Asset Allocation

Highlights Portfolio Strategy The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, and they will continue to underpin the equity market. We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon. While the path of least resistance remains higher for the S&P biotech index, we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. Relative supply/demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.   Recent Changes Initiate a long S&P homebuilders/short S&P real estate trade, today. Table 1 There's No Limit There's No Limit Feature The SPX had a bumper week last week, but failed to pierce through the 200-day moving average. A flare up in the US/China trade war, a barrage of positive coronavirus vaccine news and Jay Powell’s 60 minutes interview brought back some volatility in trading, however, the VIX remains in a steady downturn. Importantly, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, Chart 1). Chart 1Positioning Is Far... Positioning Is Far... Positioning Is Far... In other words, there is still room for equities to rise before sentiment reaches greedy levels. A number of other indicators we track confirm that recent SPX trading is associated more with panic than with euphoria. Namely, Chart 2 shows that our Complacency-Anxiety, Capitulation and Equity Sentiment Indicators, all corroborate that investor confidence is far from previous exuberant peaks, and signal that there is scope for additional equity gains on a cyclical 9-12 month time horizon.  Delving deeper into investor psyche, our sense is that there are three distinct camps of investors at the current juncture, two of which are fiercely battling it out in the stock market. Chart 2…From Complacent …From Complacent …From Complacent First there are the pessimists that we call “second wavers” that are more often than not also “Fed non-believers” or “Fed fighters”. They argue that stocks are extremely expensive and if a second wave of the corona virus hits, then stocks are going to plunge anew given the lack of a valuation cushion, as all the money in the world (Fed QE5) cannot cure the virus (top panel, Chart 3). Second, there are the optimists that are hopeful that a vaccine/drug cocktail discovery is looming to effectively eradicate the coronavirus. These investors also believe in the smooth reopening of the economy. But, even if there were a second wave, their thinking goes that our societies/governments/health care systems are all going to be more prepared and effective to deal with a second viral outbreak in the fall. In addition, they are in the “do not fight the Fed” camp. Finally, there are the more moderate investors that lie somewhere in between these two camps. They sat tight and held on to their stock positions during the 36% peak-to-trough SPX drawdown and have likely been on the sidelines lately (bottom panel, Chart 3) awaiting a catalyst to either deploy fresh capital or raise some cash. We are in the more optimistic camp and while a vaccine may be months away, we will have to figure out a way as a society to more effectively protect the elderly that are most at risk from the virus and continue to live on, as we first posited in the March 23rd Weekly Report when we outlined 20 reasons to buy stocks and reprint here: "20. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus."1 Chart 3Cash Hoarding Is Associated With Market Troughs Cash Hoarding Is Associated With Market Troughs Cash Hoarding Is Associated With Market Troughs Chart 4Loose Monetary Policy… Loose Monetary Policy… Loose Monetary Policy… Moreover, we definitely refrain from fighting the Fed as we outlined in our recent “Fight Central Banks At Your Own Peril” Weekly Report2 and reiterate that view today (Chart 4). While some investors were surprised by Jay Powell’s 60 Minutes interview remarks on the way the Fed digitally creates money, Ben Bernanke in another 60 Minutes interview in March 20093 made a similar comment that we cited in our March 23 Weekly Report (please refer to reason number 6 to buy equities).4 Importantly, we felt that Jay Powell’s demeanor was more like “please test our resolve Mr. Market if you reckon the FOMC is out of ammunition”. As a reminder, the Fed is in a position of strength: devaluing a currency is easy, revaluing/defending a currency is difficult and at times impossible as FX (and gold) reserves eventually run dry. In sum, the Fed’s extremely easy monetary backdrop along with easy fiscal policy (Chart 5) remain the dominant macro themes, and they will continue to underpin the equity market. Eventually, a liquidity handoff to growth will take root, and the SPX will no longer require the immense fiscal and monetary supports. As a result we continue to believe that stocks will be higher in the coming 9-12 months. Chart 5…And Easy Fiscal Policy Are Underpinning Stocks …And Easy Fiscal Policy Are Underpinning Stocks …And Easy Fiscal Policy Are Underpinning Stocks Biotech Delivers We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits, however we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (Chart 6). The broader-based NASDAQ biotech index comprising 209 stocks has also quietly sprang to uncharted territory. True, relative share prices have yet to make the all-time high leap, but have bested the market roughly by 30% year-to-date irrespective of the biotech index or ETF tracked (Chart 6). Importantly, growth stocks in general and biotech stocks in particular perform exceptionally well in a disinflationary growth environment. Therefore biotech stocks are the primary beneficiaries of the Fed’s QE5 and NIRP policies at a time when inflation is missing in action (top panel, Chart 7). Chart 6Earnings-Led Advance Earnings-Led Advance Earnings-Led Advance This goldilocks backdrop is also evident in the US bank credit impulse that has gone parabolic. When there is flushing liquidity and growth is scarce and declining, investors flock to any growth they can get their hands on (bottom panel, Chart 7). Chart 7Goldilocks Backdrop Goldilocks Backdrop Goldilocks Backdrop US dollar based liquidity, also underpins biotech stocks. In recent research, we have been highlighting that the Fed is indirectly targeting the debasing of the greenback. All this excess US dollar liquidity will eventually boost global growth, and reflate corporate earnings via the export relief valve. Biotech stocks will also get a fillip from a depreciating US dollar (Chart 8). Our overweight thesis in biotech was predicated – among other things – upon Big Pharma taking out biotech players and acquiring their coveted drug pipelines. We continue to side with the potential M&A targets, rather than the acquirers. The number of industry M&A deals has reached fever pitch and deal premia are still averaging over 60% (Chart 9). Chart 8Dollar Flooding Is A Boon For Biotech Equities Dollar Flooding Is A Boon For Biotech Equities Dollar Flooding Is A Boon For Biotech Equities Currently, the global race to find a coronavirus vaccine has further propelled biotech stocks. Indeed, investors are voting with their feet and are betting on a vaccine breakthrough. Thus, the allure of biotech stocks has also increased a notch as the possibility of a vaccine makes their earnings streams even more valuable and desirable to Big Pharma. A mega M&A deal in the space would not take us by surprise. Chart 9M&A Activity Will Remain Robust M&A Activity Will Remain Robust M&A Activity Will Remain Robust A few words are in order on the earnings, valuation and technical fronts. While relative share price momentum is galloping higher, it is moving in lockstep with rising earnings estimates (second panel, Chart 10). We would be extremely concerned if this were a multiple expansion driven relative share price advance. In fact, the biotech forward P/E trades both below the historical mean and at a 39% discount to the broad market hovering near an all-time low (Chart 10). Even on a dividend yield basis, biotech stocks are cheap sporting a higher (and safer) dividend yield than the SPX (bottom panel, Chart 10). Chart 10Biotech Stocks Are As Cheap As They Have Ever Been Biotech Stocks Are As Cheap As They Have Ever Been Biotech Stocks Are As Cheap As They Have Ever Been Chart 11Earnings Hurdle Remains Low Earnings Hurdle Remains Low Earnings Hurdle Remains Low Finally, relative long-term profit growth euphoria reaching astronomical levels, preceded previous S&P biotech index peaks: three times in the past two decades biotech stocks were projected to surpass SPX profit growth by roughly 10%. The current reading has plunged to negative 1.2% (Chart 11). Netting it all out, the global race for a coronavirus vaccine, robust earnings growth, ample US dollar liquidity and generationally low interest rates suggest that the path of least resistance remains higher for the S&P biotech index.   Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. Intra-Real Estate Trade Idea There is an exploitable trade opportunity in the real estate market, preferring residential real estate to commercial real estate (CRE). The cleanest way to play this is via a long S&P homebuilders/short S&P REITs pair trade, and we recommend initiating such a market-neutral trade today. Relative performance remains below the upward sloping time trend and at least a mini overshoot phase is in the cards in the coming quarters (Chart 12). One of the key drivers for this pair trade is the ebb and flow of owning versus renting and the current message is positive for homebuilders at the expense of REITs (Chart 13). Chart 12Looming Overshoot Phase Looming Overshoot Phase Looming Overshoot Phase Chart 13Own Versus Rent Upswing Is Bullish For The Pair Trade Own Versus Rent Upswing Is Bullish For The Pair Trade Own Versus Rent Upswing Is Bullish For The Pair Trade Home ownership has suffered a setback and never reclaimed its pre GFC highs. However, there is pent up demand for single family homes, especially given the recent drubbing of interest rates which should bring first time home buyers back into the market. Millennials up to now have been more of a renter generation, but as household formation increases for the largest cohort in the US, homeownership will make a comeback. One can argue that both real estate segments are interest rate sensitive and that they should benefit from lower rates. However, banks are more willing to lend to consumers in order to buy a home rather than to investors for CRE properties/projects by a factor of 2:1 according to the latest Federal Reserve Senior Loan Officer survey.5 Similarly, whereas demand for CRE loans has collapsed according to the same survey in April, demand for residential real estate loans spiked (top panel, Chart 14). In times of coronavirus-induced social distancing there is a lot more risk associated with CRE versus residential properties. Apartment REITs for example have an element of density-related risk versus the allure of a single family home in the suburbs. Likely social distancing will place a premium on single family homes in coming quarters at the expense of living in high rises in the city. This backdrop bodes well for home prices, but ill for CRE prices which according to Green Street Advisors contracted by 9% in April.6 Keep in mind that residential real estate price only very recently surpassed their 2006 zenith whereas CRE price are still hovering at one standard deviation above the previous peak (Chart 14). Debt deflation is a real threat for CRE prices and given that REITs are at the bottom of this levered asset’s capital structure it is last to collect.  Also the long-term ramifications to demand on CRE are grave compared with residential real estate. On the office REIT segment as an example, we deem that corporations will rethink their often expensive downtown office space requirements and likely downsize, as working from home has become mainstream. The unintended consequence of this realization is that demand for (larger) single family homes will also increase as workers opt to set up more comfortable working spaces at suburban homes. Chart 14Homebuilders Have The Upper Hand Homebuilders Have The Upper Hand Homebuilders Have The Upper Hand Shopping mall REITs are under relentless attack from the Amazonification of the economy and now have to contend with social distancing. The retail shopping experience will never be the same again sustaining the threat of extinction for shopping centers. On the construction front, single family housing starts are breaking ground at the historical mean and way below the 2006 peak run-rate, however, multi-family supply has gone parabolic (Chart 15). These diverging supply conditions are a harbinger of rising relative share prices. Finally, with regard to technicals and valuations homebuilders have the upper hand. Our Technical Indicator is in the neutral zone and relative valuations have collapsed near all-time lows offering a compelling entry point to the pair trade (Chart 16). Chart 15Supply Dynamics Favor Homebuilders Supply Dynamics Favor Homebuilders Supply Dynamics Favor Homebuilders Chart 16Relative Pessimism Is Contrarily Positive Relative Pessimism Is Contrarily Positive Relative Pessimism Is Contrarily Positive Netting it all out, relative supply and demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.  Bottom Line: Initiate a long S&P homebuilders/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. 3    https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    https://www.federalreserve.gov/data/sloos/sloos-202004.htm 6    https://www.greenstreetadvisors.com/insights/CPPI             Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations There's No Limit There's No Limit Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights German bunds and Swiss bonds are no longer haven assets. The haven assets are the Swiss franc, Japanese yen, and US T-bonds. Gold is less effective as a haven asset. During this year’s coronavirus crash, the gold price fell by -7 percent. As such, our haven asset of choice for a further demand shock would be the 30-year T-bond, whose price rose by 10 percent during the crash. Technology and healthcare are the two sectors most likely to contain haven equities. Fractal trade: long Polish zloty versus euro. German Bunds And Swiss Bonds Are No Longer Haven Assets Chart of the WeekGold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset Gold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset Gold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset European investors have been left defenceless. German bunds and Swiss bonds used to be the safest of haven assets. You used to be able to bet your bottom dollar – or euro or Swiss franc for that matter – that the bond prices would rally during a demand shock. Not in 2020. When the global economy and stock markets collapsed from mid-February through mid-March, the DAX slumped by -39 percent. Yet the German 10-year bund price, rather than rallying, fell by -2 percent, while the Swiss 10-year bond price fell by -4 percent.1  The lower limit to bond yields is around -1 percent. The reason is that German and Swiss bond yields are close to the practical lower limit to yields, which we believe is around -1 percent (Chart I-2). This means that German and Swiss bond prices cannot rise much, though they can theoretically fall a lot. Chart I-2German And Swiss Bond Yields Are Near Their Practical Lower Bound German And Swiss Bond Yields Are Near Their Practical Lower Bound German And Swiss Bond Yields Are Near Their Practical Lower Bound The behaviour of German bunds and Swiss bonds during the current crisis contrasts with previous episodes of market stress when their yields were unconstrained by the -1 percent lower limit. During the heat of the euro debt crisis in 2011, the 10-year bund price rallied by 12 percent. Likewise, during the frenzy of the global financial crisis in 2008, the 10-year bund price rallied by 7 percent (Chart I-3 - Chart I-5). Chart I-3German And Swiss Bonds Protected Investors During The 2008 Crash German And Swiss Bonds Protected Investors During The 2008 Crash German And Swiss Bonds Protected Investors During The 2008 Crash Chart I-4German And Swiss Bonds Protected Investors During The 2011 Crash German And Swiss Bonds Protected Investors During The 2011 Crash German And Swiss Bonds Protected Investors During The 2011 Crash Chart I-5German And Swiss Bonds Did Not Protect Investors During The 2020 Crash German And Swiss Bonds Did Not Protect Investors During The 2020 Crash German And Swiss Bonds Did Not Protect Investors During The 2020 Crash The defencelessness of European investors can also be illustrated via a ‘balanced’ 25:75 portfolio containing the DAX and 10-year German bund. The balanced portfolio theory is that a large weighting to bonds should counterbalance a sharp sell-off in equities, thereby protecting the overall portfolio. The theory worked well… until now. In this year’s coronavirus crisis, the 25:75 DAX/bund portfolio suffered a loss of -13 percent. This is substantially worse than the loss of -2 percent during the euro debt crisis in 2011, and the loss of -7 percent during the global financial crisis in 2008 (Chart I-6 - Chart I-8). Chart I-6A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash Chart I-7A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash Chart I-8A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash What Are The Haven Assets? The lower limit to the policy interest rate – and therefore bond yields – is around -1 percent, because -1 percent counterbalances the storage costs of holding physical cash or other stores of value. If banks passed a deeply negative policy rate to their depositors, the depositors would flee into other stores of value. But if banks did not pass a deeply negative policy rate to their depositors, it would wipe out the banks’ net interest (profit) margin. Either way, a deeply negative policy rate would destroy the banking system. German and Swiss bond prices cannot rise much. German and Swiss bond yields are close to the -1 percent lower limit, meaning that the bond prices are close to their upper limit. Begging the question: what are the haven assets whose prices will rise and protect long-only investors when economic demand slumps? We can think of three. The Swiss franc. The Japanese yen (Chart I-9). US T-bonds. Chart I-9The Swiss Franc And Japanese Yen Are Haven Assets The Swiss Franc And Japanese Yen Are Haven Assets The Swiss Franc And Japanese Yen Are Haven Assets During the coronavirus crash, the 10-year T-bond price rallied by 4 percent while the 30-year T-bond price rallied by 10 percent (Chart I-10). Compared with German bund and Swiss bond yields, US T-bond yields were – and still are – further from the -1 percent lower limit. The good news is that long-dated T-bonds can still protect investors during a demand shock, although be warned that the extent of protection diminishes as yields get closer to the lower limit. Chart I-10Long-Dated US T-Bonds Are Haven Assets Long-Dated US T-Bonds Are Haven Assets Long-Dated US T-Bonds Are Haven Assets What about gold? As gold has a zero yield, it becomes relatively more attractive to own as the yield on other haven assets declines and turns negative. In fact, through the last three years, the gold price has been nothing more than a proxy for the US 30-year T-bond price (Chart of the Week). But gold is an inferior haven asset. During the coronavirus crash, the gold price fell by -7 percent, meaning it did not offer the protection that T-bonds offered. As such, our haven asset of choice for a further demand shock would not be gold. It would be the 30-year T-bond. What Are The Haven Equities? Many investors still use (root mean squared) volatility as a metric of investment risk. There’s a big problem with this. Volatility treats price upside the same as price downside. This is unrealistic. Nobody minds the price upside, they only care about the downside! Hence, a truer metric of risk is the potential for short-term losses versus gains. This truer measure of risk is known as negative asymmetry, or negative skew. In the twilight zone of ultra-low bond yields, bond prices take on this unattractive negative skew. As German bunds and Swiss bonds have taught us this year, bond prices can suffer losses, but they cannot offer gains. This means that bonds become riskier investments relative to other long-duration investments such as equities whose own negative skew remains relatively stable. The upshot is that the prospective return offered by equities must collapse. This is because both components of the equity return – the bond yield plus the equity risk premium – shrink simultaneously.  Equity valuations rise as an exponential function of inverted bond yields. Given that valuation is just the inverse of prospective return, the effect is that equity valuations rise as an exponential function of inverted bond yields. Chart I-11 illustrates this exponentiality by showing that technology equity multiples have tightly tracked the inverted bond yield plotted on a logarithmic scale. Chart I-11Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Unfortunately, not all equities will benefit from this powerful dynamic. Equities must meet two crucial conditions to justify this exponential re-rating. One condition is that their sales and profits must be relatively resilient in the face of the current coronavirus induced demand shock. And they should not be at risk of a structural discontinuity, as is likely for say airlines, leisure and many other old-fashioned cyclicals. A second condition is that their cashflows must be weighted further into the future, so that their ‘net present values’ are much more geared to the decline in bond yields. Equities that meet these two conditions are likely to benefit the most from the ongoing era of ultra-low bond yields. And the two equity sectors that appear the biggest beneficiaries are technology and healthcare. In the coronavirus world, these two sectors will likely contain the haven equities. Stay structurally overweight technology and healthcare. Fractal Trading System* This week’s recommended trade is to go long the Polish zloty versus the euro. The profit-target and symmetrical stop-loss are set at 2 percent. Most of the other open trades are flat, though long Australian 30-year bonds versus US 30-year T-bonds and Euro area personal products versus healthcare are comfortably in profit.  The rolling 1-year win ratio now stands at 61 percent. Chart I-12PLN/EUR PLN/EUR PLN/EUR 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 From February 19 through March 18, 2020. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Treasuries: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Negative Rates: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. EM Sovereigns: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Don’t Expect A Taper Tantrum The big announcement in bond markets last week was the Treasury department detailing its plans for note and bond issuance in the second and third quarters. Of course, with the CARES act injecting $2.8 trillion into the economy, investors were already prepared for a big step up in issuance.1 But the numbers are striking nonetheless, particularly at the long-end of the curve. Overall note and bond issuance will reach $910 billion in Q3, roughly equal to the 2010 peak as a percent of GDP (Chart 1). Issuance beyond the 10-year point of the curve (i.e. the 30-year bond and new 20-year bond) will far exceed its financial crisis highpoint (bottom panel). Many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months. Long-maturity Treasury yields jumped after the Treasury’s announcement on Wednesday before reversing all of that bounce the following day. But despite the mild market reaction, many bond investors are understandably worried that surging issuance will put significant upward pressure on yields in the coming months, especially with the Fed paring its pace of Treasury purchases (Chart 2). Chart 1Gross Treasury Issuance Gross Treasury Issuance Gross Treasury Issuance Chart 2Fed Buying Fewer Treasuries Fed Buying Fewer Treasuries Fed Buying Fewer Treasuries Our base case outlook is that Treasury yields will be marginally higher by the end of the year, and the yield curve will be steeper.2 However, we do not foresee a Taper Tantrum-style bond market rout. Treasury supply will continue to expand in the months ahead. But on the flipside, the Fed’s forward rate guidance will remain very dovish. If investors believe that short-dated interest rates will stay pinned near zero for a long time, fear of significant losses will remain low and Treasury demand will keep pace with supply, even at the long-end of the curve. Chart 3No Taper Tantrum In 2020 No Taper Tantrum In 2020 No Taper Tantrum In 2020 Yes, the Fed has scaled back its pace of Treasury purchases during the past few weeks, removing a significant source of demand from the market. However, it has also given no indication that it intends to lighten up on monetary stimulus broadly speaking. Based on the Fed’s dovish posture, we can be sure that if surging issuance leads to undesirably high term premiums at the long-end of the Treasury curve, the Fed will quickly ramp purchases back up to squash them. In general, our view is that all dramatic bond sell-offs are caused by the market suddenly pricing in a much more hawkish Fed reaction function. This can be driven by surprisingly strong economic growth and inflation, or by investors collectively changing their assessments of how the Fed will react. In this regard, the 2013 Taper Tantrum is an interesting case study. The Treasury curve bear-steepened dramatically in 2013 after Fed Chair Ben Bernanke laid out the Fed’s plan for winding down asset purchases. But this is not a simple story of bond yields rising because the market reacted to less demand in the form of Fed purchases. Rather, yields rose so much because Bernanke signaled to investors that the overall stance of monetary policy was much less accommodative than they had previously thought. Notice that gold fell sharply during this period (Chart 3), not because of less direct demand for Treasuries but because a more hawkish Fed meant less long-run inflation risk. The dynamic is illustrated very clearly by the CRB Raw Industrials / Gold ratio (Chart 3, bottom panel). The ratio is highly correlated with long-dated Treasury yields, meaning that for yields to shoot higher we need to see either a surge in global demand (i.e. CRB commodity prices) or a hawkish shift in the Fed’s reaction function (i.e. a drop in the gold price). If, as we expect, global demand improves only modestly this year and the Fed remains steadfastly dovish, upside in both the CRB/Gold ratio and long-maturity Treasury yields will be limited. Bottom Line: Despite surging issuance, long-dated Treasury yields will move only slightly higher this year, driven by a modest recovery in global demand. There is also a risk that a second wave of COVID infections will send yields to new lows. We recommend keeping portfolio duration close to benchmark while hedging the risk of higher yields by entering duration-neutral curve steepeners. Don’t Bet On Negative Rates Table 1Fed Funds Futures The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply The massive amount of new issuance was not the only exciting development in fixed income markets last week. Short-dated yields also started to price-in the possibility of negative interest rates in the US! Table 1 shows the price of different fed funds futures contracts (as of Monday morning) and what funds rate those prices imply for each contract’s maturity month. We also show the return you would earn by taking an unlevered short position in each contract and holding to maturity, assuming that the actual fed funds rate remains unchanged. We assume that the fed funds rate will stay at its current level (0.05%) because the Fed has made it very clear that a negative policy rate is not an option that will be considered. As evidence, we present some excerpts from recent Fed communications. Fed Chair Jerome Powell from his March 15 press conference:3 So, as I’ve noted on several occasions, really, the Committee – as you know, we did a year-plus-long study of our tools and strategies and communications. And we, really, at the end of that, and also when we started out, we view forward guidance and asset purchases – asset purchases and also different variations and combinations of those tools as the basic elements of our toolkit once the federal funds rate reaches the effective lower bound – so, really, forward guidance, asset purchases, and combinations of those. You know, we looked at negative policy rates during the Global Financial Crisis, we monitored their use in other jurisdictions, we continue to do so, but we do not see negative policy rates as likely to be an appropriate policy response here in the United States. The Fed staff’s assessment of negative interest rates from the October 2019 FOMC minutes:4 The briefing also discussed negative interest rates, a policy option implemented by several foreign central banks. The staff noted that although the evidence so far suggested that this tool had provided accommodation in jurisdictions where it had been employed, there were also indications of possible adverse side effects. Moreover, differences between the US financial system and the financial systems of those jurisdictions suggested that the foreign experience may not provide a useful guide in assessing whether negative interest rates would be effective in the United States. FOMC participants’ assessment of negative interest rates from the October 2019 minutes:5 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative interest rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. Participants noted that negative interest rates would entail risks of introducing significant complexity or distortions to the financial system. In particular, some participants cautioned that the financial system in the United States is considerably different from those in countries that implemented negative interest rate policies, and that negative rates could have more significant adverse effects on market functioning and financial stability here than abroad. Notwithstanding these considerations, participants did not rule out the possibility that circumstances could arise in which it might be appropriate to reassess the potential role of negative interest rates as a policy tool. It is always possible that the Fed’s view of negative interest rates will change in the future. However, this won’t happen any time soon. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. The Fed still has other zero-lower-bound policy options it can deploy before it gets desperate enough to re-consider negative rates. For example, one logical next step would be to bring back the Evans Rule. That is, specify economic targets (related to unemployment and inflation) that must be met before the Fed will consider lifting rates. If that sort of forward guidance is deemed insufficient, the Fed could adopt a plan recently advocated by Governor Lael Brainard and start to cap short-maturity bond yields.6 If it wants more stimulus after that it could gradually move further out the curve, capping bond yields for longer and longer maturities. According to the FOMC minutes, this sort of Yield Curve Control policy had more support among participants at the October 2019 FOMC meeting than did negative interest rates:7 A few participants saw benefits to capping longer-term interest rates that more directly influence household and business spending. In addition, capping longer-maturity interest rates using balance sheet tools, if judged as credible by market participants, might require a smaller amount of asset purchases to provide a similar amount of accommodation as a quantity-based program purchasing longer-maturity securities. However, many participants raised concerns about capping long-term rates. Some of those participants noted that uncertainty regarding the neutral federal funds rate and regarding the effects of rate ceiling policies on future interest rates and inflation made it difficult to determine the appropriate level of the rate ceiling or when that ceiling should be removed; that maintaining a rate ceiling could result in an elevated level of the Federal Reserve’s balance sheet or significant volatility in its size or maturity composition; or that managing longer-term interest rates might be seen as interacting with the federal debt management process. By contrast, a majority of participants saw greater benefits in using balance sheet tools to cap shorter-term interest rates and reinforce forward guidance about the near-term path of the policy rate. Bottom Line: The Fed will not cut rates into negative territory any time soon. Investors who are able to do so should go short fed funds futures contracts that are priced for negative rates. For example, a short position in the June 2021 fed funds futures contract will earn an unlevered 6.5 bps if the fed funds rate remains unchanged and the position is held to maturity. No Buying Opportunity Yet In EM Sovereigns When assessing the outlook for the US dollar denominated sovereign debt of emerging markets we consider two main factors: Valuation, relative to both US Treasuries and US corporate credit. The outlook for EM currencies versus the dollar. Ideally, we want to move into EM sovereign debt when spreads look attractive relative to the domestic investment alternatives and when EM currencies are on the cusp of rallying versus the dollar. Valuation At first blush, value looks like it has improved considerably for EM sovereigns. The average spread on the Bloomberg Barclays EM Sovereign index is 167 bps wider than it was at the beginning of the year and the spread differential with the duration-matched Ba-rated US corporate bond index is elevated compared to the recent past (Chart 4). However, widening has been driven by a select few distressed countries (e.g. Ecuador, Argentina and Lebanon). When we strip those out and look only at the investment grade EM sovereign index (Chart 4, panels 3 & 4), the average spread looks relatively tight compared to a duration-matched position in Baa-rated US corporate credit. Chart 4Only A Few EMs Look Cheap Only A few EMs Look Cheap Only A few EMs Look Cheap Because country-specific trends often exert undue influence on the overall index, we find it helpful to look at value on a country-by-country basis. Chart 5A shows the average option-adjusted spread for major countries included in the Bloomberg Barclays EM Sovereign index. This chart makes no adjustments for credit rating or duration, and as such we see the lower-rated nations (Turkey, South Africa, Brazil) offering the widest spreads. Chart 5B shows each country’s spread relative to a duration and credit rating matched position in US corporate credit. Viewed this way, the most attractive opportunities lie in Mexico, Saudi Arabia, UAE, Colombia, Qatar and South Africa. Chart 5AUSD-Denominated EM Sovereign Debt By Country: Spread Versus Treasuries The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply Chart 5BUSD-Denominated EM Sovereign Debt By Country: Spread Versus US Credit The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply Currency Outlook Chart 6EM Currencies Are Linked To Global Growth EM Currencies Are Linked To Global Growth EM Currencies Are Linked To Global Growth Currency is important for EM sovereign spreads because a stronger local currency literally makes US dollars cheaper for the EM nation to acquire. This, in turn, makes its USD-denominated debt easier to service, leading to tighter spreads. Chart 6 shows that EM Sovereign excess returns versus US Treasuries closely track EM currency performance. We also observe a strong link between EM currencies and high-frequency global growth indicators like the CRB Raw Industrials commodity price index (Chart 6, bottom panel). Based on this, we would only expect EM currencies to strengthen when global demand starts to pick up. Further, as our Emerging Market strategists wrote in a recent report, EM central banks are behaving differently during this recession than they have in past downturns.8 In the past, EMs would often run relatively tight monetary policies in order to fend off currency depreciation in the hopes of preventing capital outflows. This time, EM central banks are cutting rates aggressively, allowing their currencies to depreciate but supporting domestic demand. This is bearish for EM currencies and sovereign spreads in the near-term, but will probably lead to stronger economic recovery down the road. At the country level, we assess how vulnerable each country’s currency is to further depreciation by looking at its ratio of exports to foreign debt obligations.9 This ratio is a measure of US dollars coming in over a 12-month period relative to 12-month US dollar debt obligations. It has a relatively tight correlation with the dollar-denominated sovereign spread (Chart 7A). Low-rated countries, like Turkey and South Africa, have relatively low export coverage of foreign debt obligations, while Russia and South Korea have relatively strong debt coverage. Combining Valuation & Currency Outlook Chart 7B shows the same measure of currency vulnerability on the horizontal axis, but shows EM spreads relative to duration and credit rating matched US corporate credit on the vertical axis. Here, we see that Russia offers poor valuation, but a relatively safe currency. Meanwhile, Colombia offers an attractive spread but has a poor currency outlook. In this chart, Mexico stands out as the most attractive on a risk/reward basis. Chart 7AEM Sovereign Spread Versus Currency Vulnerability The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply Chart 7BEM Sovereign Spread Over US Credit Versus Currency Vulnerability The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply You will notice that the three Middle Eastern countries that stood out as having attractive spreads in Chart 5B are not shown in Charts 7A and 7B. This is because some data are unavailable, and also because those countries operate with currency pegs. Despite attractive spreads in those countries, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. As our EM strategists wrote in a recent Special Report, if oil prices remain structurally low in the coming years (~$40 range), pressure will grow for Saudi Arabia to break its currency peg and allow some depreciation.10  The same holds true for Qatar and UAE. A bet on those countries’ sovereign spreads today amounts to a bet on higher oil prices. Despite attractive spreads, we would not advise long-run positions in the USD-denominated sovereign debt of Saudi Arabia, Qatar or UAE. Bottom Line: US bond investors should avoid USD-denominated EM sovereign debt and focus instead on US corporate credit rated Ba and higher. Of the EM countries with large USD bond markets, Mexican debt looks most attractive on a risk/reward basis. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed Facilities The Treasury Market Amid Surging Supply The Treasury Market Amid Surging Supply   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes  1 For more details on the size and potential efficacy of the CARES act please see Bank Credit Analyst Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “The Policy-Driven Bond Market”, dated May 5, 2020, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20200315.pdf 4  https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 5 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 6 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 7 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf 8 Please see Emerging Markets Strategy Weekly Report, “EM Domestic Bonds And Currencies”, dated April 23, 2020, available at ems.bcaresearch.com 9 For more information on this ratio please see Emerging Markets Strategy Special Report, “EM: Foreign Currency Debt Strains”, dated April 22, 2020, available at ems.bcaresearch.com 10 Please see Emerging Markets Strategy Special Report, “Saudi Riyal Devaluation: Not Imminent But Necessary”, dated May 7, 2020, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The Fed’s unorthodox monetary policy is aimed at quashing volatility, lifting asset prices and debasing the currency, all of which are equity market bullish. Grim, but backward looking, macro data are already reflected in the significant restaurant relative share price correction. Upgrade to neutral. Book profits in the underweight S&P rails portfolio position and lift exposure to neutral on the back of: a.) already reflected grim ISM services data, b.) resilient industry pricing power, c.) firming railroad profit margin backdrop and d.) encouraging signs from our EPS growth model.   Recent Changes Augment the S&P restaurants index to neutral, today. Upgrade the S&P railroads index to a benchmark allocation, today. Table 1 The Bottomless Punchbowl The Bottomless Punchbowl Feature The SPX made a fresh run to recovery highs last week, cheering forward looking news of reopening of the economy and neglecting backward looking downbeat employment and PMI releases. Extremely easy fiscal and monetary policies remain the dominant macro themes, and underpin our sanguine equity market view for the coming 9-12 months. While Bill Martin’s infamous 1955 portrayal of the Fed as “the chaperone who ordered the punch bowl removed just when the party was really warming up”,1 the Jay Powell led Fed has done the opposite, and rightly so: it has ordered and delivered a bottomless punchbowl. The Fed’s unorthodox monetary policy is aimed at quashing volatility (Chart 1), lifting asset prices and debasing the currency, all of which are equity market bullish. According to Leo Krippner’s shadow short rates (SSR) estimate, the shadow fed funds rate is negative and should continue to support the SPX (SSR shown inverted, Chart 2). Chart 1Vol Will Melt Vol Will Melt Vol Will Melt Chart 2Crumbling Shadow Rates Underpin The SPX… Crumbling Shadow Rates Underpin The SPX… Crumbling Shadow Rates Underpin The SPX…   In fact, there are two distinct avenues that declining interest rates underpin equities: First, falling interest rates are a boon to equities via a rising price-to-earnings multiple (SSR shown inverted, Chart 3). While the 12-month forward multiple is above a 20 handle, the highest point since the dotcom bubble era, using second and third fiscal year sell-side profit estimates – which better resemble trend EPS – results in a more tame forward P/E multiple with more upside (Chart 4). Second, while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues. As a reminder, 40% of SPX sales are internationally sourced and thus a falling greenback is a boon to S&P 500 turnover (bottom panel, Chart 5). Chart 3…Via Higher Valuations …Via Higher Valuations …Via Higher Valuations Keep in mind that most of global trade is conducted in USD and when trade collapses it creates a US dollar shortage (i.e. fewer US dollars are circulating around) that lifts the value of the reserve currency and vice versa. Cognizant of that, the Fed is trying to provide ample US dollar liquidity and aid in pushing the greenback lower (top panel, Chart 5). Chart 4Peer Across The EPS Valley, And Valuations Have Room To Rise Peer Across The EPS Valley, And Valuations Have Room To Rise Peer Across The EPS Valley, And Valuations Have Room To Rise Chart 5Depreciating USD Is A Boon For SPX Sales Depreciating USD Is A Boon For SPX Sales Depreciating USD Is A Boon For SPX Sales Drilling beneath the SPX’s surface, early-cyclical consumer discretionary equities are the primary beneficiaries of negative SSR. The top panel of Chart 6 shows that over the past three decades relative share prices are the mirror image of interest rates. This cycle, household finances are in order and coupled with generationally low interest rates signal that consumer spending will recover smartly as the economy opens up in coming quarters. Thus, consumer discretionary stocks should sustain their outperformance (middle & bottom panels, Chart 6). A small digression with regard to the reopening of the economy is in order. Pundits have been discussing and showing the three distinct waves of the Spanish flu as the closest parallel with the current pandemic. Chart 7 shows these three waves using UK data, but the UK equity market (and the DOW for that matter) did not really budge back then. Keep in mind this was in the midst of a recession as the Great War was about to end on November 11, 1918 (Remembrance Day). Chart 6Stick With Consumer Discretionary Exposure Stick With Consumer Discretionary Exposure Stick With Consumer Discretionary Exposure Chart 7The 1918 UK Parallel, Including Equities The 1918 UK Parallel, Including Equities   The 1918 UK Parallel, Including Equities     While no one really knows how in the long-term this pandemic will affect the economy, the stock market, society in general and consumer behavior in particular, our sense is that uncertainty will continue to recede in the coming months irrespective of the second and third likely waves. Why? Because not only do governments know more about this invisible enemy, but they (and hospitals) will also be more prepared to deal with any future outbreaks. Moreover, given that there is a race to get a novel coronavirus vaccine (and treatment) the world over, a breakthrough will soon materialize; MRNA’s recent FDA phase II clinical trial for their vaccine candidate is a case in point. Receding uncertainty is great news for stock investors. Meanwhile, in recent research we highlighted that early-cyclical interest rate-sensitive equities do in fact lead the GICS1 sector pack in recessionary recoveries based on empirical evidence.2 As a reminder, in mid-April we lifted the S&P consumer discretionary sector to overweight and this week we are updating our views on a hard hit subindex. We are also upgrading a deep cyclical services industry to neutral. Preparing To Dine Out It no longer pays to be underweight the S&P restaurants index; upgrade to neutral today. Not only the reopening of the economy will, at the margin, bring back diners (take out mostly) to restaurants, but the two heavyweights that comprise 80% of the market cap of the S&P restaurants group are anything but discretionary. In our view, MCD is defensive and SBUX has become a staple. Thus, as the economy slowly reopens and store traffic picks up, these bellwether stocks will lead this index higher. Relative share prices have corrected to the twenty-year uptrend line and hover near the previous two breakout points in 2011/12 and 2015/16 where they should find enough support (top panel, Chart 8). With regard to macro data, most of the restaurant-relevant releases are looking in the rear view mirror. In other words, the trouncing in restaurant retail sales and employment, food-away-from-home PCE and even the collapse in the Restaurant Performance Index were “known knowns” (Chart 8). Therefore, all of this grim news is already reflected in the 30% drubbing in relative performance from peak-to-trough. Chart 8Grim Data Priced In Grim Data Priced In Grim Data Priced In Chart 9Dollar The Reflator Dollar The Reflator Dollar The Reflator Domestic restaurant sales should stabilize in the coming months. If the Fed manages to devalue the US dollar (please see discussion above), then even international revenues in general and Chinese sourced sales in particular will rekindle overall industry turnover (Chart 9). Keep in mind that China’s economy reopening is leading the global economy by about six weeks. Importantly, construction spending on restaurants is falling like a stone and this decline in supply and industry capex will provide a much needed offset to free cash flow generation (middle panel, Chart 10). Nevertheless, three key concerns keep us at bay and prevent us from turning outright bullish. First, net debt-to-EBITDA has taken a steep turn for the worst of late, and while it is mostly driven by the shortfall in cash flow, it is still quite unnerving (bottom panel, Chart 11). Second, there is margin trouble that restauranteurs have yet to work out, and a rising wage bill will continue to weigh on profit growth (second panel, Chart 11). Finally, relative valuations are lofty for our liking. On a 12-month forward P/E basis the S&P restaurants index is trading at 53% premium to the SPX and 26% above the historical mean (third panel, Chart 11). Chart 10Supply Restraint Is Positive Supply Restraint Is Positive Supply Restraint Is Positive Chart 11Watch These Risks Watch These Risks Watch These Risks Netting it all out, grim but backward looking macro data are already reflected in the significant restaurant relative share price correction. Lift exposure to a benchmark allocation. Bottom Line: Lift the S&P restaurants index to neutral for a relative loss of 13.7% since inception. The ticker symbols for the stocks in this index are: BLBG: S5REST – MCD, SBUX, YUMB, CMG, DRI. Upgrade Rails To Neutral Over the past three years we have been mostly on the right side of rails both in bull and bear phases; today we recommend cementing relative gains of 6.4% since inception, and lifting exposure to neutral. Rails are the largest transports subgroup and this services industry is showcasing impressive resilience in times of adversity. True, the latest ISM non-manufacturing survey made for grim reading. Both the headline number and most of the key subcomponents of the survey were tough to digest: the overall survey fell near the GFC lows (bottom panel, Chart 12), the Business Activity Index collapsed to 26%, an all-time low. While this survey can fall anew next month, we deem that extreme pessimism reigns supreme, and as the US economy is slated to reopen some semblance of normality will return in coming months. Tack on the improving export data out of China, and we are cautiously optimistic that rail hauling services will soon stage a comeback (middle panel, Chart 12). Chart 12As Bad As It Gets As Bad As It Gets As Bad As It Gets Chart 13Green Shoots Green Shoots Green Shoots The defensive nature of rails is most evident in industry pricing power (third panel, Chart 13). Railroad selling prices are holding their own despite a sizable drop in volumes. Moreover, CEOs exercised caution and refrained from adding to headcount. Taken together, they are boosting our profit margin proxy, which can serve as a catalyst to lift relative share price momentum out of its recent funk (second panel, Chart 13). Similarly, our 3 factor S&P rail EPS growth model is heralding a pickup in profits in the back half of the year (bottom panel, Chart 13). Despite all these tailwinds, there are some powerful offsets that tame our optimism on railroards. Intermodal rail shipments are a major freight category and thus a key determinant of rail profitability. As consumer confidence remains in freefall, downbeat retail sales will cast a dark shadow on this essential rail freight category (Chart 14). Finally, the industry’s rising debt profile is still a primary concern. Rail executives neglected capex in recent years and instead raised debt in order to retire equity and enhance shareholder value. We continue to view this “investment” backdrop with skepticism and prior to further augmenting exposure to an overweight stance we would want to see an easing on the debt uptake directed at these shareholder friendly activities (Chart 15). Chart 14The Consumer Is A Sore Spot The Consumer Is A Sore Spot The Consumer Is A Sore Spot Chart 15Debt Burden Flashing Red Debt Burden Flashing Red Debt Burden Flashing Red In sum, we are compelled to take profits in our underweight S&P rails portfolio position and lift exposure to neutral on the back of: a.) already reflected grim ISM services data, b.) resilient industry pricing power, c.) firming railroad profit margin backdrop and d.) encouraging signs from our EPS growth model. Bottom Line: Lift the S&P railroads index to a benchmark allocation today booking a profit of 6.4% since inception. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – UNP, NSC, CSX, KSU.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://fraser.stlouisfed.org/title/statements-speeches-william-mcchesney-martin-jr-448/address-new-york-group-investment-bankers-association-america-7800 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations The Bottomless Punchbowl The Bottomless Punchbowl Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

In lieu of the next weekly report I will be presenting the quarterly webcast ‘Leaving The Euro Would Be MAD, But Mad Things Can Happen’ on Thursday 14 May at 10.00AM EDT (3.00PM BST, 4.00PM CEST, 10.00PM HKT). As usual, the webcast will take a TED talk format lasting 18 minutes, followed by live questions. Don’t miss it. Highlights For the time being, stick with the very successful strategies of: Overweighting higher yielding US T-bonds versus negative yielding German bunds and Swiss bonds. Overweighting technology and healthcare versus banks and materials. Overweighting growth versus value. Overweighting the S&P 500 versus the Eurostoxx 50. Overweighting Germany, France, and Switzerland in a European equity portfolio. The big caveat is that these strategies are highly correlated. Fractal trade: long euro area personal products versus healthcare. Feature Chart I-1Bond Yields And Commodity Prices Are Correlating To One Bond Yields And Commodity Prices Are Correlating To One Bond Yields And Commodity Prices Are Correlating To One Chatting with friends, family and clients it seems that our lives under lockdown and social distancing have lost much of their differentiation across time and space. Wherever in the world we live, whatever we do, our days and lives are correlating to one. Interestingly, the financial markets have experienced a similar loss of differentiation. In the coronavirus world, markets are also correlating to one. Financial Markets Are Not Complicated One of our abiding investment mantras is that: Financial markets are complex, but they are not complicated. The words complex and complicated are sometimes used synonymously, but they mean different things. Complex means something that is not fully predictable or analysable. Complicated means something that is made up of many parts. Financial markets are not complicated. The financial markets are not complicated because a few parts drive the relative prices of everything, though these parts themselves are complex. Identify and understand these few parts and you will get all your investment decisions right: asset allocation, sector allocation, style allocation, regional allocation, country allocation. This has become even more so this year as our response to the coronavirus has correlated all our lives and economic behaviour to one. One fundamental part is the bond yield. The collapse in commodity prices, more than any other real-time indicator, illustrates the demand destruction resulting from coronavirus-induced lockdowns and social distancing. Bond yields have plunged in lockstep with this demand destruction, given the implications for higher unemployment as well as lower inflation – the two key tenets that drive central bank policy (Chart of the Week). The plunging bond yield, in turn, has driven the underperformance of banks (Chart I-2), for two reasons. First, to the extent that a depressed bond yield reflects a low-growth economy, it also reflects a poorer outlook for bank credit growth, which effectively constitutes a bank’s ‘sales’. Second, a depressed bond yield means a flat or inverted yield curve, which squeezes bank net interest (profit) margins. Chart I-2Banks And Bond Yields Are Correlating To One Banks And Bond Yields Are Correlating To One Banks And Bond Yields Are Correlating To One Conversely, the plunging bond yield has signified an environment in which big tech and healthcare equities outperform (Chart I-3 and Chart I-4), also for two reasons. First, big tech and healthcare sales are more protected against a sudden dip in the economy. Second, their cashflows are weighted further into the future, and so their ‘net present values’ rise more when bond yields plunge. Chart I-3Tech (Inverted) And Bond Yields Are Correlating To One Tech (Inverted) And Bond Yields Are Correlating To One Tech (Inverted) And Bond Yields Are Correlating To One Chart I-4Healthcare (Inverted) And Bond Yields Are Correlating To One Healthcare (Inverted) And Bond Yields Are Correlating To One Healthcare (Inverted) And Bond Yields Are Correlating To One A declining bond yield also signifies an environment in which basic materials equities underperform, as our first chart powerfully illustrates. So, if you call the bond yield right, you will get your asset allocation between cash and bonds right, but you will also your equity sector allocation right. And if you get your equity sector allocation right you will automatically get your value versus growth style allocation right too. At an overarching level, the value versus growth allocation is nothing more than the performance of value sectors, like banks, versus growth sectors, like big tech and healthcare (Chart I-5). Chart I-5Value Versus Growth = Banks Versus Tech Value Versus Growth = Banks Versus Tech Value Versus Growth = Banks Versus Tech Furthermore, you will also get your regional and country allocation right. This is because each major stock market has distinguishing ‘long’ sectors in which it contains up to a quarter of its total market capitalisation, as well as distinguishing ‘short’ sectors in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint which drives relative performance (Table I-1): Table I-1The Sector Fingerprints Of Major Regional Stock Markets Markets Are Correlating To One Markets Are Correlating To One FTSE 100 = long financials and energy, short technology. Eurostoxx 50 = long financials, short technology and healthcare. Nikkei 225 = long industrials, short financials and energy. S&P 500 = long technology and healthcare, short materials. MSCI Emerging Markets = long financials, short healthcare. Specifically, the distinguishing fingerprints of the Eurostoxx 50 and the S&P 500 mean that the Eurostoxx 50 has a 12 percent over-representation to financials and materials at the expense of an 18 percent under-representation to technology and healthcare. It follows that if banks and materials underperform technology and healthcare, the Eurostoxx 50 must underperform the S&P 500. Everything else is irrelevant (Chart I-6). Chart I-6Euro Area Versus US = Banks Versus Tech Euro Area Versus US = Banks Versus Tech Euro Area Versus US = Banks Versus Tech The same principle applies to the stock markets within Europe. Relative performance comes from nothing more than the stock market’s long and short sector fingerprint combined with sector performance (Table I-2 and Table I-3). Table I-2The Sector Fingerprints Of Euro Area Stock Markets Markets Are Correlating To One Markets Are Correlating To One Table I-3The Sector Fingerprints Of Non Euro Area European Stock Markets Markets Are Correlating To One Markets Are Correlating To One For example, if healthcare outperforms then its overrepresentation in the stock markets of Switzerland and Denmark means that they must outperform too (Chart I-7 and Chart I-8). Likewise, if technology outperforms, then the technology-heavy Netherlands stock market must outperform (Chart I-9). Chart I-7Long Switzerland = Long Healthcare Long Switzerland = Long Healthcare Long Switzerland = Long Healthcare Chart I-8Long Denmark = Long Healthcare Long Denmark = Long Healthcare Long Denmark = Long Healthcare Chart I-9Long Netherlands = Long Tech Long Netherlands = Long Tech Long Netherlands = Long Tech All Investment Strategies Are Highly Correlated To repeat, financial markets are not complicated. If you get the over-arching decision(s) right, you will get everything right. The unfortunate corollary is that if you get the over-arching decision wrong you will get everything wrong. Asset allocation, sector allocation, style allocation, regional allocation, and country allocation are correlating to one. We really wish that financial markets were more complicated – because then asset allocation, sector allocation, style allocation, regional allocation and country allocation would be independent investment decisions which offered diversification at the total portfolio level. But the charts in this report should make it crystal clear that all these separate decisions are correlating to one. They are all really the same decision. Today, the decision on where bond yields are headed is particularly tough because they have already come down a lot in a very short space of time. Yet we do not foresee a sustained backup in yields for three reasons: First, even if governments ease lockdowns and reopen economies, demand will remain depressed. Most people are isolating themselves or socially distancing not because their governments are forcing them to, but because they fear infection. The easing of lockdowns, per se, will not remove that fear. And if workers are forced back into jobs when it is unsafe, then infection rates will start to rise again. Second, unless commodity prices rise sharply in the coming months the base effect of commodity prices will put downward pressure on 12-month inflation rates later in the summer (Chart I-10). To the extent that central banks focus on – and target – these totemic annual inflation rates, it will be very difficult to turn hawkish. On the contrary, there may be pressure to turn even more dovish. Chart I-10The Base Effect Will Weigh On Inflation Later This Year The Base Effect Will Weigh On Inflation Later This Year The Base Effect Will Weigh On Inflation Later This Year Third, our most trusted technical indicator is not flashing the red signal that bonds are dangerously overbought, as they were in January 2019, August 2019, and early-March 2020 (Chart I-11). Chart I-11Bonds Are Not Yet At A Technical Tipping Point Bonds Are Not Yet At A Technical Tipping Point Bonds Are Not Yet At A Technical Tipping Point So, for the time being, we are sticking with the very successful strategies of: Overweighting higher yielding US T-bonds versus negative yielding German bunds and Swiss bonds. Overweighting technology and healthcare versus banks and materials. Overweighting growth versus value. Overweighting the S&P 500 versus the Eurostoxx 50. Overweighting Germany, France, and Switzerland in a European equity portfolio. The big caveat is that these strategies are highly correlated. Fractal Trading System* With markets correlating to one, it is becoming more difficult to find trades which are not correlated with the over-arching driver. Hence, this week’s recommended trade is a pair-trade between two defensive sectors: long euro area personal products versus healthcare. The profit target is 7 percent, with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-12Euro Area Personal Products Vs. Health Care Euro Area Personal Products Vs. Health Care Euro Area Personal Products Vs. Health Care 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 Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Chart 1Low-Rated Junk Returns Are Lagging Low-Rated Junk Returns Are Lagging Low-Rated Junk Returns Are Lagging The story of bond markets in April is a story about the Federal Reserve. Traditional relationships have broken down and clear divisions have formed between sectors that are receiving Fed support and those that are not. For example, we would usually expect the riskiest (i.e. lowest-rated) pockets of the corporate bond market to perform worst in down markets and best in up markets. However, Fed intervention has disrupted this dynamic since the central bank announced a slew of emergency lending facilities on March 23. Since then, Baa and Ba rated corporates – sectors that benefit from Fed support – have behaved as usual, but lower-rated junk bonds – sectors that remain cut off from Fed support – have lagged (Chart 1). To take advantage of this disruption, we continue to advocate a strategy of favoring sectors that have attractive spreads and that benefit from Fed support. Appendix A of this report presents returns across a range of fixed income sectors since the Fed’s intervention began on March 23. We will update this table regularly going forward to keep tabs on the policy-driven disruptions to typical bond market behavior. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 455 basis points in April, bringing year-to-date excess returns up to -871 bps. The average index spread tightened 70 bps on the month, and 171 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, even after all that tightening, the index spread remains 113 bps wider than it was at the end of last year (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support through the SMCCF and PMCCF.1 The sector therefore meets both of our criteria for purchase and we recommend an overweight allocation. One note of caution is that, as Chair Powell emphasized at last week’s FOMC press conference, the Fed has lending powers but not spending powers. That is, it can forestall bankruptcy for eligible firms by offering loans, but many firms will still see their credit ratings downgraded if they become saddled with debt. Already, Moody’s downgraded 219 issuers in March and upgraded only 19 (panel 4). Downgrades surely continued through April and will persist in the months ahead. With that in mind, there is value in favoring sectors and firms that are unlikely to face downgrade during the recession. As we explained in last week’s report, subordinate bank bonds are attractive in this regard.2 Banks remain very well capitalized and subordinate bonds offer greater expected returns than higher-rated senior bank debt.  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Policy-Driven Bond Market The Policy-Driven Bond Market Table 3B The Policy-Driven Bond Market The Policy-Driven Bond Market High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 420 basis points in April, bringing year-to-date excess returns up to -1308 bps. The average index spread tightened 136 bps on the month, and 356 bps since the Fed unveiled its corporate bond purchase programs on March 23 (Chart 3A). As noted on page 1, the junk bond market is experiencing unusually large return differentiation between credit tiers. This is because the Fed is offering support to the higher-rated segments of the market (Ba and some B), while the lower-rated tiers have been left out in the cold.3 We recommend that investors overweight Ba-rated junk bonds because that sector meets our criteria of offering elevated spreads compared to history and benefitting from Fed support. However, we will only recommend owning bonds rated B and lower if those sectors offer adequate compensation for expected default losses. On that note, Chart 3B shows the relationship between 12-month B-rated excess returns and the Default-Adjusted Spread. We define three scenarios for default losses: The mild scenario is a 6% default rate and 25% recovery rate, the moderate scenario is a 9% default rate and 25% recovery rate, the severe scenario is a 12% default rate and 25% recovery rate. Our base case expectation lies somewhere between the moderate and severe scenarios. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios The Policy-Driven Bond Market The Policy-Driven Bond Market As Chart 3B makes plain, B-rated spreads don’t offer adequate compensation for our base case default loss scenario. The same hold true for credits rated Caa & lower.4 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 48 basis points in April, bringing year-to-date excess returns up to -34 bps. The conventional 30-year zero-volatility spread tightened 24 bps on the month, split between 18 bps of option-adjusted spread (OAS) tightening and a 6 bps reduction in expected prepayment losses (aka option cost). Agency MBS benefit a great deal from Fed intervention. In fact, the Fed is aggressively purchasing the securities in the secondary market. However, we see better opportunities elsewhere in US fixed income. MBS spreads have already completely recovered from March’s sell off and spreads are low compared to other sectors. The conventional 30-year MBS OAS is 70 bps below the Aa-rated corporate OAS (Chart 4), 82 bps below the Aaa-rated consumer ABS OAS, 135 bps below the Aaa-rated non-agency CMBS OAS and 48 bps below the Agency CMBS OAS. Moreover, the primary mortgage rate has still not declined very much despite this year’s huge fall in Treasury yields. This leaves open the possibility that the mortgage rate could come down in the coming months, leading to a renewed spike in refinancing activity. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 44 basis points in April, bringing year-to-date excess returns up to -626 bps. Sovereign debt underperformed duration-equivalent Treasuries by 69 bps on the month, dragging year-to-date excess returns down to -1434 bps. Foreign Agencies outperformed the Treasury benchmark by 151 bps in April, bringing year-to-date excess returns up to -888 bps. Local Authority debt outperformed Treasuries by 98 bps in April, bringing year-to-date excess returns up to -859 bps. Domestic Agency bonds outperformed by 16 bps, bringing year-to-date excess returns up to -87 bps. Supranationals outperformed by 24 bps, bringing year-to-date excess returns up to -39 bps. USD-denominated Sovereign bonds didn’t rally alongside US corporate credit in April. Rather, spreads widened on the month since the sector only benefits modestly from Fed intervention via currency swap lines for a select few countries.5 The result of April’s underperformance is that Sovereign spreads are no longer very expensive compared to US corporate credit (Chart 5). A buying opportunity could emerge in USD-denominated Sovereign debt during the next few months, but we would want to see signs of emerging market currencies forming a bottom versus the dollar before making that call. As of now, EM currencies continue to weaken (bottom panel). Municipal Bonds: Overweight Chart 6State & Local Governments Need Support State & Local Governments Need Support State & Local Governments Need Support Municipal bonds underperformed the duration-equivalent Treasury index by 167 basis points in April, dragging year-to-date excess returns down to -909 bps (before adjusting for the tax advantage). The spreads between Aaa-rated municipal yields and Treasury yields tightened at the short end of the curve but widened significantly at the long end (Chart 6). Specifically, the 2-year spread tightened 18 bps on the month and the 5-year spread tightened 7 bps on the month. However, the 10-year, 20-year and 30-year spreads widened 6 bps, 32 bps and 34 bps, respectively. The divergence between spread changes at the short and long ends of the curve is once again the result of Fed intervention. The Fed’s Municipal Liquidity Facility initially promised to extend credit to state & local governments for a maximum maturity of 2 years. This was later extended to three years and several other changes were made to allow more municipalities to access the facility.6 We see a buying opportunity in municipal bonds at both long and short maturities. First and foremost, the Fed has already shown that it is willing to modify the scope of its lending facilities if some segments of the market are in distress, and the moral hazard argument against lending to state and local governments is weak when the Fed is already active in the corporate sector. Second, despite Senate Majority Leader Mitch McConnell’s posturing, Congress will likely authorize more direct aid to distressed state & local governments in the coming weeks.7 All in all, elevated spreads offer a compelling buying opportunity in municipal debt.   Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in April. The 2-year/10-year Treasury slope flattened 3 bps on the month to 44 bps. The 5-year/30-year slope flattened 6 bps on the month to 92 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.8 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.9 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 198 basis points in April, bringing year-to-date excess returns up to -552 bps. The 10-year TIPS breakeven inflation rate rose 21 bps to 1.08%. The 5-year/5-year forward TIPS breakeven inflation rate rose 17 bps to 1.43%. As we noted in a recent report, March’s market crash created an extraordinary amount of long-run value in TIPS.10 For example, the 10-year and 5-year TIPS breakeven inflation rates are down to 1.08% and 0.68%, respectively. This means that a buy & hold position long TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.68% for the next five years, or greater than 1.08% for the next ten (Chart 8). This seems like a slam dunk. On a shorter time horizon, investors should also consider entering real yield curve steepeners.11 The recent collapse in oil prices drove down short-dated inflation expectations. This, in turn, caused short-maturity real yields to rise because the Fed’s zero-lower-bound policy has killed nominal yield volatility at the short-end of the curve (panels 4 & 5). During the last recession, the real yield curve steepened sharply once oil prices troughed in 2008. We think now is a good time to position for a similar outcome.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed securities outperformed the duration-equivalent Treasury index by 117 basis points in April, bringing year-to-date excess returns up to -203 bps. The index option-adjusted spread for Aaa-rated ABS tightened 51 bps on the month to 140 bps. It remains 100 bps above where it was at the beginning of the year. Aaa-rated consumer ABS meet both our criteria to own. Index spreads are elevated compared to typical historical levels and the sector benefits from Fed support through the TALF program.12 Specifically, TALF allows investors to borrow against Aaa ABS collateral at a rate of OIS + 125 bps. The current index yield remains above that level (Chart 9).13 The combination of attractive valuations and strong Fed support makes this sector a buy. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -789 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 19 bps on the month to 190 bps. Aaa-rated CMBS actually outperformed duration-matched Treasuries by 100 bps in April, in contrast to the lower credit tiers, which lagged. Once again, the divergence between Aaa and lower credit tier performance is driven by the Fed. Aaa-rated CMBS benefit from TALF, while lower-rated securities do not.14 In fact, TALF borrowers can access the facility at a rate of OIS + 125 bps. The index yield remains well above this level (Chart 10).   The combination of attractive valuation and strong Fed support makes Aaa-rated non-agency CMBS a buy. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 144 basis points in April, bringing year-to-date excess returns up to -221 bps. The average index spread tightened 27 bps on the month to 103 bps, still well above typical historical levels (panel 4). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities The Policy-Driven Bond Market The Policy-Driven Bond Market Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 30 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 30 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Policy-Driven Bond Market The Policy-Driven Bond Market Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market ​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For a more detailed description of the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 4 For a more detailed analysis of Default-Adjusted Spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 The complete list of countries, and more detailed analysis of the swap lines, is found in US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For more details on the MLF please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 7 Please see Geopolitical Strategy Weekly Report, “Drowning In Oil (GeoRisk Update)”, dated April 24, 2020, available at gps.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 9 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 11 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 12 For details of TALF please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Portfolio Strategy An easy Fed as far as the eye can see and World War-like fiscal easing packages as the Trump administration prepares to slowly reopen the economy, signal that the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Relative indebtedness and profit margin improvements, extremely oversold technicals and significant relative undervaluation along with an encouraging message from financial market indicators, all suggest that it no longer pays to have a large cap bias. Book gains and step aside. Recent Changes Our long S&P 500/short S&P 600 position was stopped out last Tuesday for a 37% gain since inception.1 Last Wednesday our rolling stop was also triggered on the overweight in the S&P managed health care index – it is now neutral – for a gain of 26% since inception.2 Table 1 Things Are Looking Up Things Are Looking Up Feature The SPX made a run for the technically important 200-day moving average last week, and managed to climb to fresh recovery highs before giving back those gains as profit taking intensified late in the week. Three key drivers underpinned stocks and dominated the newsflow: First, resurfacing of positive news on remdesivir, a GILD drug, in treating the novel coronavirus. Second, the Fed reiterating its commitment to ZIRP and QE5 (Chart 1). And third, the quintuplet tech titans (MSFT, AAPL, GOOGL, AMZN & FB) reporting solid profits and April guidance, thus alleviating investors’ fears of a complete breakdown in tech revenues and EPS. Chart 1Easy Central Bank Monetary Policy Stance… Easy Central Bank Monetary Policy Stance… Easy Central Bank Monetary Policy Stance… Tack on the World War-like fiscal easing packages (Chart 2) and the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Chart 2…And An Easier Fiscal Policy Setting Are A Boon For Stocks …And An Easier Fiscal Policy Setting Are A Boon For Stocks …And An Easier Fiscal Policy Setting Are A Boon For Stocks Granted all of these monies are finding their way into the markets not only via higher asset prices, but also – and most crucially – the Fed’s massive liquidity injection is suppressing volatility. First, Fed actions have crushed the bond market’s vol, as depicted by Bank Of America’s MOVE index, that has now crumbled to a level last seen prior to the equity market drubbing. Similarly, the Fed has also quashed the VIX index which is now hovering near 35, down from a peak of 85 last month. Importantly, volatility petered out prior to the equity market’s trough, and so did different volatility curves (volatilities and volatility curve shown inverted, Chart 3). Turning over to S&P 500 net earnings revisions (NER), this mean reverting series was first tracked by I/B/E/S in 1985, and two weeks ago collapsed to the nadir of the GFC (Chart 4). Every time the NER ratio has hit such depressed levels, stocks have subsequently staged a powerful comeback. This has occurred five distinct times in the past 35 years and the SPX was 15% higher on average in the following twelve months (Chart 4). Chart 3Vols Lead On The Way Up And Down Vols Lead On The Way Up And Down Vols Lead On The Way Up And Down   Chart 4Extremely Depressed Net Earnings Revisions Have Troughed Extremely Depressed Net Earnings Revisions Have Troughed Extremely Depressed Net Earnings Revisions Have Troughed Drilling deeper beneath the surface is revealing. Analysts have been indiscriminately downgrading profits across all sectors. True, last week’s update revealed a tick up, which is an encouraging sign that the avalanche of downgrades may have already hit a climax (Charts 5 &  6). Chart 5Too Much Pessimism… Too Much Pessimism… Too Much Pessimism… Chart 6…Across The Board …Across The Board …Across The Board Importantly, our in-house calculated SPX sector EPS breadth is probing all-time lows. But, if the Fed manages to devalue the US dollar then a sharp reversal will ensue. Keep in mind, that the greenback and our EPS breadth indicator are inversely correlated as 40% of SPX sales are sourced internationally (Chart 7). Chart 7As Bad As It Gets As Bad As It Gets As Bad As It Gets Finally, a few words on the character of the equity market’s advance since the March 23 lows are in order. Contrary to popular belief, this has been an extremely broad based rally and the stocks that have done the best are not the large/mega caps. Instead the median stock has far outpaced the top market cap ranked constituents. In other words, the stocks that have rebounded the most are the ones that had fallen the most. Using Bloomberg data on SPX constituents from the March 23 lows until April 28, the first mega cap company that makes it to the top return ranks is CVX at the 22nd spot. UNH is 85th, ABT 90th and XOM 132nd. The tech titans start appearing below the 350th mark with MSFT 353rd, AAPL 362nd, FB 370th, AMZN 394th and GOOGL 439th. In other words, both the Value Line Arithmetic and Geometric indexes have been outperforming the SPX since the March 23 lows (top & middle panels, Chart 8). Similarly, small caps have also been besting the SPX (bottom panel, Chart 8). Notably, all three of these hypersensitive indexes have also led the SPX bottom. This week, we update our size view that was stopped out last Tuesday as the rolling stop was triggered for a gain of 37% since inception, and do some housekeeping. Chart 8Broad Based Rally Broad Based Rally Broad Based Rally Lock In Profits In the Size Bias And Move To The Sidelines In the spring of 2018 we initiated a size preference of large caps at the expense of small caps. At the time, we went against the grain as the investment community was arguing that small caps would offer the best protection from President’s Trump trade hawkishness. Their reasoning was that small caps are domestically oriented and would benefit from a rising dollar given low export exposure. While we were slightly offside for a quarter, this size preference recouped all the losses by October 2018, and never looked back since then. Our thesis was predicated upon relative indebtedness, relative profitability and relative profit margin outlook, all of which were in favor of large caps. Earlier this year when markets were convulsing we instituted a risk management metric with a rolling 10% stop on this size preference in order to protect profits for our portfolio.3 This past Tuesday our 10% rolling stop was triggered and we are obeying this stop, monetizing 37% gains since inception and we are moving to the sidelines on the size bias (Chart 9). Chart 9Take Profits And Move To The Sidelines Take Profits And Move To The Sidelines Take Profits And Move To The Sidelines Following a near collapse to two standard deviations below the six year mean, small cap performance has returned to the mean and is primed to sustain this reflex rebound. In marked contrast, large caps only corrected to their six year average and are now trading at over one standard deviation above that mean (Chart 10). When the economy was shut down small and medium businesses were clearly the outfits that would hurt the most. Their only rescue came belated in the form of the fiscal package. Thus, investors started pricing in a steep default cycle with SMEs at the forefront of the bankruptcy curve (top panel, Chart 10). In contrast, large caps with access to untapped credit lines, the bond and equity markets as well as their own cash coffers would not suffer as severely (second panel, Chart 10). Chart 10Large Cap Outperformance Reached An Extreme Large Cap Outperformance Reached An Extreme Large Cap Outperformance Reached An Extreme Now that the economy is on the verge of slowly reopening, we do not want to overstay our welcome and refrain from betting on a further jump in the large/small ratio; instead we opt to book profits and move to the sidelines. With regard to profit fundamentals, our relative jobs proxy has peaked and is no longer favoring large caps (second panel, Chart 11). Similarly, profit margins have likely bottomed for small caps while they have maxed out for large caps (third panel, Chart 11). On the relative indebtedness front, small cap net debt-to-EBITDA remains sky high but it has crested which is at the margin positive (bottom panel, Chart 11). Meanwhile, as the Fed has opened up the liquidity spigots, the government is as spendthrift as it can be and committed to slowly reopen the economy, then at some point in the summer the pendulum will swing the opposite way and some semblance of normality will return to the US economy. Therefore, this inflection point will end the threat of deflation and likely serve as a catalyst for a small/large multiple expansion phase (Chart 12). Chart 11Marginal Small Cap Improvements Marginal Small Cap Improvements Marginal Small Cap Improvements Chart 12When The Economy Turns, So Will Small Caps When The Economy Turns, So Will Small Caps When The Economy Turns, So Will Small Caps With regard to the message that financial market variables are sending for the small/large ratio, the collapse of the VIX is a welcome development (VIX shown inverted, Chart 13). Similarly, the yield curve has been in steepening mode again emitting a positive “risk on” signal. Under such a backdrop and given depressed technicals and bombed out valuations it is prudent not to wager against small caps at this juncture (Chart 14). Chart 13Leading Financial Market Indicators Say Do Not Overstay Your Welcome Leading Financial Market Indicators Say Do Not Overstay Your Welcome Leading Financial Market Indicators Say Do Not Overstay Your Welcome Chart 14Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Netting it all out, relative indebtedness and profit margin improvements, the slow reopening of the economy in the coming months, extremely oversold technicals and significant relative undervaluation along with an encouraging message from financial market indicators, all signal that it no longer pays to have a large cap bias. Bottom Line: Move to the sidelines on the size bias and crystalize profits of 37% since inception. Housekeeping Last Wednesday our rolling stop was also triggered on the overweight in the S&P managed health care index – it is now neutral – for a gain of 26% since inception (top panel, Chart 15).4 In addition, we are stepping aside from the COVID-proof basket of stocks we recommended six weeks ago.5 The coronavirus unintended consequences will alter government, business and consumer behaviors and it will most definitely affect consumer tastes, underscoring that the companies that comprise our COVID profit basket will likely be long-term winners. However, this basket has served its purpose and given that the global economy is on the verge of reopening it will be increasingly difficult to outperform the broad market. Thus, we are moving to the sidelines for a modest relative gain of 0.8% (second & third panels, Chart 15). Finally, our freshly minted market-neutral and intra-commodity long S&P oil & gas exploration & production/short global gold miners pair trade has gone parabolic right out of the gate soaring to 20% in a mere week. As a result of this explosive up-move, we are instituting a 10% rolling stop in this pair trade in order to protect profits for our portfolio (bottom panel, Chart 15). Chart 15Housekeeping Housekeeping Housekeeping     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Daily Report, “Book Gains In Preferring Large Caps To Small Caps” dated April 30, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Daily Report, “Take Profits In HMOs And Move To The Sidelines” dated May 1, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Daily Report, “Closing Out All High-Conviction Calls” dated March 20, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Daily Report, “Take Profits In HMOs And Move To The Sidelines” dated May 1, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Daily Report, “Corona Virus Proof Portfolio” dated March 18, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Things Are Looking Up Things Are Looking Up Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The air is thick with denunciations of the Fed’s new round of aggressive interventions … : In financial circles, it’s beginning to sound like the winter of 2008-9 all over again, as respected thought leaders with enviable track records decry bailouts. … but we are firmly resolved to keep judgments about what central banks ought to do out of our analysis of the market impacts of their actions: “Dogmatic” is about the worst thing one BCA researcher can call another. The Fed’s expanded lending remit may simply be the logical evolution of the Debt Supercycle: The Debt Supercycle may have reached its natural limit, but policy makers won’t surrender such a cherished tool without a fight. Capitalism isn’t entirely dead, and the Fed isn’t the Coast Guard or the Forest Service: The new approach is meant to protect society, not individuals who get themselves into idiosyncratic trouble. Feature We will be holding a webcast next Monday, May 11th at 10:00 a.m. Eastern time in lieu of publishing a Weekly Report. Please join us with your questions to make it a fully interactive event. We will resume our regular publication schedule on the 18th. Here we go again. A potentially catastrophic recession has arrived, and the Fed has embarked on a series of unprecedented actions to try to shield the economy from it. Its goal is to stave off hysteresis, whereby a cyclical downturn, left unchecked, gives rise to a structural albatross that weighs on long-run growth. Just how much a central bank ought to interpose itself between the economy and its participants can be a matter of fierce debate, as it was in November 2010, when 23 members of the broader economic community, including three elite investors and a handful of respected economists, signed an open letter to Ben Bernanke, urging him to abandon QE2 (Box 1). Box 1 A Central Bank Can’t Win Open Letter to Ben Bernanke November 15, 2010 We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment. We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus. We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy. The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either US or global economic problems.1 Dire forecasts about the effects of the Fed's unconven-tional GFC interventions have not come to pass and have since been emulated by other major central banks. No one bats a thousand when predicting the future, but the authors of the letter could not have been further off the mark when they warned about currency debasement and inflation. Monetary policy has not yet been normalized in the way anyone would have defined it at the time, but other central banks have overcome their aversion to QE, pursuing it as avidly as the Fed (Chart 1). One should also note that some of the author-investors were not disinterested observers. QE signaled an extended period of easy monetary conditions that was likely to narrow distinctions among individual companies, undermining stock-picking processes that had produced outperformance against a conventional monetary policy backdrop. Chart 1What Was Once Unthinkable Has Become Routine What Was Once Unthinkable Has Become Routine What Was Once Unthinkable Has Become Routine Moral Hazard Inflation and the dollar are well down the list in the latest round of denunciations, which are principally occupied with moral hazard. In his outlook last week, Guggenheim Investments’ CIO Scott Minerd warned that the Fed’s purchases of corporate debt establish a new precedent that will have a persistent half-life, if QE is any guide. By socializing credit risk, he asserts, the purchases mark the end of US free-market capitalism as we have always known it. Two weeks before, Howard Marks argued that capitalist principles are being undermined by the Fed’s programs, if not entirely overthrown: Most of us believe in the free-market system as the best allocator of resources. Now it seems the government is happy to step in and take the place of private actors. We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market. When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called “moral hazard.” There’s an old saying … to the effect that “capitalism without bankruptcy is like Catholicism without hell.” It appeals to me strongly. Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it. We have never been enamored of the concept of the Fed put because we don’t think it is terribly relevant for any individual investment decision maker, and relying on it could be hazardous to one’s health. First, the Fed put is absolutely not an at-the-money put, or even a put with a strike price that is only slightly out of the money. It doesn’t do an investor much good if the Fed doesn’t ride to the rescue until his/her position is 30% underwater. Second, the Fed doesn’t care if any individual entity fails. It only acts to protect the overall financial system and the broad economy. An individual entity that gets into trouble cannot count on the Fed to throw it a lifeline. The Fed is not the Coast Guard or the Forest Service, which will go to great lengths to rescue a foolhardy or unskilled pilot or hiker who gets in over his or her head in rough weather. It cares only about the collective, and the only way an individual entity can count on receiving aid is if everyone else runs into trouble at the same time. That collective insurance policy may promote some operational risk-taking at the margin, but we wouldn’t want to rely on it. How could an overleveraged company possibly know that a critical mass of other companies will get into trouble at the same time? The Fed put doesn’t apply to the first entity to fail, or to entities in industries that are not seen as critical. It could surely encourage investors to lend to entities of dubious quality, but timing is everything there, too. The less-than-pristine borrower will have to hold on long enough to be somewhere in the middle of the pack of failing entities to qualify for a life preserver. The Trouble With The Austrians We lean to the view that moral hazard, as promoted by Fed policies, is largely in the eye of the beholder. The ability to perceive moral hazard seems to be related to one’s propensity for moral indignation. Austrian School devotees (Box 2) regularly have that propensity in spades. Box 2 An Austrian’s Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle’s unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. Austrians despise the existence of such an arrangement, but it is so thoroughly entrenched in the reigning orthodoxy that an investor who becomes emotionally invested in opposing it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek dueling via raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor’s dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers’ attention. The simple conceit animating the video – Keynesianism is fun; Austrians are dour scolds – resonates deeply with elected officials, even if they never studied Economics. Voters love free drinks, but hate being told to eat their vegetables. There are no atheists in foxholes, and there are no Austrians in crises. When push comes to shove, government officials will do what they can to alleviate economic pain. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should maintain a laser-like focus on what is most likely to happen and strive to suppress extraneous notions about what should happen. The Debt Supercycle’s Second Act Chart 3The End Of An Era? The End Of An Era? The End Of An Era? Call us jaded, but after 20-plus years in the business, the Austrians, with their fusty rectitude and gold-standard nostalgia, have come to seem like utopians. We prefer to borrow a page from public choice theory, and assume that elected and appointed officials respond to incentives just as surely as individuals outside of government. Legislators will pull fiscal levers to keep the party going and extend their own tenures, while the Fed will do its utmost to preserve its discretion to steer the economy as it sees fit. From that perspective, the Fed’s pull-out-all-the-stops approach to protecting markets and the economy simply looks like a logical evolution of the Debt Supercycle (Box 3). Now that a decade of zero and near-zero rates has failed to stimulate private sector borrowing (Chart 3), our colleague Martin Barnes has written that the Debt Supercycle is played out. Changing consumer preferences (Chart 4) and regulatory measures reining in banks’ lending capacity have impeded the credit channel, sharply degrading the Fed’s conventional policy arsenal. Central bankers want to remain in the thick of the action as much as any other bureaucrats, and it follows that the Fed has expanded its remit with unconventional measures that maintain its relevance. Chart 4Consumer Preferences Have Changed Since The GFC Consumer Preferences Have Changed Since The GFC Consumer Preferences Have Changed Since The GFC Box 3 The Debt Supercycle Longtime BCA clients are familiar with the Debt Supercycle concept, which holds that postwar Fed stimulus provoked successive waves of household and corporate borrowing to reflate the economy following recessions. Managing the economy with countercyclical fiscal and monetary policy has helped make recessions less frequent and less severe than they had been under the laissez faire prewar approach (Chart 2). Chart 2Intervention Has Helped Tame Cyclical Oscillations Intervention Has Helped Tame Cyclical Oscillations Intervention Has Helped Tame Cyclical Oscillations The only rub was that serial interventions to promote a quickening in the flow of new credit left the economy with an ever-increasing stock of debt. The prewar recessions were vicious, but bank and business failures allowed for frequent balance sheet resets that purged the economy of its boom excesses. The Debt Supercycle effectively sacrificed modest increments of structural stability for cyclical stability. Structural instability rose in step with the stock of debt, driving up the potential long-run cost of cyclical slumps, making the preservation of the Debt Supercycle increasingly imperative. Investment Implications We do not think investors should adjust to the new central banking orthodoxy by loading their portfolios with risk to embrace the Fed put. That put only applies to markets collectively, and cannot be seen as insurance for any single economic entity or asset portfolio. It would also be a mistake to renounce risk, however, by refusing to participate in a rigged game that violates Austrian principles. Investors should simply recognize that the new monetary orthodoxy calls for central banks to throw the kitchen sink at major economic threats. That suggests that shorts or underweights in risk assets based on macro vulnerabilities should be covered or closed without delay once a preset downside target has been reached. It seems that investors had 2009 in mind when they dove back into risk assets upon the Fed’s March 23rd announcement of its mix of revised and brand-new lending facilities and the March 27th passage of the CARES Act.2 No one wants to miss a big policy-induced bounce. Buy what the Fed is buying, and don't stress over it. Investors should buy what the Fed’s buying while its purchase programs and lending facilities are operating. That subset includes agency CMBS, AAA-rated CMBS, AAA-rated ABS, investment grade corporate debt and newly fallen angels in the BB-rated tier. Though they’ve already had a hearty bounce, agency mortgage REITs offer an equity vehicle for playing the Fed-purchase theme, as do the SIFI banks, which are the biggest indirect beneficiary of reduced default rates. We expect Guggenheim’s admonition that the Fed’s support of corporate borrowers will have a long half-life will prove to be accurate. As our Chief Global Fixed Income strategist put it at last week’s meeting to review long-term virus impacts, “Everyone on this call may be retired before a central banker ever utters the word ‘taper’ again.” That may not be the backdrop this free-markets devotee would choose, but it’s the backdrop all of us will have for the foreseeable future, and we’re determined to make the most of it.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1https://www.hoover.org/research/open-letter-ben-bernanke. Accessed April 28, 2020. 2 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary of the Fed’s Anti-Virus Measures," available at www.bcaresearch.com.

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2020.  The model has not made significant changes this month. Now Spain, Australia, Sweden and the US are the top four overweight countries, while Japan, the UK, France and Switzerland remain the four underweight countries, as shown in Table 1.  Table 1GAA DM Model Vs. MSCI World GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in April by 105 bps. The Level 1 model outperformed by 32 bps because of the overweight in the US. The Level 2 model outperformed by 241 bps thanks to the overweight of Australia and Canada, and the underweight in Japan, the UK, France and Switzerland. Since going live, the overall model has outperformed by 105 bps, with 135 bps of outperformance by the Level 2 model, and 29 bps of outperformance from the Level 1. Chart 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) GAA US Vs. Non US Model (Level 1) GAA US Vs. Non US Model (Level 1) Chart 3GAA Non US Model (Level 2) GAA Non US Model (Level 2) GAA Non US Model (Level 2) For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of April 30, 2020. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model turned negative on cyclical sectors in the beginning of March as the COVID-19 crisis intensified and growth indicators deteriorated. Throughout March, April and now May, the model continues to tilt towards defensive sectors. This has helped mitigate the shortfall in early March. However, that came at a cost as the model underperformed the benchmark by 33 basis points over the past month. The global growth proxy used in our model remains negative. This will continue to make the model's positioning focused on less cyclical sectors. The momentum component led the model to overweight Consumer Discretionary over the past month at the expense of Utilities. The unprecedented global monetary measures taken by global central banks should keep the liquidity component favouring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, we continue to highlight that the Info Tech’s valuation component has broken into overweight territory (yet the model awaits a downwards confirming momentum signal to recommend an underweight). The model is now overweight four sectors in total, two cyclical sector versus two defensive sectors. These are Information Technology, Consumer Discretionary, Consumer Staples, and Health Care. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Overall Model Performance GAA Quant Model Updates GAA Quant Model Updates Table 4Current Model Allocations GAA Quant Model Updates GAA Quant Model Updates Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Senior Analyst amrh@bcaresearch.com

Feature Global equities have seen an astonishing rally since mid-March, rising by 28%. This leaves them only 13% below their level at the beginning of the year. This is particularly remarkable given the unprecedented decline in economic activity with, for example, US GDP shrinking by an annualized 4.8% quarter-on-quarter in Q1, and the consensus forecasting it to fall by as much as 30% in Q2. Given this, risk assets are pricing in a highly optimistic trajectory over the coming months: a rapid return to normalcy, a V-shaped economic recovery, and minimal side-effects from the sudden stop to the world economy. In our Q2 Quarterly, we wrote we would turn more cautious if the S&P 500 moved quickly above 2,750.1 With it now at 2910, we are therefore lowering our recommendation on global equities on a 12-month horizon from Overweight to Neutral. The balance of probabilities – and the possibility of a second wave of the pandemic, rising corporate defaults, and problems among EM borrowers – simply does not justify an outright risk-on stance. Bear markets typically end 3-4 months before the economy bottoms (Table 1). If March was the low for stocks, therefore, this implies that the recession will end in June or July. BCA Research’s view is that the recovery is more likely to be U-shaped than V-shaped. Table 1Stocks Bottom On Average 3-4 Months Before The Recession Ends Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Chart 1New COVID-19 Cases Have Peaked New COVID-19 Cases Have Peaked New COVID-19 Cases Have Peaked What triggered the rally? Most notably, it anticipated a peaking of new COVID-19 cases in the world outside China (Chart 1). Several countries, notably Spain and Italy, have already felt able to ease quarantine rules, and others will do so during May. This raises the possibility that the pandemic will largely be over by July (except perhaps in a few developing countries, such as Brazil, where strict containment was shunned). The rally was fueled by unprecedented fiscal and monetary measures taken by the authorities everywhere. In the US, for example, the various new Federal Reserve liquidity programs add up to $4.2 trillion (20% of GDP) (Chart 2). The balance-sheets of major global central banks, particularly the Fed's, have ballooned in just a few weeks (Chart 3). As a result, US money supply and dollar liquidity have soared (Chart 4). Normally, when there is a flood of liquidity over and above what is needed to fund the real economy, that excess liquidity flows into asset markets, weakens the dollar, and boosts commodities and Emerging Markets. But these are not normal times. Liquidity injections amid deteriorating economic conditions cushion the downside but do not necessarily improve the outlook immediately – as we witnessed in 2007-2008.   Chart 2Multiple New Stimulus Programs… Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Chart 3...Made Central Bank Balance-Sheets Balloon... ...Made Central Bank Balance-Sheets Balloon... ...Made Central Bank Balance-Sheets Balloon... Chart 4...And Dollar Liquidity Soar ...And Dollar Liquidity Soar ...And Dollar Liquidity Soar Chart 5Pandemics Usually Have Several Waves Pandemics Usually Have Several Waves Pandemics Usually Have Several Waves The biggest risk is that the pandemic lingers. Epidemiologists agree that COVID-19 will not disappear until (1) a vaccine is available, likely to be 12-18 months (if one is possible at all – there is still no vaccine for HIV or SARS), or (2) 65-80% of the population has had the disease, creating “herd immunity”. Maybe a vaccine will be ready sooner, or a therapeutic treatment will drastically lower the mortality rate – but investors should not bet on it. It is worth remembering that the last big pandemic, the Spanish ‘flu of 1918-1919, had several waves, with the second the deadliest (Chart 5). It is possible that each time governments ease containment measures, the number of new cases will rise again. And even if they don’t, how likely is it that consumers will go back to shopping, eating in restaurants, or travelling as before? Big data from China show a general return to work but not to going out for entertainment (Chart 6). This is likely to remain a drag on the economy for a considerable period.   Chart 6Chinese Remain Reluctant To Go Out Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Moreover, the fiscal and stimulus packages will help to tide over households and companies in advanced economies during the toughest times – replacing lost wages, and providing bridging loans – but they do not solve the fundamental problem for firms that have lost most of their revenues. US corporate debt is at its highest percentage of GDP in recent history – and the ratio is even higher in parts of Europe, Japan, and China (Chart 7). Bankruptcies are likely to rise, which will make banks more cautious about lending, further tightening credit conditions. Moreover, stimulus packages won’t help Emerging Market borrowers, which have around $4 trillion of outstanding foreign-currency-denominated debt. With the sharp rise in EM credit spreads and fall in currencies over the past three months, many will struggle to service and repay this debt (Chart 8). Chart 7Corporate Debt Is At A Worrying Level Corporate Debt Is At A Worrying Level Corporate Debt Is At A Worrying Level Chart 8EM Dollar Borrowers Will Struggle EM Dollar Borrowers Will Struggle EM Dollar Borrowers Will Struggle     Portfolio construction is about probabilities. The scenario priced into risk assets currently – a rapid return to the status quo ante – could turn out to be correct. But there is a significant probability that it does not. We therefore recommend taking some risk off the table. We would not switch into quality government bonds as a hedge, since current yields would give little return even in a disastrous economic scenario – and could produce very negative returns if inflation picks up. We, rather, recommend Overweights in cash and gold, and a relatively low-beta tilt within equities.  Equities: Valuations, especially in the US, have not hit typical market-bottom levels. The price/book ratio for US equities, for example, troughed only at 2.9 in March, compared to a bear-market low of 1.5 in 2009 (Chart 9). Earnings will probably be revised down further: the consensus still expects only a 12% decline in S&P 500 EPS in 2020 (and a 21% jump next year); earnings revisions are usually closely correlated to stock prices (Chart 10). We, therefore, remain cautious in our regional equity positioning, with an Overweight on US stocks, and a somewhat defensive sector tilt (Overweights in IT and Healthcare, along with Industrials as a play on Chinese stimulus). One factor to watch: any sustained pickup in value and small-cap stocks, which showed some signs of appearing in late April (Chart 11). This has historically signaled the beginning of a bull market. Chart 9US Valuations Are Not At Usual Bottom Lows US Valuations Are Not At Usual Bottom Lows US Valuations Are Not At Usual Bottom Lows Chart 10Weak Earnings Can Drag Markets Down Further Weak Earnings Can Drag Markets Down Further Weak Earnings Can Drag Markets Down Further     Chart 11When Will Value And Small Caps Pick Up? When Will Value And Small Caps Pick Up? When Will Value And Small Caps Pick Up? Fixed Income: Quality government bonds look highly unattractive at current yields. Our calculations suggest only an 6.7% return from 10-year US Treasuries and 4.6% from Bunds even if their yields fall to the lowest possible level, 0% and -1% respectively. Inflation-linked bonds, especially in the US, the UK, Australia and Canada, look very undervalued, however.2 US 10-year breakevens have fallen to as low as 1.1% (Chart 12). In spread product, the best strategy at the moment is to buy what central banks are buying. That means investment-grade bonds in the US and Europe, Fallen Angels3  (since both the Fed and ECB will backstop bonds that were downgraded to junk in the past month), US Aaa CMBS and ABS, Agency CMBS, and munis. But the riskier end of the junk-bond universe looks unattractive. Even a moderate default cycle (with a 9% default rate for junk bonds – compared to 15% in the last recession – and a 25% recovery rate) would point to an excess return from B-rated corporate bonds of -20% over the next 12 months (Chart 13). Chart 12TIPS Look Very Cheap TIPS Look Very Cheap TIPS Look Very Cheap Chart 13Avoid The Lower End Of Junk Monthly Portfolio Update: The Balance Of Probabilities Monthly Portfolio Update: The Balance Of Probabilities Currencies: The dollar has moved sideways on a trade-weighted basis over the past two months. We remain Neutral, since in the short term the dollar could face upward pressure as a safe-haven play, especially versus Emerging Market currencies, if investors start to worry again about growth. In the longer run, however, the dollar looks expensive relative to purchasing power parity (Chart 14), and interest-rate differentials no longer favor it as they have done over much of the past decade (Chart 15). BCA Research’s FX strategists recommend a barbell strategy in currencies, with Overweights in cheap cyclical currencies such as the Canadian dollar and Norwegian krone, as well as safe havens such as the yen.4 Chart 14Dollar Is Expensive... Dollar Is Expensive... Dollar Is Expensive... Chart 15...And No Longer Benefits From Higher Rates ...And No Longer Benefits From Higher Rates ...And No Longer Benefits From Higher Rates     Commodities: After the extraordinary behavior of near-month WTI futures in April, the crude price should settle down. BCA Research’s energy strategists argue that renewed production cuts from Saudi Arabia and Russia, combined with a near-normalization in demand in H2, should push crude-oil balances back into a supply deficit by Q3 (Chart 16). Chart 16Oil Price Should Rise In H2 Oil Price Should Rise in H2 Oil Price Should Rise in H2 They forecast Brent to rise to $42 a barrel by the end of 2020, compared to $24 now. Industrial metals prices have generally remained depressed, despite the recovery in risk assets (Chart 17). But the effects of Chinese stimulus, combined with a weaker dollar, should cause them to recover later in the year (Chart 18). Gold remains a good hedge against further economic shocks or an eventual resurgence in inflation. Chart 17Metal Prices Haven't Recovered... Metal Prices Haven't Recovered... Metal Prices Haven't Recovered... Chart 18...But Should Soon Benefit From Chinese Stimulus ...But Should Soon Benefit From Chinese Stimulus ...But Should Soon Benefit From Chinese Stimulus   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 2  Please see Global Fixed Income Strategy, "Global Inflation Expectations Are Now Too Low," dated April 28, 2020. 3  Bonds that have recently been downgraded from investment grade to sub-investment grade. 4  Please see Foreign Exchange Strategy, "QE And Currencies," dated April 17, 2020. GAA Asset Allocation