Economy

Highlights EM QE programs will ensure that EM local currency bond yields will drop further. However, the impact of these EM QE programs on EM currencies is ambiguous. Continue receiving long-term swap rates in a number of EM economies. QE programs globally constitute public debt monetization. A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. However, DM and EM QE programs could fuel financial market manias. Feature Chart I-1Broad Money Is Booming In DM And Accelerating In EM In this report we discuss the various quantitative easing programs (QEs) that have begun to surface in emerging economies. This is a new phenomenon that will likely mark a major precedent for EM central banks. Over time, these programs will likely become more prominent tools in EM. Understanding these unorthodox monetary policy easing measures in EM and DM is of paramount importance to investors. We use a Q&A format to discuss and elaborate on this topic. Question: What has forced the authorities to launch QE programs in EM and what forms have they taken? Answer: QE programs in developing countries are in their infancy. Several governments launched them in haste in the month of March in response to the recession and panic selloff that was occurring across global financial markets. These programs will be shaped by different forces and take different forms over time. Generally, QE programs are implemented in order to: (1) halt the abrupt deleveraging among local commercial banks amid the COVID-19 crisis (2) ensure credit continues to flow to the real economy (companies and households) (3) bring down long-term interest rates and prevent large government borrowings from crowding out the private sector. In addition to slashing policy rates, many EM central banks (CBs) are implementing one or more of the following initiatives to achieve these objectives: I.  Providing unlimited liquidity to commercial banks through various facilities II.  Buying government bonds III. Conducting direct purchases of local currency corporate bonds and, in some cases, mortgage-backed securities IV. Direct lending to non-banks such as mutual funds and enterprises V. Expanding the range of public and private sector securities that can be used as collateral when lending to banks The second, third and fourth types of operations can be considered forms of QE to the extent that they fall beyond the scope of customary CB operations. The latest QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. Table I-1 provides information about various central bank policies across mainstream EM countries. Details are still limited regarding the technicalities, quantity and timelines of some of these measures. Table I-1Quantitative Easing Policies Annouced By Emerging Economies Question: Do these QEs represent a public debt and fiscal deficit monetization? Answer: Yes, monetary and fiscal policies are being coordinated and these QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. These QE policies have been designed to ensure that the cost of government borrowing does not rise amid the surge in public sector borrowing requirements. Especially at a time when foreign investors were abandoning EM financial markets. Governments have deployed large fiscal stimulus packages to offset the devastating economic impact of COVID-19 induced shutdowns. Coupled with a collapse in fiscal revenues, this has resulted in a widening of fiscal deficits and large borrowing requirements. Chart I-2EM QEs Are Intended To Drive Down Local Bond Yields EM local currency government bond yields spiked in March (Chart I-2). This prompted CBs in many EMs to announce government bond purchasing programs in order to bring down government bond yields. Government bond yields influence other interest rates such as those for consumer and business loans. Higher borrowing costs amid a deep recession would have been lethal for corporate and household debtors. Additionally, it would have materially damaged public debt dynamics. To bring down government bond yields and ensure that policy rate cuts translate into lower borrowing costs across the entire yield curve, CBs have begun purchasing government bonds in the following developing countries: Brazil, South Africa, Poland, Colombia, India, Malaysia, Indonesia, Thailand and Korea. Government bond yields in many EMs have declined since mid-March (Chart I-2). That could be at least partially attributed to EM CBs’ QE programs. CB purchases of government bonds in either primary or secondary markets, qualify as public debt monetization. Question: How are QEs different from conventional CB operations and what makes them so unique as to warrant investor attention? Answer: There are three things that distinguish these QE initiatives from traditional CB operations: First, CBs do not typically lend to non-banks. They do not lend to or purchase credit instruments issued by non-banks. Hence, by purchasing corporate bonds and issuing loans to non-banks, CBs have entered into unchartered territory. This is also true for the Federal Reserve and CBs in other advanced economies. Second, by buying government bonds CBs are conducting an outright monetization of public debts and fiscal deficits. This is true for central banks in both EM and DM. Outside QEs, monetary authorities typically set the short-term interest rate and provide enough liquidity to the banking system to keep short-term interbank rates on par with policy rates. Chart I-3Fed’s Ownership Of Treasurys Prior to the launch of QE programs, CB operations with long-term government bonds were limited in scope and often technical in nature. For example, the Fed’s ownership of US Treasury securities rose by only 40% from $550 billion in 2002 to $775 billion in 2006. By comparison, it has doubled from $2 trillion to $4 trillion since September 2019 (Chart I-3). When CBs buy government bonds en masse, as they are currently doing in many countries, we are no longer talking about open market operations, but rather the monetization of public debt. Third, by launching QEs, CBs affect long-term interest rates. When financial markets are malfunctioning, which results in unjustifiably elevated long-term interest rates and cost of capital, QEs become essential to ensure the monetary policy transmission channel is operating effectively.  Nevertheless, as we have seen in the cases of the ECB and Bank of Japan, the use of QEs can become addictive. Once CBs have deployed QEs, they have a hard time abandoning them. When the financial systems and markets get accustomed to zero or negative nominal interest rates and to a constant overflow of CB liquidity, the termination of QEs will be disruptive and painful. Consequently, there is a risk that both DM and EM CBs will end up overdoing it with QEs - suppress long-term interest rates too much, for too long and for no justifiable reason. This will in turn lead to misallocations of capital, asset bubbles and other distortions in financial markets and real economies. If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise even if real output returns to its potential pace. Question: Is it fair to say that QEs lead only to an increase in commercial banks’ excess reserves at the CB, and that they have no real impact on the money supply? In other words, if commercial banks do not lend, is it true that the money supply will not expand and, thereby, QEs will never lead to higher rates of inflation?  Answer: Not really. QEs have a much more nuanced impact on the money supply. Moreover, the relationship between the money supply and the inflation rate is not straightforward. We will consider several examples, dissecting the impact of QEs on both excess reserves (ER) and the money supply. But first, let us recall that the broad money supply is the sum of both the cash in circulation and all types of deposits in commercial banks, including demand, time and savings deposits. Commercial banks’ ER at CBs are not included in either the narrow or broad definitions of money supply. Case 1: When a central bank purchases securities from or lends to a bank, ER rise although no deposit is created, so the money supply does not change.  Case 2: When a central bank purchases securities from or lends money to non-banks, this transaction creates both an ER and a new deposit in commercial banks, meaning that the money supply does increase. Case 3: When a commercial bank buys securities from or lends to non-banks, ER do not change while a new deposit is created “out of thin air”, so that the money supply rises. Conversely, when a bank sells a security to a non-bank, or a non-bank repays a loan, the money supply (i.e. the amount of deposits in the banking system) shrinks. To sum up, QEs lead to a larger money supply when CBs purchase assets from or lend to non-banks. When CBs purchase assets from banks, no new money (deposits) are created. Importantly, the money supply also expands when commercial banks buy securities from or lend to non-banks. Chart I-4A and I-4B reveal that QEs in the US, the UK, Japan and the euro area, over the past 10 or so, years have created a lot of ER but little money supply. Chart I-4AExcess Reserves Have Expanded More Than Broad Money In US, Japan… Chart I-4B… Euro Area And UK   In China, the broad money supply has been exploding since 2009. The commercial banks have, on their own, generated an enormous increase in the money supply “out of thin air”, by making loans to and buying securities from non-banks, even though there has been much less ER creation from the PBoC (Chart I-5). The top panel of Chart I-6 illustrates the remarkable evolution of broad money supply in China versus the US, the euro area and Japan. In the chart, broad money supply in these four economies is plotted along the same scale, since January 2009, when QEs began in DM and the credit boom commenced in China. Even though ERs have expanded much more in the US, the euro area and Japan (Chart I-6, bottom panel), broad money growth in China outstripped all other economies by a large margin (Chart I-6, top panel). Chart I-5Excess Reserves Have Expanded Less Than Broad Money In China Chart I-6Broad Money And Excess Reserves: China Versus DM     As we discussed in our previous reports on money, credit and savings, money supply growth is not at all contingent on savings in an economy. Rather, outside of QEs money in all countries is primarily created by the commercial banks when they lend to or purchase assets from non-banks. Still, the nature of QE is now changing in the US. Chart I-7 reveals that the broad money supply is booming faster than it ever has, since World War II. As the Fed lends directly to businesses and purchases corporate bonds that are largely held by non-banks, the money supply will explode in the US, alongside a surge in ER. Chart I-7US Money Growth: The Sky Is The Limit Chart I-8April Datapoints Suggest Notable EM Money Growth Acceleration Similar trends will occur in EM and other DM (Chart I-8): as their CBs buy securities from non-banks, they will simultaneously create both ER and new deposits at commercial banks (money supply). Question: Does this potential explosion in money supply globally – and in the US in particular – imply that there is an imminent risk of an inflation outbreak in the real economy? Answer: A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. Inflation (rising prices of goods and services) also depends on the velocity of money and the productive capacity of an economy. Nominal GDP = Velocity of Money x Money Supply In turn, Nominal GDP = Output Volume x Prices Hence, Output Volume x Prices = Velocity of Money x Money Supply Finally, Prices = (Velocity of Money x Money Supply) / Output Volume. Therefore, inflation is contingent not only on the money supply but also on the velocity of money and the output volume. The money supply will continue surging in the US and will boom in the rest of the world as other CBs also deploy QEs (Chart I-7 and I-8). However, the surge in money supply has so far been offset by a lower velocity of money (Chart I-9Aand I-9B). The velocity of money reflects the willingness of consumers and businesses to spend their money. Chart I-9AVelocity Of Money Dropped In March Chart I-9BVelocity Of Money Dropped In March If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise. In a nutshell, money growth will be booming worldwide due to QEs but the velocity of money, or the willingness to spend, will be the critical factor in determining inflation dynamics in the months and years to come. Question: Will the current excessive creation of money leak into asset prices and produce asset bubbles? Answer: It could. As we discussed in our January report titled, A Primer On Liquidity, an abundant money supply is conducive to higher asset prices and bubbles, but it is not a sufficient condition. Investors should be willing to allocate money to financial assets in order for the latter to appreciate. For example, since the beginning of this year, global risk assets have gone through an enormous roller-coaster ride. Through mid-February, risk assets were buoyant and the oft-cited rationale for the rally was plentiful liquidity. Then, from mid-February on through late March, we witnessed historic liquidity crunches across all financial markets, including US Treasurys. It is crucial to note that neither ER in the global banking system, nor global narrow and broad money slowed down during that period (Chart I-1 on page 1 and Charts I-4A and I-4B on page 6). Investors were simply liquidating financial assets and raising their cash level. Since late March, risk assets have been rallying as investors have felt more comfortable taking on more risk. Overall, whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Just as price inflation in the real economy is dependent on the willingness of consumers and businesses to spend their money on goods and services, financial asset price appreciation is contingent on the animal spirit of all investors and their inclination to take on more risk. Whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Question: How does the stock of US dollars (the broad money supply) compare with the value of US-denominated securities available to investors? Has the Fed’s purchases of securities not shrunk the amount of publicly-traded securities available to investors? Answer: Yes, indeed, they have. One of the distortions that the Fed’s and other CBs' QEs created has been the shrinkage of publicly-traded bonds and stocks. This has certainly lifted asset prices to levels they would have otherwise not reached. Chart I-10 plots the ratio of the US broad money supply-to-the market value of all US dollar-denominated securities. The US broad money supply represents all US dollars in the world – in cash and in electronic bank deposits. The denominator is the market capitalization of US denominated stocks and all types of bonds held by non-bank investors. It is calculated as the sum of the following: US equity market capitalization (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); and the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. Chart I-10The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The higher this ratio, the more US dollar deposits, or liquidity, is available per one dollar of market value of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, this ratio is somewhat elevated meaning that liquidity is relatively abundant. However, as argued above, animal spirits among investors are as important in driving financial asset prices as the amount of money supply. Question: What will happen to exchange rates in general, and to EM currencies in particular, given that almost every country in the world is expanding its money supply, simultaneously? Answer: There is no stable correlation between the relative money supply of two individual economies and their bi-lateral exchange rate. In addition, this is the first time that QEs are being deployed in both DM and EM countries at the same time. Therefore, there is no easy and straightforward answer to this question. Chart I-11EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? We recommend using the following framework to think about EM exchange rates versus the US dollar, at the moment: 1. EM currencies in aggregate will continue to be driven by global growth, as they have been historically. Chart I-11 illustrates that the EM ex-China currency index correlates with industrial commodity prices. The basis for this correlation is that they are both driven by the global business cycle. So far, the advance in both EM exchange rates and industrial commodities has been tame. It is still not clear if this is merely a rebound from very oversold levels or rather the beginning of a cyclical rally. 2. The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: US imports should expand, meaning that the US should send dollars to the rest of the world by buying goods and services. This has not yet happened though, as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. US investors should channel US dollars to EM to purchase EM financial assets. 3. From an individual EM perspective, there are several scenarios to consider: If a country’s QE: materially boosts its real growth, its currency will rally in spite of ongoing domestic QE; fails to meaningfully boost growth, its exchange rate will weaken; produces a rapid rise in inflation, its currency will depreciate; is used to finance unsustainable public debt dynamics, its currency will depreciate. As we have written in the recent reports, this could very well be the case in Brazil and South Africa. Investment Conclusions We expect EM local yields to fall further. For absolute-return investors we continue to recommend receiving swap rates in Korea, China, India, Malaysia, Russia, Colombia and Mexico. Our country allocation for EM local currency bond portfolios is always presented at the end of our reports on page 15. We continue shorting a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. However, if the strength in EM currencies persists in the near term, we will close our short positions. Continue underweighting EM equities and credit within global equity and credit portfolios, respectively. Within the EM credit space, favor sovereign to corporate credit. On that issue, please refer to our April 22, Special Report on EM foreign currency debt. For dedicated EM equity managers, we recommend overweighting Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Indonesia, India, the Philippines, the UAE, South Africa and Brazil. Please refer to our Open Position Table on page 14. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, Next week we will be sending you a Special Report providing our insights on the much-anticipated China National People’s Congress. We think the messages sent from the conference will be highly relevant to both the global economy and financial markets. Please note: instead of Wednesday, the Special Report will be published on Thursday the 28th of May. Best regards, Jing Sima China Strategist Highlights Insert HiEarly signs suggest a renewed appetite among Chinese consumers for real assets and durable goods. China’s discretionary consumption will likely benefit greatly from pro-growth measures, and recover much faster than the aggregate consumption.   The unemployment rate has been rising and largely concentrated in lower-income workers. Elevated unemployment will be a drag on China’s overall consumption, but its impact on discretionary consumption is limited. We are initiating two trades: long investable consumer discretionary/short investable consumer staples and long domestic consumer discretionary/broad A-share market. Feature Chart 1Sectors Directly Benefiting From Stimulus Are Recovering Faster Economic data released last week showed that China’s economy continued to recover, particularly the infrastructure, construction and high-tech sectors (Chart 1). On the other hand, household consumption, which accounts for nearly 40% of the country’s economy, remained in a deep contraction in April. While we think the annual growth in China’s aggregate household demand will remain muted this year, the breakdown in April’s retail sales data suggests that the speed in consumer discretionary spending is already accelerating (Chart 2). During economic recoveries, consumer discretionary spending usually rebounds ahead of a recovery in overall consumption. Even though the current economic downturn is extra-ordinary, we believe that China’s discretionary consumption growth will pick up faster and stronger than the aggregate household consumption. Consumer discretionary stocks, an early cyclical sector in China’s equity market, troughed about 3 months ahead of a bottoming in Chinese investable and domestic stock prices in previous cycles. In line with our constructive view on Chinese stocks in the next 6 to 12 months, we recommend investors overweight Chinese consumer discretionary stocks relative to the benchmarks. In addition, we are initiating a long position in investable consumer discretionary versus investable consumer staples, and a long position in domestic consumer discretionary versus A-share market. Chart 2Discretionary Consumption Is Rebounding Faster Than Staples China’s Stimulus-Driven Consumption Cycles Chinese consumption cycles since 2008 have mostly reflected the effectiveness of China’s pro-consumption and stimulus policies. So far, the Chinese government’s stimulus measures have been concentrated in the corporate sector rather than households. Nevertheless, government pro-growth measures, flush liquidity in the market and global travel restrictions should provide a lift to domestic sales of durable and luxury goods. Chart 3 illustrates how, in contrast to the US, China’s retail sales have grown faster than nominal GDP during every economic downturn since 2008. A reason for this counter-cyclicality in China’s consumption is that the monthly retail sales data consists of household, government and business purchases.  Since the Chinese government tends to increase its expenditures during economic downturns, the increases in government purchases help to offset the declines in household and business consumption. Chart 3Retail Sales In China Have Become 'Countercyclical' Since 2008 Chart 4China's Post-GFC Consumption Cycles Largely Driven By Stimulus A more important contributor to the faster retail sales growth during economic down cycles is government stimulus. Direct pro-consumption policies, such as sales tax cuts and subsidies, helped to boost auto sales in every cycle since 2008, whereas stimulus measures to enhance home sales indirectly led to an upcycle in the sales of home appliances in 2015-2016 (Chart 4).  April’s retail sales data showed a sharp rebound in Chinese household consumption in autos, appliances and furniture (Chart 5). The strong comeback in durable goods purchases in April was driven by a release of pent-up demand and government pro-consumption measures. Since March, local governments have handed out subsidies, vouchers and tax reductions on consumer durable goods purchases and discretionary spending, such as travel and restaurant dining. By end-April, an estimate of 40 billion yuan worth of consumption vouchers were issued by provincial and city-level governments, with more than 90 percent of them targeted at discretionary goods and services. We think the government will announce further policies to support consumption at the May 22-23 National People’s Congress.  Chart 5A Strong Comeback In Durable Goods Sales Chinese consumers took on more medium- and long-term loans in March and April, indicating a renewed appetite for purchasing real assets and durable goods (Chart 6). This is partially because consumers want to take advantage of lower interest rates and easier monetary conditions. Moreover, Chinese households may also be seeking real assets to hedge future inflation and financial market uncertainties. Housing in China in the past two decades has been perceived as countercyclical and a low-risk asset that holds value. Early signs indicate a renewed Chinese consumers’ appetite for real assets and durable goods. Both land sales and real estate investment growth returned to positive territory in April, while the contraction in floor space started, completed, and sold all narrowed. The upward cycle in the property market should continue to support a recovery in household appliances and furniture (Chart 7).   Chart 6Appetite For Real Asset Purchases May Be Returning Chart 7A Recovering Property Market Should Help Boost Home Appliance Sales In addition, global travel restrictions will likely remain in place through this year. This may prompt Chinese consumers to allocate a larger portion of their discretionary spending budgets to domestic, high-end consumer goods and services. Bottom Line: Early signs indicate a renewed consumer appetite for real assets and durable goods. The government’s pro-consumption and pro-growth measures should further boost discretionary spending. The Wealth Effect The consumption behavior of Chinese households will likely be driven by both the change in the value of their assets, and their expectations of the immediate or perceived future loss of employment and income. Housing is the largest part of Chinese households’ net worth.1 At the same time, financial assets account for a much lower share of Chinese households’ net worth versus their American peers.2 Home prices are much less volatile than stock prices, and we expect home prices in China to grow faster this year than in 2019. Hence the wealth effect of housing on Chinese consumers should remain positive. The unemployment rate has been elevated, but job losses so far are concentrated in the labor-intensive, lower-skilled manufacturing and service sectors (Chart 8). While lower-income workers account for more than half of China’s total population, their share of the country’s total household wealth and income is dismal compared with households in the top 10 percentile earnings3  (Chart 9). In fact, households in the bottom 40 percentile essentially have no discretionary spending capacity.4 Households in the top 40 group (middle- and upper middle-class urbanites) are the main driver of China’s discretionary and luxury goods market.5 Chart 8Job Losses So Far Concentrated In Lower-Skilled, Lower-Wage Manufacturing & Service Sectors Chart 9Higher-Income Chinese Households Will Drive Recovery In Discretionary Consumption Because poorer households tend to have a higher marginal propensity to consume than the richer ones, China’s high income inequality may reduce the aggregate demand and has the potential to structurally stagnate its household consumption growth. This is a topic we hope to provide insights on in our future research. Cyclically, however, accommodative monetary conditions and outsized stimulus during economic downturns often help augment richer households’ net worth as well as increase their discretionary purchasing power. Our constructive view on China’s discretionary consumption could change if a second wave of Covid-19 infections is virulent enough to trigger another round of global lockdowns. In this case unemployment may expand from lower-income to middle-class Chinese consumers and extend from temporary to permanent job losses.  Consumption will also be constrained by more widespread income declines and renewed physical lockdowns.  Bottom Line: Job losses are concentrated in the lower-income household group so far. While developments in the pandemic remain fluid, our baseline view suggests that the wealth effect will have a limited impact on Chinese middle-class consumers. Investment Conclusions The recovery is still in its early stages, but government stimulus is bearing fruit in discretionary consumption. Furthermore, the elevated unemployment rate should prompt the government to roll out more consumption and growth-supporting measures at this week’s NPC conference, which will help further boost Chinese consumers’ appetite for discretionary spending.  China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries. China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries (Chart 10). The overwhelming shares of China’s online tech titans in the investable market, such as Alibaba and JD, make a strong case to overweight the consumer discretionary sector given that both online platforms will continue to benefit from the Chinese government’s pro-consumption schemes. On the other hand, the behavior of consumer discretionary versus consumer staples in China’s A-share market has been atypical.  Chart 11 shows domestic consumer discretionary stocks have consistently underperformed consumer staples since 2015, even during the 2016/2017 upcycle in broad market stock prices. We think a few underlying factors may be at play: Chart 10The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... Chart 11...It Is Not The Case In The Onshore Market Food and beverage companies in mainland China have one of the highest ROAs and the lowest financial leverages, which is preferred by Chinese domestic investors; Chinese liquor brands such as Kweichow Moutai and Wuliangye, which are listed on the A-share market and within the consumer staples group, have become collectable luxury goods. They have helped driving up the prices of consumer staple equities (Chart 12);  Soaring food prices since 2017 have helped to widen profit margins among food processing firms (Chart 13).   Chart 12Some 'Consumer Staples' Have Become Luxury Goods Chart 13Soaring Food Prices Also A Contributing Factor For investors with a time horizon longer than a 12 months, consumer discretionary sector is a winner. However, for investors with a time horizon longer than 12 months, average returns in consumer discretionary stocks still beat staples in the past three market recoveries (Table 1). This is true for both onshore and offshore markets. As such, we recommend investors go long on consumer discretionary versus consumer staples in the investable market, and also go long on domestic consumer discretionary versus the broad domestic market. We are initiating these two trades today. Table 1CD Sector Still A Winner On A 12-18 Month Horizon   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Housing accounts for 59.1% in Chinese households’ net worth, compared with 30% in the US. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 220.4% of Chinese households’ total net worth is in financial assets. In the US, the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 3China’s low-income households account for about 60% of China’s population as of 2015. “How well-off is China’s middle class?” Center For Strategy & International Studies. https://chinapower.csis.org/china-middle-class/ 4 “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 5China Consumer Report 2020, McKinsey & Company, December 2019 Cyclical Investment Stance Equity Sector Recommendations

Special Report

What Can 1918/1919 Teach Us About COVID-19?    “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905   Chart 1Coronavirus: As Contagious But Not As Deadly As Spanish Flu Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart 1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.1  Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart 2The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart 2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.2 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map 1).3 Map 1The Spread Of Influenza Through Europe Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.4  Most countries did not begin investigating and reporting cases until the second wave was underway (Chart 3). Chart 3Most Countries Began Reporting Only When The Second Wave Hit This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart 4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.5 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart 4A Unique Characteristic: Impacting Younger Adults By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.6 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans.  The number of passengers carried during the months of the pandemic did noticeably decline though (Chart 5). Chart 5Travel Slowed...Just Not Enough Table 1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Table 1Measures Applied Then Are Very Similar To Those Applied Today Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table 2). Table 2NPIs Were Implemented Only For Short Periods Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart 6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart 6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart 6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart 6, panel 3) Chart 7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart 6Fast Response And Longer Implementation Led To Fewer Deaths... Chart 7...So Did Policy Strictness For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919.  While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.7,8 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart 8). Chart 8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... Chart 9...And So Can Highly Effective Measures Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart 9).9 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted.   The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).10 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.11 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.12 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.13 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart 10). Chart 10Short-Term Price Impact Was Disinflationary US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart 11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.14  Factory employment in New York fell by over 10% during this period.  Chart 11Loss Of Middle-Aged Adults = Loss Of Breadwinners The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart 12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart 12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart 12Activity Slowed, But Rebounded Quickly Chart 13The War Had A Bigger Impact On The Stock Market Than The Pandemic The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart 13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.15   Chart 14Monetary Policy Was Easy...Even Before The Pandemic Started The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart 14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic.   Amr Hanafy Senior Analyst amrh@bcaresearch.com Footnotes 1  Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 2 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 3 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 4 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 5 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 6 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 7 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 8 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 9 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 10Please see https://www.nber.org/cycles.html 11Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/research-reports/pandemic_flu_report.pdf 12Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 13Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 14Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 15Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 16Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.

Special Report

Highlights Fed/BoE NIRP: It is too soon for either the Fed or Bank of England to consider a move to a negative interest rate policy (NIRP), even with US and UK money markets flirting with pricing in that outcome. Lessons from “NIRP 1.0”: In the countries that did go to negative rates in 2014-16 (Japan, Switzerland, the euro area, Sweden and Denmark), there existed some combination of weak economies, near-0% inflation, anemic credit growth or unwanted currency appreciation. Negative rates were needed to help fight those trends by driving down longer-term bond yields. NIRP 2.0?: Among the major countries without negative rate policies in effect (the US, UK, Canada and Australia), there is no evidence that longer-term borrowing rates need to fall further to boost credit growth, even in the midst of deep recessions. However, additional strength of the stubbornly resilient US dollar could be the deflationary shock that eventually forces the Fed into NIRP. Feature Chart 1NIRP 2.0 Would Trigger A Surge Of Negative Yielding Bonds Within a 20-month window in 2014-16, the central banks of Japan, Sweden, the euro area, Switzerland and Denmark all cut policy interest rates to below 0% - where they remain to this day. Fast forward to 2020, in the midst of a global pandemic and deep worldwide recession that has already forced major developed market central banks to cut rates close to 0%, there is now increased speculation that the negative interest rate policy (NIRP) club might soon get a few new members. The Federal Reserve has been front and center in that group. Fed funds futures contracts had recently priced in slightly negative rates in 2021, despite Fed Chair Jerome Powell repeatedly saying that a sub-0% funds rate was not in the Fed’s plans. The Bank of England (BoE) has also seen markets inch toward pricing in negative rates, although BoE officials have been more open to the idea of negative rates as a viable policy choice. Even the Reserve Bank of New Zealand has suggested that negative rates may be needed there soon. An expansion of the list of countries that have moved to negative rates, beyond the “NIRP 1.0” group of 2014-16, has the potential to drive down global bond yields even further. Already, there is $11 trillion of negative yielding debt within the Bloomberg Barclays Global Aggregate index, representing 20% of the total (Chart 1) If there is a shift to negative rates in the potential “NIRP 2.0” group of major developed economies with policy rates now near 0% – a list that includes the US, the UK, Canada and Australia – then the amount of negative yielding debt worldwide will soar to new highs. An expansion of the list of countries that have moved to negative rates, beyond the “NIRP 1.0” group of 2014-16, has the potential to drive down global bond yields even further. In this report, we take a look at the conditions that led the NIRP 1.0 countries to shift to negative rates in the middle of the last decade, to see if any similarities exist in non-NIRP countries today. We conclude that the conditions are not yet in place for a shift to sub-0% policy rates in the US, the UK, Canada or Australia – all countries where central banks still have other policy tools available to provide stimulus before resorting to negative rates. How Negative Interest Rates Can “Work” To Revive Growth Broadly speaking, central banks around the world have had difficulty meeting their inflation targets since the 2008 Global Financial Crisis. The main reason for this has been sub-par economic growth, much of which is structural due to aging demographics and weak productivity. Since central bankers must stick to their legislated inflation targeting mandates, they are forced to cut rates when economic growth and inflation are too low. If real economic growth remains weak for structural reasons, then central banks can enter into a cycle of continually cutting rates all the way to zero, or even below zero, in order to try and prevent low inflation from becoming entrenched into longer-term inflation expectations. If growth and inflation continue to languish even after policy rates have reached 0%, then other tools must be used to ease monetary conditions to try and stimulate economies. These typically involve driving down longer-term borrowing rates (bond yields) through dovish forward guidance on future monetary policy, bond purchases through quantitative easing (QE) and, if those don’t work, moving to negative policy interest rates. A nice summary indicator to identify this intertwined dynamic of real economic growth and inflation is to look at the trend growth rate of nominal GDP. Chart 2 shows the policy interest rates three-year annualized trend of nominal GDP growth for the NIRP 1.0 countries, dating back to before the 2008 crisis. Japan stands out as the weakest of the group, with trend nominal growth contracting during and after the 2009 recession, while struggling to reach even +2% since then. The euro area, Sweden and Switzerland all enjoyed +5% nominal growth prior to 2008, before a plunge to the 1-2% range during and after the recession. After that, the three countries had varying degrees of economic success. Between 2016 and 2019, Sweden saw trend nominal growth between 4-5%, while the euro area struggled to achieve even +3% nominal growth and Switzerland maintained a Japan-like pace. Chart 2Fewer Tools Left For NIRP 1.0 Countries To Boost Growth Chart 3NIRP 2.0 Candidates Can Still Expand QE First The European Central Bank (ECB), Swiss National Bank (SNB), the Bank of Japan (BoJ) and Sweden’s Riksbank all cut policy rates aggressively in 2008/09, helping spur a recovery in nominal growth. The central banks had to keep rates lower for longer because of structurally weak growth, leaving far less capacity to ease aggressively in response to the growth downturn a few years later. Eventually, the ECB, SNB, BoJ and Riksbank all went to negative rates between June 2014 and February 2016. The BoJ and SNB, facing persistent headwinds from strengthening currencies, also resorted to aggressive balance sheet expansion to provide additional monetary stimulus – trends that have continued to this day, with both central banks having balance sheets equal to around 120% of GDP. The experience of these four NIRP 1.0 countries showed that the move to negative rates was a process that began in the 2008 financial crisis. Central banks there were unable to raise rates much, if at all, after the recession, leaving little ammunition to fight the varying growth slowdowns suffered between 2012 and 2016. Eventually, rates had to be cut below 0% which, combined with QE, helped generate lower bond yields, weaker currencies and, eventually, a pickup in growth and inflation. Looking at the NIRP 2.0 candidate countries, nominal GDP growth has also struggled since the financial crisis, unable to stay much above 3-4% in the US, Canada and the UK. Only Australia has seen trend growth reach peaks closer to 5-6% (Chart 3). The Fed, BoE, Reserve Bank of Australia (RBA) and Bank of Canada (BoC) all also cut rates aggressively in 2008/09, with the Fed and BoE doing QE buying of domestic bonds. Rates were left at low levels after the crisis in the US and UK, with only the RBA and, to a lesser extent, the BoC hiking rates after the recession ended. When growth slowed again in these countries during the 2014-16 period, the RBA and BoC did lower policy rates, but negative rates were avoided by all four central banks. Today, nominal growth rates have collapsed because of the COVID-19 lockdowns that have shuttered much of the world economy. Central banks that have had any remaining capacity to cut policy rates back to 0% have done so, yet this recession has already become so deep that additional declines in rates may be necessary to stabilize unemployment and inflation. The experience of the NIRP 1.0 countries shows that negative rates can also be effective in boosting growth – especially in countries suffering unwanted currency strength. One way to see the problem that monetary policymakers are now facing is by looking at Taylor Rule estimates of appropriate interest rate levels (Charts 4 and 5). Given the rapid surge in global unemployment rates to levels that, in some cases, have not been seen since the Great Depression (Chart 6), alongside decelerating inflation, Taylor Rule implied policy rates are now deeply negative in the US (-5.6%), Canada (-2.9%) and euro area (-1.7%).1 Taylor Rules show that moderately negative rates are also needed in Sweden (-0.5%), Switzerland (-0.2%) and Japan (-0.2%). Only in Australia (+1.3%) and the UK (+0.3%) is the Taylor Rule indicating that negative rates are not currently required. Chart 4Taylor Rule Says More Rate Cuts Needed Here … Chart 5… But Rates Are Appropriate Here Chart 6The Main Reason Why Taylor Rule Implied Policy Rates Have Plunged Among the potential NIRP 2.0 candidates, the negative rate option has been avoided and aggressive QE balance sheet expansion has been pursued by all of them – including the BoC and RBA who avoided asset purchase programs in 2008/09. Balance sheet expansion can be an adequate substitute for policy interest rate cuts by helping drive down longer-term bond yields and borrowing rates, which helps spur credit demand and, eventually, economic growth. Yet the experience of the NIRP 1.0 countries shows that negative rates can also be effective in boosting growth – especially in countries suffering unwanted currency strength. How negative rates worked for the NIRP 1.0 countries For the ECB (Chart 7), BoJ (Chart 8), Riksbank (Chart 9) and SNB, the path from negative policy rates in 2014-16 to, eventually, faster economic growth and inflation followed a similar process: Chart 7The Euro Area's Negative Rates Experience Chart 8Japan's Negative Rates Experience Chart 9Sweden's Negative Rates Experience Moving to negative policy rates resulted in a sharp decline in nominal government bond yields The fall in yields helped trigger currency depreciation Nominal yields fell faster than inflation expectations, allowing real bond yields to turn negative Credit growth eventually began to pick up in response to the decline in real borrowing costs Inflation bottomed out and started to move higher. In Japan, the euro area and Sweden, this process played out fairly rapidly with credit growth and inflation bottoming within 6-12 months of the move to negative rates. Only in Switzerland (Chart 10), where the SNB gave up on currency intervention in January 2015, was the process delayed, as the surge in the currency triggered a move into deeper deflation and higher real bond yields. It took a little more than a year for the deflationary impact of the franc’s surge to fade, allowing real bond yields to decline and credit growth and inflation to bottom out and recover. The implication is clear – negative rates are good for real assets, but troublesome for banks.  Of course, we are talking about the pure economic effect of negative rates as a monetary policy tool. There are side effects of having negative nominal interest rates and deeply negative real bond yields, like surging asset values (especially for real assets like housing). Bank profitability is also negatively impacted by the sharp fall in longer-term bond yields that hurts net interest margins, even with higher lending volumes and reduced non-performing loans. Chart 10Switzerland's Negative Rates Experience Chart 11Negative Rates Are Good For Real Assets This can be seen in Charts 11 & 12, which compare the performance of real house prices and bank equities (relative to the domestic equity market) in the years leading up to, and following, the move to negative rates in 2014-16 for the NIRP 1.0 countries. The implication is clear – negative rates are good for real assets, but troublesome for banks. Chart 12Negative Rates Are Bad For Bank Stocks Nonetheless, the experience of the NIRP 1.0 countries suggests that the potential NIRP 2.0 countries could see similar benefits on growth and inflation – but not before other policy options are exhausted first. Bottom Line: In the countries that did go to negative rates in 2014-16 (Japan, Switzerland, the euro area, Sweden and Denmark), there existed some combination of weak economies, near-0% inflation, anemic credit growth or unwanted currency appreciation. Negative rates were needed to help fight those trends by driving down longer-term bond yields and helping spur credit growth and, eventually, some inflation. Depreciating currencies had a big role to play in generating those outcomes. Negative Rates Are Not Necessary (Yet) In The NIRP 2.0 Countries As discussed earlier, the sharp surge in unemployment because of the COVID-19 global recession means that negative interest rates may now be “appropriate” in the US and Canada, based on Taylor Rules. Negative rates are not needed in the UK and Australia, however, although policy rates need to stay very low in both countries. A similar divergence can be seen in inflation. Headline CPI inflation rates were already under severe downward pressure from the recent collapse in oil prices. The surge in spare economic capacity opened up by the current recession can only exacerbate the disinflation trend. However, the drop in inflation has been more acute in the US and Canada relative to the UK and Australia, suggesting a greater need for the Fed and BoC to be even more stimulative than the BoE or RBA (Chart 13). A renewed breakout of the currency to new cyclical highs could be the deflationary signal that triggers the Fed into an even more aggressive policy response. There is one area where the Fed stands alone in this group. The relentless strength of the US dollar, even as the Fed’s rate cuts have taken much of the attractive carry out of the greenback, hurts US export competitiveness in a demand-deficient recessionary global economy. The strong dollar also acts as a dampening influence on US inflation. A renewed breakout of the currency to new cyclical highs could be the deflationary signal that triggers the Fed into an even more aggressive policy response (Chart 14). This would mirror the experience of the NIRP 1.0 countries prior to the move to negative rates, where unwanted currency strength crippled both economic growth and inflation. Chart 13The Threat Of Deflation Could Trigger NIRP Chart 14Could More USD Strength Drag The Fed Into NIRP? For now, the Fed has many other policy options open before negative rates would be seriously considered. The reach of its QE programs could be expanded even further, even including equity purchases. The existing bond QE could be combined with a specific yield target (i.e. yield curve control) for shorter-maturity US Treasuries, helping anchor US yields at low levels for longer. Summing it all up, we do not see the need for any of the NIRP 2.0 candidates to move to negative rates anytime soon. The need for such extreme policies is not yet necessary, though, both in the US and the other NIRP 2.0 candidate countries. Bank lending is expanding at a double-digit pace in the US, and still at a decent 5-7% pace in the UK, Canada and Australia, even in the midst of a sharp recession (Chart 15). This may only be due to the numerous loan guarantees provided by governments as part of fiscal stimulus responses, or it may be related to companies running down credit lines to maintain liquidity. The experience of the NIRP 1.0 countries, though, suggests that credit growth must be far weaker than this to require negative policy rates to push down longer-term borrowing costs. Chart 15These Already Look Very "NIRP-ish" Chart 16Too Soon For Global NIRP, Maintain Neutral Global Duration Exposure Summing it all up, we do not see the need for any of the NIRP 2.0 candidates to move to negative rates anytime soon. In terms of investment implications, we continue to recommend an overall neutral stance on global duration exposure, as we see little immediate impetus for yields to move lower because of reduced expectations of future interest rates or inflation (Chart 16). We will continue to watch currency levels and credit growth as a sign that policymakers may need to shift their tone in the coming months. Bottom Line: Among the major countries without negative rate policies in effect (the US, UK, Canada and Australia), there is no evidence that longer-term borrowing rates need to fall further to boost credit growth, even in the midst of deep recessions. However, additional strength of the stubbornly resilient US dollar could be the deflationary shock that eventually forces the Fed into NIRP.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Footnotes 1 Our specification of the Taylor Rule uses unemployment rates relative to full employment (NAIRU) levels as the measure of spare capacity in the economies. For the neutral real interest rate, we use the New York Fed’s estimate of r-star for the US, Canada, the euro area and the UK; while using the OECD’s estimate of potential GDP growth as the neutral real rate measure for countries where we have no r-star estimate (Japan, Sweden, Switzerland and Australia).