their long VIX positions. Thereby, share prices could drop alongside a falling VIX. Therefore, we are using the recent surge in equity volatility to close our long position in implied EM equity volatility. Even though risks to EM share prices are still skewed to the downside, their selloff may not be accompanied by substantially higher EM equity volatility. However, we continue to recommend betting on higher implied volatility in EM currencies. The latter still remains very low. Investment Conclusions We reinstated our short position on the EM equity index on January 30, and this trade remains intact. For global equity portfolios, we continue to recommend underweighting EM versus DM. Within the EM equity universe, our overweights are Korea, Thailand, Russia, central Europe, Mexico, Vietnam, Pakistan and the UAE. Our underweights are Indonesia, the Philippines, South Africa, Turkey and Colombia. We are contemplating downgrading Brazilian equities from neutral to underweight. The change is primarily driven by our downbeat view on banks (Chart I-16). This is in addition to our existing bearish view on commodities. We will publish a Special Report on Brazilian banks in the coming weeks. Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Among the EM equity sectors, we continue to recommend a long EM consumer staples/short banks trade (Chart I-17, top panel) as well as a short both EM and Chinese banks versus their US peers positions (Chart I-17, middle and bottom panels). Chart I-16Brazilian Bank Stocks Are Breaking Down? Chart I-17Our Favored EM Equity Sector Bets   We continue to recommend a short position in a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. We are also structurally bearish on the RMB. Today we are booking profits on the short Colombian peso / long Russian ruble trade (please refer to section on Colombia on pages 13-17). With respect to EM local currency bonds and EM sovereign credit, our overweights are Mexico, Russia, Colombia, Thailand, Malaysia and Korea. Our underweights are South Africa, Turkey, Indonesia, and the Philippines. The remaining markets warrant a neutral allocation. As always, the list of recommendations is available at end of each week’s report and on our web page. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Colombia: Upgrade Domestic Bonds; Take Profits On Short Peso Trade Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums Chart II-6Consumer Spending Has Been Supported By Borrowing Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, We are publishing an abbreviated report this week. Last night, I sent you a special report written by Matt Gertken, BCA’s chief geopolitical strategist, containing his analysis of the US presidential race following Super Tuesday’s results. I hope you will take the time to read Matt’s excellent report. Best regards, Peter Berezin, Chief Global Strategist Highlights While a 1918 Spanish flu-type scenario cannot be ruled out, it is unlikely. Evidence is emerging that a handful of sensible measures can significantly slow the spread of the virus. The fact that the number of new cases outside of China fell from 2,410 on March 3rd to 2,160 on March 4th indicates that these measures may be working. The saga of the Diamond Princess cruise liner suggests that the true fatality rate may be under 1%. Tentative evidence that the virus has mutated into a less lethal form implies that the fatality rate could fall even more. Investors should remain overweight equities. The shift towards even looser monetary policy in the US and elsewhere has increased the probability that stocks will rip higher, perhaps even entering a full-fledged bubble like they did in 1998 after the Fed cut rates in the wake of Long-Term Capital Management‘s implosion. Global bond yields will rise modestly from current levels. While the Fed is highly likely to cut rates another 25 basis points later this month, we doubt that rates will stay as low for as long as markets currently anticipate. US yields will increase more than yields abroad, which should take some pressure off the dollar. Nevertheless, as a countercyclical currency, the greenback will likely trade lower over the remainder of the year as global growth begins to reaccelerate. Stay Overweight Stocks We upgraded our near-term view on global equities last Friday morning after having penned a report the prior week entitled “Markets Too Complacent About The Coronavirus”. Despite this morning’s setback, the MSCI All-Country World index is still up 5.5% in dollar terms since our upgrade. The rebound in stocks has prompted some clients to ask whether it makes sense to revert to a more cautious stance again. The stock market is certainly pricing in a less apocalyptic scenario than it was on Friday. Nevertheless, we think investors should maintain a bullish posture towards equities for the time being. The shift towards even looser monetary policy in the US and elsewhere has increased the probability that stocks will rip higher, perhaps even entering a full-fledged bubble like they did in 1998 after the Fed cut rates in the wake of Long-Term Capital Management‘s implosion. A Manageable Problem While a 1918 Spanish flu-type scenario cannot be ruled out, it is unlikely. For one thing, most people died from secondary bacterial pneumonia back then. The virus damaged the lungs and bronchial tubes of its victims, permitting common bacteria to infect the lungs. This problem can now be readily treated with antibiotics. Moreover, as China’s experience demonstrates, it is possible to contain the coronavirus. China has recorded just 42 new cases outside of Hubei since February 26. The number of cases in Hubei has also plunged. In fact, the government has already closed one of its makeshift hospitals built to house COVID-19 patients. One might argue that other countries will not be able to implement the same draconian measures that China was willing to take. We are sympathetic to this view, but would note that Singapore and Hong Kong have also been able to stem the outbreak without imposing mass quarantines. In fact, it is worth noting that the number of new cases outside of China fell from 2,410 on March 3rd to 2,160 on March 4th. While one day does not make a trend, it is an encouraging development. Keep Washing It may turn out that a handful of sensible measures can significantly slow the spread of the virus, and perhaps even in a best-case scenario, stop it in its tracks. These include frequent handwashing, avoiding mass gatherings, and wearing a face mask in public. Granted, a mask will not help you much if you are not already infected, but if a social norm is established that compels everyone to wear a mask in public for a period of a few months, then those who are infected but do not know it will pose less of a risk to others. Extreme shaming of people who waltz into work with cold symptoms would also be a good idea. Who knows, we might even end up realizing my lifelong dream of replacing the grubby western handshake with a much more elegant Thai wai. What’s The Current Fatality Rate? A simple calculation of the number of COVID-19 deaths divided by the number of confirmed cases implies that the current fatality rate is around 3%. However, this figure is probably overstated because the denominator excludes people with mild symptoms who were never tested. The outbreak on the Diamond Princess cruise liner offers a potentially important natural experiment. Of the 705 people on board who have contracted the virus, only six have died. All six were over the age of 70. This is actually a fairly low fatality rate, considering that those on board were probably exposed to concentrated viral loads, and in some cases, had their treatment delayed. Admittedly, not everyone on board has fully recovered. Thus, more deaths could still occur. Nevertheless, the cruise ship’s saga does suggest that the true fatality rate from COVID-19 may be less than 1%, with most of the deaths confined to the elderly and those with pre-existing respiratory conditions.  Two Virus Strains The other piece of good news has to do with the virus itself. A recent study conducted by researchers at Peking University’s School of Life Sciences and the Institut Pasteur of Shanghai has revealed that the virus has evolved into two major strains, designated L and S. Strain L is the more pervasive and aggressive of the two, but has become less common since early January.1  This is not surprising. Viruses that quickly leave people bedridden will spread less rapidly than those that produce milder symptoms. This suggests that the fatality rate from the virus could trend lower. Joementum The other market-relevant development this week was Joe Biden‘s better-than-expected performance in the South Carolina primary on Saturday and the Super Tuesday states. Betting markets are now giving Biden a 76% chance of becoming the Democratic nominee, up from 7% on February 11. Unlike in 1918 when the Bolsheviks consolidated power, Bernie “I don’t mind people calling me a communist” Sanders no longer has much of a path to becoming America’s first socialist leader. As president, Joe Biden would likely take a more conciliatory stance towards trade issues with China. That said, if the Democrats manage to capture the Senate, Biden would probably be willing to sign into law a bill that reversed at least part of Trump’s corporate tax cuts. On balance, the impact on markets would probably not be huge regardless of who wins the election. This suggests that US political risk could fade over the coming months. That is bullish for stocks. Investment Conclusions Investors should overweight global equities over both a 3-month and 12-month horizon. Bond yields will rise modestly from current levels. While the Fed is highly likely to cut rates a further 25 basis points later this month, we doubt that rates will stay as low for as long as markets currently anticipate. US yields will increase more than yields abroad, which should take some pressure off the dollar. Nevertheless, as a countercyclical currency, the greenback will likely trade lower over the remainder of the year as global growth begins to reaccelerate. The combination of stronger growth and a weaker dollar will lift commodity prices, while also giving cyclical stocks and financials a boost. Cyclicals and financials are overrepresented in non-US indices, which implies that international stocks will outperform their US peers.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1    Xiaolu Tang, Changcheng Wu, Xiang Li, Yuhe Song, Xinmin Yao, Xinkai Wu, Yuange Duan, Hong Zhang, Yirong Wang, Zhaohui Qian, Jie Cui, Jian Lu, “On the origin and continuing evolution of SARS-CoV-2,” National Science Review (March 3, 2020). Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Trades Closed In 2015-2020

Highlights Financial markets are now fully priced for an economic downturn lasting one quarter… …but they are not fully priced for a recession. To go tactically long equities versus bonds requires a high conviction that the coronavirus induced downturn will last no longer than one quarter. The big risk is that the coronavirus incubation period might be very long, rendering containment strategies ineffective. Hence, a better investment play is to go long positive yielding US T-bonds and/or UK gilts versus negative yielding Swiss bonds and/or German bunds… …or go long negative yielding currencies versus positive yielding currencies. Our favoured expression is long CHF/USD. Fractal trade: overweight Poland versus Portugal. Feature Chart I-1AFinancial Markets Are Priced For A One-Quarter Downturn... Chart I-1B...But Not For A ##br##Recession They say that when China sneezes, the rest of the world catches a cold. But the saying was meant as an economic metaphor, not as a literal medical truth.1 The current coronavirus crisis has two potential happy endings: ‘containment’, in which its worldwide contagion is halted; or ‘normalisation’, in which it becomes accepted as just another type of winter flu. The virus crisis also has a potential unhappy ending in which neither containment nor normalisation can happen. Containing Contagion To determine whether the virus crisis has a happy or unhappy ending, we must answer three crucial questions: 1. Does the virus thrive only in cold weather? If yes, then the onset of spring and summer should naturally contain the contagion (in the northern hemisphere). We are not experts in epidemiology or immunology, but we understand that the Covid-19 virus surface is a lipid (fat) which could become fragile at higher temperatures. Albeit this might just be a temporary containment until temperatures drop again. 2. Does the virus have a short incubation period before symptoms arise? If yes, then quarantining and containment will be effective because infected people are quickly identified. But if, after infection, there is a long asymptomatic period, then containment would be impossible – because for an extended period the virus would be ‘under cover’. In this regard, the dispersion of infections is as important as the number of infections. A thousand cases across a hundred countries is much more worrying than a thousand cases concentrated in two or three countries (Chart I-2). Chart I-2Covid-19 Has Spread To 80 Countries 3. Are most infections going undetected because the symptoms are very mild? If yes, then the true mortality rate of the Covid-19 virus is much lower than we think, and perhaps not that different to the mortality rate of winter flu, at around 1 in a 1000. In which case, the new virus could become ‘normalised’ as a variant of the flu. But if the current mortality rate, at ten times deadlier than the flu, is accurate, then it would be difficult to normalise (Chart I-3). Chart I-3The Covid-19 Mortality Rate Is Ten Times Deadlier Than The Flu. Or Is It? An unhappy ending to the crisis will happen if the answer to all three questions is ‘no’. The main risk is that the asymptomatic incubation period appears to be quite long, rendering containment strategies ineffective. Still, even if the happy ending happens, there are two further questions. How much disruption will the economy suffer before the happy ending? And what have the financial markets priced? The Economic Disruption The disruption to the economy comes from both the supply side and the demand side: the supply side because containment strategies such as quarantining entire towns, shuttering factories, and cancelling major sports and social events hurt output; the demand side because a fearful public’s reluctance to use public transport, visit crowded places such as shopping malls, or travel abroad hurt spending. In this way, both production and consumption will suffer a large hit in the first quarter, at the very least. However, when normal activity eventually resumes, production and consumption will bounce back to pre-crisis levels, and in some cases overshoot pre-crisis levels. For example, if the crisis lasts for a quarter, movie-goers will return to the cinemas as usual in the second quarter, albeit they will not compensate for the visit they missed in the first quarter; but for manufacturers, the backlog of components that were not made during the first quarter will mean that twice as many will be made in the second quarter. For the financial markets, it is not the depth of the V that is important so much as its length. Therefore, economic output will experience a ‘V’ (Chart I-4): a lurch down followed by a symmetrical, or potentially even larger, snapback. However, for the financial markets, it is not the depth of the V that is important so much as its length. Chart I-4Economic Output Will Experience A 'V' The Financial Market Disruption Anticipating the economy to experience a V, investors respond to the crisis according to the expected length of the V versus the different lengths of their investment horizons. By length of investment horizon, we mean the minimum timeframe over which the investor cares about a price move, or ‘marks to market’. Say the market expects the downturn to last three months, followed by a full recovery. A three-month investor, caring about the price in three months, will capitulate. He will sell all his equities and buy bonds. Whereas a six-month investor, caring about the price only in six months, will not capitulate because he will factor in both the down-leg and subsequent up-leg of the V. Meanwhile, a twelve-month investor will be completely unfazed by the short-lived downturn. Therefore, if the downturn lasts one quarter only, the market will bottom when all the three-month investors have capitulated, which is to say become indistinguishable in their behaviour from a 1-day trader. In technical terms, the tell-tale sign for this capitulation is that three-month (65-day) fractal structure of the market totally collapses. Last Friday, the financial markets reached this point, meaning that financial markets are now fully priced for an economic downturn lasting one quarter (Chart I-5). Chart I-5When 3-Month Investors Capitulate It Usually Signals A Trend-Reversal... However, six-month and longer horizon investors are still a long way from capitulation. Meaning that the markets are not yet priced for a recession – defined as a contraction in activity lasting two or more straight quarters. It follows that if the down-leg of the V lasts significantly longer than a quarter then equities and other risk-assets have further downside versus high-quality bonds (Chart of the Week). During the global financial crisis, three-month investors had fully capitulated by September 3 2008 when equities had underperformed bonds by a seemingly huge 20 percent. However, equities went on to underperform bonds by a further 50 percent and only found a bottom when eighteen-month investors had fully capitulated in early 2009 (Chart I-6). This makes perfect sense, because profits contracted for a full eighteen months (Chart I-7). Chart I-6...But In The Global Financial Crisis The Market Turned Only When 18-Month Investors Had Capitulated... Chart I-7...Because In The Global Financial Crisis, Profits Contracted For 18 Months All of which brings us to a very powerful investment identity: Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated = the length of the downturn. The message right today is to go tactically long equities versus bonds if you have high conviction that the coronavirus induced downturn will last no longer than one quarter. Given that the coronavirus incubation period appears to be quite long, rendering containment strategies ineffective, we do not have such a high conviction on this tactical trade. Central banks that are already at the limits of monetary policy easing cannot ease much more. Instead, we have much higher conviction that those central banks that are already at the limits of monetary policy easing cannot ease much relative to those that have the scope to ease. The conclusion is: go long positive yielding US T-bonds and/or UK gilts versus negative yielding Swiss bonds and/or German bunds. Conversely, go long negative yielding currencies versus positive yielding currencies. Our favoured expression is long CHF/USD (Chart I-8). Chart I-8Overweight Positive-Yielding Bonds, And Overweight Negative-Yielding Currencies Fractal Trading System* This week’s recommended trade is to overweight Poland versus Portugal. Set the profit target at 3.5 percent with a symmetrical stop-loss. In other trades, long EUR/GBP achieved its 2 percent profit target at which it was closed. And short palladium has quickly gone into profit, given that the palladium price is down 10 percent in the last week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9Poland Vs. Portugal When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 The original version of the metaphor is attributed to the nineteenth century Austrian diplomat Klemens Metternich who said: “When France sneezes all of Europe catches a cold”. Subsequently, the Metternich metaphor has been adapted for any economy with outsized influence on the rest of the world. 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