Economy

Highlights Fear of deflation – especially at current debt levels – will keep central-bank policy looser for longer. As a result, monetary authorities will do whatever it takes to revive inflation and inflation expectations to move policy rates away from the zero lower bound. EM income growth will rebound, and the US dollar will weaken as monetary and fiscal stimulus reach the real economy. This will be bullish for commodities, including gold. Over the medium to long term, the reversal in globalization and the atrophy of working-age populations will be inflationary: Labor markets will tighten as economic growth recovers and baby-boomers continue to retire, pushing wages higher and savings lower. Over the short term, we are neutral gold from a pricing standpoint, and believe $1,700/oz is close to fair value. When gold pushes through $1,800/oz, longer-term demographic and economic trends will become apparent and will catalyze gold’s rally. We continue to favor gold as a portfolio hedge, as it has held value throughout the COVID-19 pandemic and the re-emergence of geopolitical tensions, particularly the return of Sino-US trade acrimony. Feature Gold will remain at ~ $1,700/oz after rallying 15% from its mid-March bottom, as markets consolidate over the short term. This new equilibrium has been fueled by North American retail investors and is slightly above our model’s fair value (Chart of the Week). While gold’s short-term price drivers appear to have stabilized over the past few weeks – i.e. real rates, US dollar, and equity uncertainty are holding fairly steady – a temporary pullback is likely. Strategically, however, the balance of risks is skewed to the upside. Chart of the WeekRetail Investment Demand Supports Gold Above Our Fair-Value Estimates Our usual framework classifies gold’s drivers into three broad categories: Demand for inflation hedges; Monetary and financial aggregates; and Demand for portfolio-diversification assets. In this report, we are narrowing our focus to concentrate on the tactical vs. strategic drivers of gold prices, to assess the metal’s upside potential over the short- and long-term horizons (Table 1). Table 1Short- vs. Long-Term Drivers Of Gold Prices Over the short-term, gold prices fluctuate mostly with changes in risk aversion, opportunity costs and relative prices vis-à-vis other assets. Longer term, gold prices trend with income and inflation cycles, along with structural changes in households’ savings rates. Short- and Medium-term Drivers Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. Western Buyers To The Rescue The COVID-19 pandemic greatly altered the composition of gold demand in 1Q20. Jewellery and bar-and-coin demand dropped 42% and 11% y/y in the wake of a collapse of Chinese and Indian demand (Chart 2, panel 1). This was offset by sharp inflows to ETF products – mainly from DM investors. ETF inflows increased by ~ 300 tons in 1Q20, and by 170 tons in April 2020 (Chart 2, panel 3). Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. However, the short-term outlook for gold could be volatile as investment and jewellery demand normalize. As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand. Chart 2Weak EM Consumer Demand Offset By Strong North America ETF Inflows Chart 3Investment Demand Overtakes Jewellery's Since 2010, investment and jewellery demand represented ~ 33% and ~ 58%, respectively, of total gold demand – excluding central bank net purchases (Chart 3). As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand – albeit at a slower pace (Chart 4). NB: A large mismatch in the speed of these adjustments could lead to an undershoot in prices – especially at current elevated positioning. Chart 4Elevated Interests In Gold From Retail Investors Chart 5Investors Allocation To Gold Is Close To 2012 Levels We’ve argued in February there was still an opportunity for investment-led growth to support prices based on the low value of investors’ total holdings of gold compared to global equities on a market-cap basis. This measure is now approaching its 2012 peak and moving toward unknown territory in terms of portfolio and wealth allocation to gold (Chart 5). This is flagging up a risk that short-term traders will want to take profits on their speculative positions, if virus-related uncertainty diminishes. On the other hand, retail buyers could hold on to their hedges. Historically, profound economic dislocations and persistent uncertainty have been complemented by shifts in investors’ behavior, leading to higher average saving rates – e.g. 1929, WWII, 2008’s GFC – (Chart 6). Additionally, downside risks to the reopening of economies worldwide remain significant, particularly given the uncertainty of the COVID-19 pandemic’s evolution: A second wave of contagion would trigger a massive flight to safety and further central bank actions to keep rates depressed. Chart 6Precautionary Savings Rise In Highly Uncertain Periods Awaiting A Setback To The USD The Fed and other systemically important central banks have taken decisive action to keep money markets functioning and to prevent a solvency crisis (Chart 7, panel 1). Ample liquidity, low economic growth, and collapsing inflation expectations pushed bond yields lower globally, which, in large measure, powered the rally in gold prices (Chart 7, panel 2). The protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year. In recent weeks, US yields have stabilized, meaning this factor will not provide much support to gold at current levels – assuming, again, no major second wave in COVID-19 contagion. The upside to rates is also limited over the short term as the increase in Treasury supply will be offset by the Fed’s dovish forward rate guidance. Still, the protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year (e.g., ahead of the US elections). Moreover, the Fed appears to be willing to risk remaining behind the curve for the foreseeable future. Bonds' protection would suffer if the Fed allows inflation overshoot (more on this below). In 2H20, we expect the USD to weaken as virus-related safe-haven demand – which fueled its 14% rally ytd vs. EM currencies – abates and the Fed’s and the US government’s responses to the crisis floods markets globally with USD liquidity.1 Relative balance-sheet and interest-rate dynamics will reassert themselves as important drivers of currency movements (Chart 8). Chart 7QE Infinity Will Keep Bond Yields Depressed Chart 8USD Deviating From Interest Rate Differentials The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Bottom Line: The sum of gold’s short-term drivers are neutral at the current $1,700/oz equilibrium. The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Long-term Drivers The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. Stimulative Policies To Boost EM Income Growth Global income growth is one of the core drivers of gold prices over long horizons (Chart 9, panel 1). As countries get wealthier, the pool of savings rises, which benefits gold, along with most financial assets. Because gold-mining production growth is relatively stable and inelastic to prices in the short-term, changes in income growth above production growth have a crucial influence on gold’s trajectory over the long run. EM countries – chiefly China and India – are the largest buyers of jewellery, bars and coins, and remain among the fastest-growing economies on the planet. Hence, since 2000, gold’s annual price change correlates strongly with their income growth (Chart 9, panel 2). In addition, central banks’ net gold purchases – which have been increasingly positive since 2009 – effectively reduce available supply to consumers. We include net purchases in our measure of total supply to separate it from consumer and investor demand – which respond to entirely different incentives (Chart 9, panel 3). We expect EM central banks will continue diversifying part of their US dollar reserves to gold.2 Chart 9Global Income Growth Drives Long Term Gold Returns Chart 10China's Economic Activity Close To Pre-COVID-19 Levels The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. China’s economic activity appears to have partly recovered from the COVID-19 shock (Chart 10). Going forward, the country’s surging fiscal and monetary stimulus, in addition to a weakening US dollar, will revive growth in neighboring Asian economies this year. Structural Deflationary Pressures Are Easing We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system. As we’ve argued in previous reports, gold acts as a good inflation hedge when there is an increase in perceived risks of significant overshoots.3 In normal times, inflation expectations move slowly and trend more or less with past inflation prints (Chart 11). However, the unprecedented global fiscal and monetary stimulus deployed to combat the COVID-19-induced recession could shift expectations rapidly and profoundly. We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system (Chart 12). Moreover, a combination of deflationary structural factors – i.e. trade globalization, expanding global value chains, and demographics – are reversing, and will gradually become inflationary.4 This is a stark difference to the post-GFC quantitative easing. Chart 11Inflation Expectations Trend Along Past Realized Inflation Rates Chart 12Surging US Broad Money Supply Firstly, globalization’s deflationary impulse – thru increasing trade and expanding global value chains – stalled a few years ago (Chart 13). Recently, ramping anti-globalization policies amidst the Sino-US trade tensions exposed vulnerabilities in the current trade infrastructure. The COVID-19 pandemic risks accelerating these trends. Following widespread quarantine measures in China, US imports from China fell sharply in February and March, and firms without pre-established supply chain relationships with other Asian countries that could backstop supply disruptions were left unable to find alternative suppliers (Table 2). Firms will likely continue diversifying their supply sources and insource critical activities to the US, post-COVID-19.5 Additionally, our Geopolitical strategists see increasing risks of renewed US pressures on China ahead of the election.6 An acceleration in de-globalization trends post-COVID-19 will disrupt international supply chains and amplify inflationary pressures. Chart 13The Structural Reversal In Globalization Trends Will Be Inflationary   Table 2Vulnerability In US Supply Chains China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking. Secondly, structural demographic trends are reversing. The world’s support ratio – i.e. the number of workers per dependent – has been trending downward since 2015 (Chart 14, panel 1). As more people around the world reach retirement age, this trend is expected to continue. This trend is especially powerful in China, whose workforce was one of the great deflationary demographic factors in previous decades. Effectively, this implies aggregate demand is likely to exceed aggregate supply as more workers become consumers. In theory, this also implies lower global savings and a higher neutral rate of interest. Consequently, a rising neutral rate, combined with our belief central bankers will be behind the curve in raising rates, increases the risks of inflation moving sharply above target. Chart 14Demographic Trends Will Become Inflationary China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking – the country could lose ~ 400 million workers over the remainder of the century (Chart 14, panel 2). The integration of the Chinese – and other EM countries – workforce during the 2000s led to a doubling of the global pool of labor supply and reduced the average labor cost. Investment Conclusion Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges. Investors need to assess the long-term consequences of these trends and policies vs. the short-term deflationary COVID-19 shock. Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges (Chart 15). While we expect higher US inflation expectations and headline rates in 2H20 – driven by the decline in the USD and the increase in oil and base-metals’ prices – we do not expect meaningful inflation-overshoot risks until late 2021. Core inflation rates will remain depressed until the large labor-supply overhang clears – in the US and globally – and the effect of the lower USD pass-through to higher prices emerges (Chart 16). Chart 15Gold Is Not Relatively Expansive, Except Vs. Commodities Chart 16The COVID-19-Induced Deflationary Effects Will Last Until Next Year Re-anchoring expectations will necessitate periods of above-target inflation rates. The short-term drivers of gold are neutral at the current $1,700/oz equilibrium, as inflation pressure won’t surface until 2H21. Moreover, there is a non-negligible risk of a short-term pullback if DM economies are successfully reopened without significant increases in COVID-19 infection rates. This should serve as a buying opportunity, as the medium- and long-term outlook remains bullish for the yellow metal. EM income growth is poised to rebound as global monetary and fiscal stimulus reach the real economy and the USD depreciates. The reversal in globalization and demographic trends will become inflationary. Policymakers will do whatever it takes to revive inflation and inflation expectations to move away from the zero lower bound. Re-anchoring expectations will necessitate periods of above-target inflation rates. Thus, real rates should be contained as QE continues to depress the term premium and inflation starts to move higher. Fear of deflation – especially at current debt levels – will keep central banks too easy for too long.   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Oil production globally is falling faster than expected, based on anecdotal press reports showing the Kingdom of Saudi Arabia (KSA) took an additional 1mm b/d of production off the market, bringing its total shut-in level to 7.5mm b/d for next month. The Saudi government urged OPEC 2.0 member states to follow its lead and reduce production further. The US EIA this week reported it expects Russia’s production to fall more than 800k b/d, while in the US production is expected to decline by a similar amount this year, and another 600k b/d in 2021. Canada’s production is expected to fall 400k b/d. Non-OPEC production overall is expected to fall 2.4mm b/d this year. We will be updating our supply-demand balances and prices forecasts in next week’s report. Base Metals: Neutral Steel markets are becoming concerned COVID-19-induced production declines will reduce iron-ore shipments. Earlier this month, 10 cities in the Brazilian state of Para, an ore-producing region, were placed under lockdown, according to FastMarkets MB, a sister publication of BCA Research. Even though ore mining and shipping have been exempted, concern that COVID-19 could reach the producing regions and affect output is growing. Benchmark 62% Fe ore is down 6.2% from its January highs (Chart 17). Precious Metals: Neutral A forecast by Australia’s Department of Industry, Science, Energy and Resources (ISER) that Australia would become the world’s largest gold producer in 2021 was seconded this week by a private forecaster, Resources Monitor. The ISER forecast Australia would overtake China as the top gold producer in its March 2020 forecast, with output reaching 383 tons next year. Australia produced 326 tons last year, vs. China’s 380 tons. Ags/Softs:  Underweight The USDA released its first estimate for the 2020/2021 marketing year, projecting corn ending stocks at 3.318 Bn bushels for the season, the largest stockpile since 1987/1998 (Chart 18). Huge planting projections will outweigh increases in exports demand of 35 Mn bushels and in usage for ethanol biofuel of 5.2 Bn bushels compared to the current season. Nonetheless corn futures hedged higher on Tuesday, rising 5.25 cents/bu, as the weak outlook was offset by downward revisions to old crop inventories. Finally wheat’s ending stocks were moderately revised up for the current season, but futures still fell to the lowest in a week due to better than expected weather in the US and higher global stocks expectations. Chart 17Supply Constraints Could Boost Prices Chart 18USDA Expects Large US Corn Stocks Increase       Footnotes 1     We’ve outlined our view on the dollar for 2020 in our April 23, 2020 Weekly Report. Please see USD Strength Restrains Commodity Recovery, available at ces.bcaresearch.com 2     The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is fading. 3    Please see our Weekly Report titled "All That Glitters ... And Then Some," published July 25, 2019. It is available at ces.bcaresearch.com 4    For more details on these structural factors please see The Bank Credit Analyst Special Reports titled "Troubling Implications Of Global Demographic Trends," and "Three Demographic Megatrends," published 28 February, 2019 and October 26, 2017.  5    Please see Sebastian Heise, “How Did China’s COVID-19 Shutdown Affect U.S. Supply Chains?,” Federal Reserve Bank of New York Liberty Street Economics, May 12, 2020. 6    Please see BCA's Geopolitical Strategy Special Alert titled "#WWIII," published May 1, 2020. It is available at gps.bcaresearch.com.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Special Report

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up Chart 2The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce Chart 4Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US Chart 9US Nationalism On The Rise Chart 10Broad-Based Anti-China Sentiment In US As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights COVID-19 & The Economy: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. Policy Responses: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Fixed Income Strategy: Downgrade Australian government bonds to neutral within global fixed income portfolios: the RBA has little room to cut rates, inflation expectations are too low and the structural convergence to global yields is largely complete. Favor inflation-linked bonds and investment grade corporate debt over government debt, as both now offer better value. Feature Chart 1The Australian Bond Yield Convergence Story Is Over Australia has a well-deserved reputation as a wonderful place to live, regularly sitting near the top of annual “world’s most livable countries” lists. A big reason for that is the stability of the economy, which has famously not suffered a recession since 1991. The COVID-19 pandemic has changed that happy economic story, with Australia now in the midst of a deep recession. Yet even during this uncertain time, Australia is living up to its reputation as a livable country, with one of the lowest rates of COVID-19 infection among the major economies. This potentially sets up Australia as an economy that can recover from the pandemic – and the growth-crushing measures used to contain its spread - more quickly than harder-hit countries like the US and Italy. For global fixed income investors, Australia has also been a very pleasant place to spend some time. The local bond market has enjoyed a stellar bull run since the 2008 Global Financial Crisis, with policy rates and yields converging to much lower global levels (Chart 1). We have steadfastly maintained a structural overweight recommendation on Australian government bonds since December 2017. Over that time, the benchmark yield on the Bloomberg Barclays Australia government bond index declined -168bps, delivering a total return of +17.6% (in local currency terms). That soundly outperformed the global government benchmark index by 5.7 percentage points (in USD-hedged terms). However, just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. Just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. In this Special Report, we take a closer look at the Australian economy and fixed income landscape after the shock of the global pandemic. Our main conclusion is that most of the juice has been squeezed out of the Australian government bond yield global convergence trade. There are, however, some interesting opportunities still available in other parts of the Australian fixed income universe, like corporates and inflation-linked bonds. Yes, Recessions Can Actually Happen In Australia Chart 2A V-Shaped Recovery Is Widely Expected During the record streak of recession-free growth in Australia, the annual growth of real GDP has never dipped below 1.1%. The fact that a recession was avoided in 2009, given the degree of the shock from the Global Financial Crisis, is a testament to the balance within the Australian economy; consumer spending is 55% of GDP, business investment is 12%, government spending is 24% and exports are 25%. This stands out in contrast to more imbalanced economies like the US (where consumer spending is 70% of GDP) and Germany (where exports are 47% of GDP). Yet the unique nature of the COVID-19 pandemic, which has forced shutdowns across the entire economy, has nullified that advantage for Australia. There is no part of the economy that can avoid a major slowdown to help prevent a full-blown recession in 2020. Yet while expectations have adjusted to this new short-term reality, there appears to be a broad consensus that this Australian recession will be a short-lived “V” rather than an extended “U”. That can be seen in the forecasts of the Bloomberg Consensus survey and the Reserve Bank of Australia (RBA), both of which are calling for a year-over-year decline in real GDP growth of at least -7% in Q2/2020. That will represent the low point of the recession, with growth expected to steadily recover over the subsequent year, with annual real GDP growth reaching +7% by the second quarter of 2021 (Chart 2). The Westpac-Melbourne Institute consumer sentiment index suffered the single greatest monthly decline in the 47-year history of the series in April. Yet there was only a modest decline in the longer-run expectations component of that survey, which remains above recent cyclical lows (bottom panel) This is a message consistent with the RBA and Bloomberg consensus forecasts, where economic resiliency is expected. One reason for that relative optimism among Australian consumers is that COVID-19 has not hit the country as hard as other nations. A recent survey of Australian consumers conducted by McKinsey in April showed that 65% of respondents named “the Australian economy” as their biggest COVID-19 related concern. At the same time, only 33% of those surveyed cited “not being able to make ends meet” as their main worry related to the virus (Chart 3). Other responses to the survey showed a similar divide, with greater concern shown for the state of the overall Australian nation compared to worries about one’s own economic or health outlook. Chart 3Australians Worrying More About The Nation Than Their Own Situation For an economy that has not seen a recession in over a generation, a relative lack of concern over one’s own financial health – even in a global pandemic that has paralyzed the world economy – may not be that surprising. Another reason for that relative optimism is that Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. The number of new daily COVID-19 cases is now only 1 per million people, according to the Johns Hopkins University data on the virus. This is down from the peak of 20 per million people reached on March 28, and substantially below the numbers seen in countries more severely struck by the virus like the US and Italy (Chart 4). Australia has also seen a relatively low fatality rate from the virus, with only 1.4% of confirmed cases resulting in deaths (Chart 5). Chart 4The COVID-19 Wave Has Crested Down Under Chart 5Australia Has Weathered The Pandemic Much Better Than Others Given these low rates of infection and death, it is likely that Australia will be able to reopen its economy faster than other nations. The Australian government has already announced an easing of the COVID-19 lockdown measures, which will include the opening of restaurants (with limited seating) and schools (on a staggered schedule). There is even talk of creating a “trans-Tasman travel bubble” with neighboring New Zealand, which has similarly low rates of COVID-19 infection. Yet even when Australians can begin resuming a more “normal” life, the backdrop for consumer spending will be constrained by relatively low income growth and high consumer debt levels (Chart 6). Real consumer spending has struggled to grow faster than 2-3% over the past decade and, with household debt now up to a staggering 190% of disposable income, a faster pace of spending is unlikely even as the economy reopens. Chart 6Weak Consumer Fundamentals Chart 7Australian Businesses Are Retrenching Among the other parts of the Australian economy, the near-term outlook is gloomy, but there are potential areas where the damage to growth could be more limited. Capital Spending Business fixed investment has been flat in real terms over the past year. With corporate profit growth already slowing rapidly and likely to contract because of the recession, firms will look to cut back on capital spending to preserve cash, leading to a bigger drag on overall growth from investment (Chart 7). According to the latest National Australia Bank business survey conducted in March, confidence has collapsed to lower levels than seen during the Global Financial Crisis, while capital spending and employment expectations have also declined sharply – trends that had already started before the COVID-19 breakout. Chart 8No Rebound In Housing Housing The housing market has long been a source of both strength and vulnerability for the Australian economy. While the days of double-digit growth in house prices are in the past, thanks to greater restrictions on banks for mortgage lending and worsening affordability, Australian housing was showing signs of life before the COVID-19 outbreak. National house prices were up +2.8% on a year-over-year basis in Q4/2019, while building approvals were stabilizing (Chart 8). That nascent housing rebound was choked off by the virus, with the Westpac-Melbourne Institute “good time to buy a home” survey plunging 30 points in April to the lowest level since February 2008. While the RBA’s interest rate cuts over the past decade have helped lower borrowing costs in Australia, the gap between the RBA cash rate and variable mortgage rates has been steadily widening (bottom panel). This suggests a worsening transmission from monetary policy into the most interest-sensitive parts of the economy like housing. Australian banks have been more stringent on mortgage lending standards over the past couple of years, which likely explains some of the widening gap between the RBA cash rate and mortgage rates. However, Australian banks have also seen an increase in their funding costs over that same period, both for onshore measures like the Bank Bill Swap Rate and offshore indicators like cross-currency basis swaps (Chart 9). Those funding costs have plunged in recent weeks, in response to the RBA’s aggressive monetary policy easing measures to help mitigate the hit to growth from COVID-19. The US Federal Reserve’s decision to activate a $60 billion currency swap line with the RBA back in March also helped reduce offshore funding costs for Australian banks. It is possible that the easing of funding costs could make banks more willing to make consumer and mortgage loans in the coming months, at lower interest rates, as the lockdown restrictions ease. This could help improve the transmission from easy RBA monetary policy to economic activity. Exports Demand for Australian exports was already starting to soften in the first few months of 2020. The year-over-year growth in total exports fell to 9.7% in March from a peak of 18.7% in July 2019. Exports to China, Australia’s largest trade partner, have held up better than non-Chinese exports (Chart 10). This was largely due to increased Chinese demand for Australian iron ore earlier in the year. Chart 9Bank Funding Pressures Have Diminished Iron ore prices have been declining more recently, but remain surprisingly elevated given the sharp contraction in global economic activity since March. This may be a sign that China’s reawakening from its own COVID-19 lockdowns, combined with more monetary and fiscal stimulus measures from Chinese policymakers, is putting a floor under the demand for Australian exports to China. Chart 10Australian Exports Will Not Rebound Anytime Soon Summing it all up, a major near-term economic contraction in Australia is unavoidable, but a relatively quick rebound could happen as domestic quarantine measures are lifted – especially given the significant amount of monetary and fiscal stimulus put in place by the RBA and the Australian government. Bottom Line: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. A Powerful Policy Response To The Recession Almost every government and central bank in the world has introduced fiscal stimulus or monetary easing measures in response to the COVID-19 economic downturn. Australia’s policymakers have been particularly aggressive, both on the monetary and (especially) fiscal side. Monetary Policy The RBA has announced a variety of measures since late March to ease financial conditions and provide more liquidity to the economy, including: cutting the cash rate by 50bps to 0.25% the introduction of quantitative easing for the first time, buying government bonds in enough quantity in secondary markets to keep the yield on 3-year Australian government debt around 0.25% introducing a Term Funding Facility for the banking system under which authorized deposit-taking institutions can get funding from the RBA for three years at a rate of 0.25%, with additional funding available to increase lending to small and medium-sized businesses an increase in the amount and maturity of daily reverse repurchase (repo) operations, to support liquidity in the financial system setting up the currency swap line with the US Fed, providing US dollar liquidity to market participants in Australia. The RBA’s decisions on cutting the cash rate the 0.25%, and capping 3-year bond yields at the same level, sent a strong message to the markets that monetary policy must be highly accommodative until the threat of COVID-19 has passed. Fixed income markets have taken notice, with the yield on the benchmark 10-year Australian government bond falling from 1.30% just before the RBA announced the easing measures on March 19th to a low of 0.68% on April 1st. The yield has since rebounded to 0.95%, but this remains well below the level prevailing before the RBA eased. Those low interest rates have also helped to keep monetary conditions easy by dampening the attractiveness, and value, of the Australian dollar. The currency has historically been driven by three factors – interest rate differentials, commodity prices and global investor risk-aversion. With the RBA’s relentless rate cuts over the past decade, capped off by the measures introduced two months ago, the dominant factor on the currency has become interest rate differentials between Australia and other countries (Chart 11). The Aussie dollar has enjoyed a bounce as global equity markets have rebounded since the collapse in March, but remains well below levels implied by the RBA Commodity Price Index. The implication is that the upside in the currency will be capped by the RBA’s interest rate stance, which has taken all the formerly attractive carry out of the Aussie dollar. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The new baseline forecast by the RBA calls for the Australian unemployment rate to double from 5.2% in Q1/2020 to 10% in Q2/2020, before drifting back down to 8.5% by Q2/2021 (Chart 12). The central bank sees the jobless rate returning to 6.5% in Q2/2022, but that will still not be enough to push headline or core CPI inflation back above 2% (middle panel). Chart 11Interest Rates Are The Main Driver Of The AUD Now Chart 12Inflation Is Dormant Down Under Inflation expectations have discounted a similar outcome. The Union Officials’ and Market Economists’ surveys of 2-year-ahead inflation expectations are both now under 2%. Market-based measures like the 2-year CPI swap rate are even more pessimistic, priced at a mere 0.12%! The recent plunge in oil prices is clearly playing a role in that extreme CPI swap pricing, but until there is some recover in market-based inflation expectations, the RBA will be unable to move away from its current emergency policy easing measures. Fiscal Policy The Australian government has been very aggressive in its economic support measures, including1: a so-called “JobKeeper Payment” to allow businesses to cover employee wages direct income support payments to individuals and households allowing temporary withdrawals from superannuation (retirement savings) plans direct financial support to businesses to “boost cash flow” temporary changes to bankruptcy laws to make it more difficult for creditors to demand payment increased financial incentives for new investment providing loan guarantees to small and medium-sized businesses temporarily easily regulatory standards (like capital ratios) for Australian banks, to free up more funds for lending The size of these combined measures is estimated to be 12.5% of GDP, according to calculations from the IMF (Chart 13). This puts Australia in the upper tier of G20 countries in terms of the size of the total government support measures, according to an analysis of fiscal policy responses to COVID-19 from our colleagues at BCA Research Global Investment Strategy.2 When looking at purely the fiscal policy response through tax changes and direct spending, and removing liquidity support and loan guarantees that may not be fully utilized, the Australian government’s stimulus response is 10.6% of GDP - the largest in the G20 (Chart 14). Chart 13Australian Policymakers Have Responded Aggressively To COVID-19 Chart 14Australia’s Planned Deficit Increase Is The Largest In The G20 Chart 15Australia Has The Fiscal Space To Be Aggressive The Australian government can deliver such a large response because it has the fiscal space to do it, with a debt/GDP ratio that was only 41.9% prior to the COVID-19 outbreak (Chart 15). This compares favorably to other countries that have delivered major stimulus packages but from a starting point of much higher levels of government debt. The Australian government can deliver such a large response because it has the fiscal space to do it. We do not see any downgrade risk for Australia’s sovereign AAA credit rating from the fiscal stimulus measures, despite the recent decision by S&P to put the nation on negative outlook. Australia will still have one of the lowest government debt/GDP ratios among the G20, even after adding in the expected increases in deficits for all the countries in 2020 (Chart 16). Chart 16Australia’s AAA Credit Rating Is Safe Net-net, the monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. This has important investment implications for Australian bond markets. The monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. Bottom Line: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Investment Conclusions We started this report by discussing the consistent outperformance of Australian government bonds versus other developed market debt over the past decade. After going through a careful analysis of the economy, inflation, monetary policy and fiscal policy, we now view the period of Australian bond outperformance as essentially complete. This leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend only a neutral duration stance for dedicated Australian fixed income portfolios; the RBA has little room to cut policy rates further; inflation expectations are too low; the nation is poised to rapidly emerge from COVID-19 lockdowns; and fiscal stimulus will be more than enough to offset the hit to domestic incomes from the recession. Country Allocation: Within global bond portfolios, we recommend downgrading Australia to neutral from overweight. The multi-year interest rate convergence story is largely complete, both in terms of central bank policy rates and longer-term bond yields. Our most reliable indicator for the future relative performance of Australian government bonds versus the global benchmark – the ratio of the OECD’s leading economic indicator for Australia to the overall OECD leading indicator – is increasing because of a greater decline in the non-Australian measure (Chart 17, second panel). This fits with the idea of the relative economic growth story turning into a headwind for Australian bonds after being a tailwind for the past few years. Within global bond portfolios, we recommend downgrading Australia to neutral from overweight.  Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the curve as part of its quantitative easing program, leaving the slope of the curve to be driven more by longer-term inflation expectations that are too depressed (third panel). Inflation-linked Bonds: We recommend overweighting Australian inflation-linked bonds versus nominal government debt. As we discussed in a recent report, breakevens on Australian inflation-linked bonds are far too low on our fair value models, which include the sharp decline in global oil prices (fourth panel).3 Chart 17Move To Neutral Duration Exposure In Australia, While Favoring Inflation-Linked Bonds Chart 18Australian Corporate Bonds Look More Attractive Now   Corporate Credit: We recommend going overweight Australian investment grade corporate debt versus government bonds. The recent spread widening has restored some value - especially when compared to the more modest increase seen in credit default spreads - while Australian equity market volatility, which correlates with spreads, has peaked (Chart 18). Also, the RBA has just announced that they will now accept investment grade corporates as collateral for its domestic repo market operations, which should increase the demand for corporates on the margin.4   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The full details of the Australian government economic response to COVID-19 can be found here: https://treasury.gov.au/sites/default/files/2020-03/Overview-Economic_Response_to_the_Coronavirus_2.pdf 2 Please see BCA Research Global Investment Strategy Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at gis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 4https://www.rba.gov.au/mkt-operations/announcements/broadening-eligibility-of-corporate-debt-securities.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index