Economy

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

Highlights Ever since the Federal Reserve’s liquidity injections, the dollar has been trading in a bifurcated manner. Historically, this has been a rare event. The main bifurcation has been between developed market and commodity/emerging market currencies. Stability in the USD/CNY exchange rate is a key indicator to watch. Movements in this cross will indicate where the balance of forces are shifting. Feature Chart I-1A Tale Of Two Dollars The Federal Reserve’s dollar liquidity injections have been massive, but two dollars continue to fight a tug of war. The first is the DXY index, which has largely surrendered to the flood of liquidity offered through the Fed’s swap lines and temporary FIMA repo facility. In fact, cross-currency basis swaps in both Japan and the euro area, a measure of offshore dollar funding stress, have eased. As a result, volatility in the DXY index has been crushed, keeping it largely below the psychological 100 level. However, on the other side of the liquidity battle front have been emerging market and commodity currencies, some of which continue to make fresh lows. Remarkably, these have included currencies such as the Brazilian real that also have swap agreements with the US. In short, a rare divergence has opened up between two dollars (Chart I-1). Historically, whenever this has occurred, either the DXY index was on the verge of making new highs, or procyclical currencies were very close to a bottom. In our April 3rd report, we suggested three reasons as to why the dollar could remain well bid in the near term.1 In this report, we explore these reasons further and offer one variable to watch as the key arbiter between the two – the USD/CNY exchange rate. A Tale Of Two Dollars The bifurcated dollar performance has been underpinned by three factors. The 14 developed and emerging market currencies that have swap lines with the Fed2 all bottomed around March 19, when the funding announcement was made. These include currencies of countries that were initially excluded from a prior swap agreement such as Australia, Norway and New Zealand. The exception to this rule has been the Brazilian real. By extension, some currencies currently excluded from the swap agreement such as the Turkish lira and South African rand remain in freefall. The temporary repo facility for foreign and international monetary authorities (FIMA), which allows FIMA account holders to temporarily exchange their Treasury securities held with the Fed for US dollars, has instilled confidence. As such, this has assuaged selling pressure on currencies with ample dollar foreign exchange reserves. However, some currencies with low reserves such as the South African rand or Turkish lira continue to face downside risks. A huge portion of offshore dollar funding has been financed by non-bank entities. Not only does a rising dollar lift the debt burden of borrowers, but it also raises solvency risk for these concerns. Notably, non-banks have limited access to central bank swap lines. Of the US$12 trillion in dollar-denominated foreign debt outstanding, 32% is from emerging markets, a share that has increased massively since the financial crisis (Chart I-2). This might explain why currencies like the Brazilian real, exposed to significant foreign-currency corporate debt obligations, continue to see selling pressure, despite the Fed facilities in place (Chart I-3). Chart I-2Rising EM Dollar Debt Chart I-3Some EM Have High External Debt In short, with the Fed and many other developed-market central banks engaged in active purchases of corporate paper, a line in the sand has been drawn between currencies where the lenders of last resort have stepped in, and others where their central banks are still unwilling to take credit risk. Put another way, certain currency markets are starting to price USD solvency risk, resulting from the broad shutdown in their economies and the rise in the greenback. Unfortunately, there is nothing the Fed can do about this. Dollar liquidity shortages tend to be vicious because they trigger negative feedback loops. As offshore dollar rates among non-banks begin to rise, this lifts the cost of capital for borrowing entities, with debt repayment replacing capital spending. This is where China can step in. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.1 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The important distinction from foreign exchange reserves is that swap agreements entail no exchange of currency. As such, it is about confidence. With low external debt and massive FX reserves, the PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves.  Certain currency markets are starting to price USD solvency risk, resulting from the broad shutdown in their economies and the rise in the greenback.  There has been a precedent to this. Since the global financial crisis, as the PBoC has been engaging in powerful monetary stimulus, the number of bilateral swap lines offered to foreign central banks has also ballooned. Bloomberg no longer publishes swap data for the PBoC, but a recent article suggests that as recent as 2018, the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 38 countries and regions, with a total amount of around 3.7 trillion yuan (Chart I-4).3 Remarkably, this excluded the US Fed. This means that the USD/CNY exchange rate will become a key arbiter of the divergence between the two dollars. If Asian and Latin American currencies can stabilize versus the RMB and the USD/CNY exchange rate can remain stable, then an informal accord has been established. So far, the RMB appears the arbiter between these two dollars (Chart I-5). Chart I-4Chinese Swaps To The Rescue? Chart I-5USD/CNY As A Dollar Arbiter We understand that geopolitical tensions between the US and China are escalating, and so the probability of such an event – if global growth rebounds earnestly – is low. However, should global growth remain weak, a fall in the RMB will highlight the PBoC is actively using its currency as a weapon. This will suggest all bets are off. Bottom Line: Developed market commodity currencies have a correlation of almost parity with EM FX (Chart I-6). An explicit swap agreement between China and emerging market countries could be the key to assuage dollar funding pressures within emerging markets. This will ease the selling pressure on developed-market commodity currencies. Chart I-6The Risk To Commodity Currencies Market Signals And Signposts Ever since Richard Nixon severed the gold-dollar link in the early ‘70s, there have been three major episodes when some currencies bucked the broad dollar trend. Historically, this has been driven by two major factors (Table I-1):4 Table I-1Summary Of Currency Divergence Episodes De-synchronized global growth A localized debt/economic crisis The first episode occurred in the early 1990s. As the world was exiting a recession in part triggered by tight US monetary policies, lower US interest rates allowed the dollar to fall along with rising global growth. Only the yen, on the back of an economy entering into a debt deflation spiral (where positive real rates begot more currency appreciation), was able to buck this trend. Developed market commodity currencies have a correlation of almost parity with EM FX. The late 1990s saw the capitulation of Asian currencies. As a safe haven, the US dollar started to benefit from repatriation flows. Asean and commodity currencies were under intense selling pressure from pegged exchange rates and a long period of low interest rates that had generated massive imbalances. Remarkably, the euro was the area of shelter..  The world in 2005-2006 was entering a full-blown mania. Procyclical currencies were benefitting from Chinese industrialization and the creation of the euro. Meanwhile, Japan continued to sag under a mountain of debt. This pushed market participants to increasingly use the yen as a funding currency for carry trades, allowing it to depreciate versus the US dollar. Enter 2020. The world today is in a synchronized slowdown, but varying degrees of policy measures suggest we could continue to see a lack of synchronicity in dollar trading over the near term: The euro area appears poised to recover faster than the US in the near term (Chart I-7). If this proves correct, any knee-jerk selloffs in the euro should be bought. This is directly linked to the speed at which European economies reopen, relative to the US. By extension, Asian currencies should do better than those in Latin America. Conclusion: the dollar could fall against the euro, but rise against some emerging market currencies. The easiest way to express this view is to buy the cheapest European currencies, such as the Norwegian krone and Swedish krona. We are long both. The yen, typically used as a funding currency, will be hostage to a sudden stop in funding flows. This is because there is no interest rate advantage anymore between Japanese and US paper, once accounting for hedging costs (Chart I-8). This suggests carry trades in developed markets, using the Japanese yen, are stuck in the barn for now. Meanwhile, as a safe haven currency, the yen will still benefit from a rise in FX volatility. Short USD/JPY hedges make sense. Chart I-7Euro Area Versus##br## US Growth Chart I-8The Yen Is No Longer An Attractive Funding Currency Commodity and emerging market FX will be the outlier against the US dollar for now. These continue to face downward pressure in the near term. In terms of commodities, the sudden stop in demand has been met with an overwhelmingly slow response to curtail supply. Eventually, higher demand will benefit these currencies, but the supply story dominates for now in crude oil and industrial commodities. That said, this week’s rise in Chinese commodity imports was encouraging. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Capitulation?,” dated April 3, 2020, available at fes.bcaresearch.com. 2 These include the Bank Of Canada, Bank Of Japan, Bank Of England, European Central Bank, the Swiss National Bank, the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank. 3 Please see The History Of Commerce, China. 4 Please see Foreign Exchange Strategy Special Report, titled “Can There Be More Than One US Dollar”, dated June 08, 2018, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: The Markit manufacturing PMI fell to 36.1 in April; the services PMI also slipped to 26.7. ISM manufacturing PMI dropped to 41.5 and non-manufacturing PMI declined to 41.8. The trade deficit widened from $39.8 billion to $44.4 billion in March. Unit labor costs increased by 4.8% quarterly in Q1, while nonfarm productivity fell by 2.5%. Initial jobless claims continued to grow by 3169K last week. The DXY index surged by 1.5% this week. The Senior Loan Officer Survey released this week reported an increasing net percentage of domestic banks tightening standards for most loan types in Q1, including C&I, auto and mortgage loans. On Tuesday, the Fed’s Raphael Bostic said that there are great uncertainties around “V-shape” recovery. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: The Markit manufacturing PMI fell further from 33.6 to 33.4 in April, while the services PMI stayed low at 12. Sentix investor confidence remained low at -41.8 in May. Retail sales contracted by 9.2% year-on-year in March, compared to a 3% increase the previous month.  The euro declined by 0.8% against the US dollar this week. The German court has criticized the ECB bond-buying programme, warning that the ECB’s purchases could be illegal under German law unless the ECB can prove otherwise. Continuing conflicts among Eurozone members and imbalances between countries could add more pressure on the ECB. In addition, the European Commission forecasts the euro zone economy to contract by a record 7.7% this year. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been negative: The manufacturing PMI fell from 43.7 to 41.9 in April. Vehicle sales kept contracting by 25.5% year-on-year in April, following a decline of 10.2% in March. Monetary base increased by 2.3% year-on-year in April, down from a 2.8% increase the previous month. The Japanese yen appreciated by 0.4% against the US dollar this week, despite broad US dollar strength. Since the beginning of the Fed swap lines operation this year, the BoJ has the highest liquidity swaps with the Fed, amounting to US$220 billion as of April 30, helping to ease dollar funding pressure in Japan. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mostly negative: The Markit manufacturing PMI fell further to 32.6 from 32.9 in April, while services PMI remained low at 13.4. Nationwide housing prices increased by 3.7% year-on-year in April, up from 3% the previous month. Money supply (M4) surged by 7.4% year-on-year in March. The British pound plunged by 2.7% against the US dollar this week. The Bank of England held interest rates unchanged on Thursday morning, while warning that the coronavirus crisis will push the UK economy into its deepest recession in 300 years. The Bank is now forecasting the output to slip by 3% in Q1, followed by a 2.5% plunge in Q2. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Building permits plunged by 4% month-on-month in March, down from 19.4% the previous month. Exports surged by 15.1% month-on-month while imports fell by 3.6% in March. The trade surplus expanded by A$6.8 billion to A$10.6 billion. The Australian dollar fell by 1.5% against the US dollar this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. More importantly, the Bank has scaled back the size and frequency of bond purchases, which so far totalled A$50 billion, while stating that they are prepared to scale-up the purchases again should conditions worsen. In addition, the RBA forecasts the output to fall by roughly 10% in the first half of 2020 and by 6% over the year, followed by a rebound of 6% next year. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits fell by 21.3% month-on-month in March, down from 5.7% increase in February. The unemployment rate ticked up from 4% to 4.2% in Q1, lower than the expected 4.4%. Employment increased by 0.7% quarter-on-quarter. The participation rate increased by 30 bps to 70.4%. In addition, wage rates increased by 2.5% annually. The New Zealand dollar dropped by 1.8% against the US dollar this week. While many may call the Q1 Labour Market Statistics a positive surprise, Statistics New Zealand has indicated that the March data from household labour force survey was interrupted due to the lockdown in March. In a typical quarter, around 25% of the interviews for this survey are carried out face-to-face. We expect the Q2 Labour Survey to show more clearly how the COVID-19 lockdown has changed New Zealand’s labour market. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI plunged from 46.1 to 33 in April. Both exports and imports fell notably in March: exports narrowed by C$2.3 billion to C$46.3 billion. Imports decreased by C$1.8 billion to C$47.7 billion. The trade deficit widened from C$0.9 billion to C$1.4 billion. Bloomberg Nanos confidence ticked up from 37.1 to 37.7 for the week ended May 1. The Canadian dollar fell by 0.9% against the US dollar this week. The decline in exports was led by auto manufacturing, aircraft, and energy products. Moreover, a depreciating Canadian dollar has largely impacted the trade values in March. When expressed in US dollar terms, export fall by 9.2% month-on-month and imports by 8.1%, which compares favourably with 4.7% decrease in exports and 3.5% decline in imports in Canadian dollars. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: The manufacturing PMI fell from 43.7 to 40.7 in April, above the expectations of 34.6. Consumer climate plunged from -9.4 to -39.3 in Q2. Headline consumer prices fell by -1.1% year-on-year in April, down from -0.5% in March, also below the expectations of -0.8%.  The unemployment rate increased from 2.8% to 3.3% on a seasonally adjusted basis in April. The Swiss franc fell by 1% against the US dollar this week. With consumer prices decreasing for a third consecutive month, the SNB has stepped up the currency intervention. Total sight deposits have increased by nearly 77 billion CHF this year, compared to only 13.2 billion CHF in 2019 and 2.3 billion CHF in 2018. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There has been no significant data release from Norway this week. The Norwegian krone appreciated by 0.6% against the US dollar this week. On Thursday morning, the Norges Bank delivered a surprise rate cut by 25 bps to a record low of 0 due to the severity of the coronavirus and huge decline in oil prices. However, they also implied that further cuts into negative territory are unlikely. In addition, Governor Øystein Olsen said that they expect the output to drop by roughly 5% this year, a decline of a magnitude that has not been seen since World War II. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Manufacturing PMI fell from 42.6 to 36.7 in April. Industrial production fell by 0.1% year-on-year in March. Manufacturing new orders contracted by 2% year-on-year in March, down from 5.7% increase in February. The Swedish krona has been more or less flat against the US dollar this week. Like the ECB, the Riksbank might have some legal issues regarding its bond purchases program. The current Riksbank Act does not allow the bank to make outright purchases of corporate bonds or other private securities on the primary or secondary markets. So far, the Riksbank has purchased 5.6 billion SEK of corporate commercial papers to support the economy under the COVID-19. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Chart 9Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.

Highlights Our baseline view foresees a U-shaped recovery, as economies slowly relax lockdown measures. There are significant risks to this forecast, however. On the upside, a vaccine or effective treatment could hasten the reopening of economies and recovery in spending. On the downside, containment measures could end up being eased too quickly, leading to a surge in new cases. A persistent spell of high unemployment could also permanently damage economies, especially if fiscal and monetary stimulus is withdrawn too quickly. In addition, geopolitical risks loom large, with the US election likely to be fought on who sounds tougher on China. Earnings estimates have yet to fall as much as we think they will, making global equities vulnerable to a near-term correction. Nevertheless, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon. Is It Safe To Come Down? We published a report two weeks ago entitled Still Stuck In The Tree where we likened the current situation to one where an angry bear has chased a hiker up a tree.1 Having reached a high enough branch to escape immediate danger, the hiker breathes a sigh of relief. As time goes by, however, the hiker starts to get nervous. Rather than disappearing back into the forest, the bear remains at the base of the tree licking its chops. Meanwhile, the hiker is cold, hungry, and late for work. Like the hiker, the investment community breathed a collective sigh of relief when the number of cases in Italy and Spain, the first two major European economies to be hit by the coronavirus, began to trend lower. In New York City, which quickly emerged as the epicentre of the crisis in the United States, more COVID patients have been discharged from hospitals than admitted for the past three weeks (Chart 1). Chart 1Discharges From New York Hospitals Have Exceeded Admissions For The Past Three Weeks Deepest Recession Since The 1930s Yet, this progress has come at a very heavy economic cost. The IMF expects the global economy to shrink by 3% this year (Chart 2). In 2009, global GDP barely contracted. Chart 2Severe Damage To The Global Economy This Year The sudden stop in economic activity has led to a surge in unemployment. According to the Bloomberg consensus estimate, the US unemployment rate rose to 16% in April. The true unemployment rate is probably higher since to be considered unemployed one has to be looking for work, which is difficult if not impossible in the presence of widespread lockdowns. Regardless, even the official unemployment rate is the worst since the Great Depression (Chart 3). Chart 3Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression   Unshackling The Economy A key difference from the 1930s is that today’s recession has been self-induced. Policymakers want workers to stay home as much as possible. The hope is that once businesses reopen, most of these workers will return to their jobs. How long will that take? Our baseline scenario envisions a slow but steady reopening of the global economy starting later this month, which should engender a U-shaped economic recovery. Since mid-March, much of the world has been trying to compensate for lost time by taking measures that would not have been necessary if policymakers had acted sooner. As Box 1 explains, some loosening of lockdown measures could be achieved without triggering a second wave of cases once the infection rate has been brought down to a sufficiently low level. To the extent that economic activity tends to move in tandem with the number of interactions that people have, a relaxation of social distancing measures should produce a modest rebound in growth. New technologies and a better understanding of how the virus is transmitted should also allow some of the more economically burdensome measures to be lifted. As we have discussed before, mass testing can go a long way towards reducing the spread of the disease (Chart 4).2 Right now, high-quality tests are in short supply, but that should change over the coming months.  Chart 4Mass Testing Will Help Increased mask production should also help. Early in the pandemic, officials in western nations promulgated the view that masks do not work. At best, this was a noble lie designed to ensure that anxious consumers did not deprive frontline workers of necessary safety equipment. At worst, it needlessly led many people astray. As East Asia’s experience shows, mask wearing saves lives. A recent paper estimated that the virus could be vanquished if 80% of people wore masks that were at least 60% effective, a very low bar that even cloth masks would pass (Chart 5).3  Chart 5Masks On! Recent research has also cast doubt on the merits of closing schools. The China/WHO joint commission could not find a single instance during contact tracing where a child transmitted the virus to an adult. A study by the UK Royal College of Paediatrics provides further support to the claim that children are unlikely to be important vectors of transmission. The evidence includes a case study of a nine year-old boy who contracted the virus in the French Alps but fortunately failed to transmit it to any of the more than 170 people he had contact with in three separate schools.4  Along the same lines, there is evidence that the odds of adults catching the virus indoors is at least one order of magnitude higher than outdoors.5 This calls into question the strategy of states such as California of clearing out prisons of dangerous felons in order to make room for beachgoers.6 Upside Risks To The U: Medical Breakthroughs While a U-shaped economic recovery remains our base case, we see both significant upside and downside risks to this outcome. The best hope for an upside surprise is that a vaccine or effective treatment becomes available soon. There are already eight human vaccine trials underway, with another 100 in the planning stages. In the race to develop a vaccine, Oxford is arguably in the lead. Scientists at the university’s Jenner Institute have developed a genetically modified virus that is harmless to people, but which still prompts the immune system to produce antibodies that may be able to fight off COVID. The vaccine has already worked well on rhesus monkeys. If it proves effective on humans, researchers hope to have several million doses available by September. On the treatment side, Gilead’s remdesivir gained FDA approval for emergency use after early results showed that it helps hasten the recovery of coronavirus patients. Hydroxychloroquine, which President Trump has touted on numerous occasions, is the subject of dozens of clinical trials internationally. While evidence that hydroxychloroquine can treat the virus post-infection is thin, there is some data to suggest that it can work well as a prophylactic.7 Research is also being conducted on nearly 200 other treatments, including an improbable contender: famotidine, the compound found in the heartburn remedy Pepcid.8  Downside Risk: Too Open, Too Soon Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First As noted above, once the number of new cases drops to sufficiently low levels, some relaxation of containment measures can be achieved without reigniting the pandemic. That said, there is a clear danger that measures will end up being relaxed too aggressively and too soon. This is precisely what happened during the Spanish Flu (Chart 6). It has become customary to talk about the risk of a second wave of infections; however, the reality is that we have not even concluded the first wave. While the number of cases in New York has been falling, it has been rising in many other US states. As a result, the total number of new coronavirus cases nationwide has remained steady for the past five weeks (Chart 7). It is the same story globally: Falling caseloads in western Europe and East Asia have been offset by rising cases in countries such as Russia, India, and Brazil (Chart 8). Chart 7The Spread Of COVID-19 Has Not Been Contained Everywhere (I) Chart 8The Spread Of Covid-19 Has Not Been Contained Everywhere (II)   Chart 9Widespread Social Distancing Has Dampened The Spread Of All Flus And Colds At the heart of the problem is that COVID-19 remains a highly contagious disease. Most studies assign a Reproduction Number, R, of 3-to-4 to the virus. As a point of comparison, the Spanish flu is estimated to have had an R of 1.8. An R of 3.5 would require about 70% of the population to acquire herd immunity to keep the virus at bay.9 As discussed in Box 2, the “true” level of herd immunity may be substantially greater than that. At this point, if you come down with a cough and fever, you should assume you have COVID. As Chart 9 shows, social distancing measures have brought the number of viral respiratory illnesses down to almost zero in the United States. Up to 30% of common cold cases stem from the coronavirus family. Just like it would be foolhardy to assume that the common cold has been banished from the face of the earth, it would be unwise to assume that COVID will not return if containment measures are quickly lifted.   Downside Risk: Permanent Economic Damage Chart 10No Spike In Bankruptcies For Now There are a lot of asymmetries in economics: It is easier to lose a job than to find one; starting a new business is also more difficult than going bankrupt.  The good news so far is that bankruptcies have been limited and most unemployed workers have not been permanently laid off (Chart 10 and Chart 11). Thus, for the most part, the links that bind firms to workers have not been severed.   Chart 11Temporary Layoffs Account For Most Of The Recent Increase In Unemployment   Unfortunately, there is a risk that the economy will suffer permanent damage if unemployment remains high and economic activity stays depressed. For some sectors, such as airlines, long-term damage is nearly assured. It took a decade for real household spending on airlines to return to pre 9/11 levels (Chart 12). It could take even longer for the physiological scars of the pandemic to fade. While businesses outside the travel and hospitality sectors will see a quicker rebound, they could still experience subdued demand for as long as social distancing measures persist. Chart 129/11 Was A Big Shock For US Air Travel There is not much that fiscal policy can do to reverse the immediate hit to GDP from the pandemic. If people cannot work, they cannot produce. What fiscal stimulus can do is push enough money into the hands of households and firms to enable them to meet their financial obligations, while hopefully creating some pent-up demand that can be unleashed when businesses reopen. For now and for the foreseeable future, there is no need to tighten fiscal policy. The private sector in the major economies is generating plenty of savings with which governments can finance budget deficits. Indeed, standard economic theory suggests that if governments tried to “save more” by reducing budget deficits, total national savings would actually decline.10   Nevertheless, just as fiscal policy was prematurely tightened in many countries following the Great Recession, there is a risk that austerity measures will be reintroduced too quickly again. Likewise, calls to tighten monetary policy could grow louder. Just this week, Germany’s constitutional court ruled that the EU Court of Justice had overstepped its powers by failing to require the ECB to conduct an assessment of the “proportionality” of its controversial asset purchase policy. The German high court ordered the Bundesbank to suspend QE in three months unless the ECB Governing Council provides “documentation” showing it meets the criteria of proportionality. Among other things, the ruling could undermine the ECB’s newly launched €750 billion Pandemic Emergency Purchase Programme (PEPP). Downside Risk: Geopolitical Tensions Had the virus originated anywhere else but China, President Trump could have made a political case for further deescalating the Sino-US trade war in an effort to shore up the US economy and stock market. Not only did that not happen, but the likelihood of a new clash between China and the US has gone up dramatically. Antipathy towards China is rising (Chart 13). As our geopolitical team has stressed, the US election is likely to be fought on who can sound tougher on China. With the economy on the ropes, Trump will try to paint Joe Biden as too passive and conflicted to stand up to China. Indeed, running as a “war president” may be Trump’s only chance of getting re-elected. Chart 13US Nationalism Is On The Rise Amid Broad-Based Anti-China Sentiment At the domestic political level, the pandemic has exacerbated already glaringly wide inequalities. While well-paid white-collar workers have been able to work from the comfort of their own homes, poorer blue-collar workers have either been furloughed or asked to continue working in a dangerous environment (in nursing homes or meat-packing plants, for example). It is not clear what the blowback from all this will be, but it is unlikely to be benign. Investment Implications Global equities and credit spreads have tracked the frequency of Google search queries for “coronavirus” remarkably well (Chart 14). As coronavirus queries rose, stocks plunged; as the number of queries subsided, stocks rallied. If there is a second wave of infections, anxiety about the virus is likely to grow again, leading to another sell-off in risk assets. Chart 14Joined At The Hip Chart 15Negative Earnings Revisions Will Weigh On Stocks In The Near Term   Earnings estimates have come down, but are still above where we think they ought to be. This makes global equities vulnerable to a correction (Chart 15). Meanwhile, retail investors have been active buyers, eagerly gobblingup stocks such as American Airlines and Norwegian Cruise Lines that have fallen on hard times recently (Chart 16). They have also been active buyers of the USO oil ETF, which is down 80% year-to-date. When retail investors are trying to catch a falling knife, that is usually an indication that stocks have yet to reach a bottom. As such, we recommend that investors maintain a somewhat cautious stance on the near-term direction of stocks. Chart 16Retail Investors Keen To Buy The Dip   Chart 17Favor Equities Over Bonds Over A 12-Month Horizon   Chart 18USD Is A Countercyclical Currency Looking further out, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon (Chart 17). If global growth does end up rebounding, cyclicals should outperform defensives. As a countercyclical currency, the dollar will probably weaken (Chart 18). A weaker greenback, in turn, will boost commodity prices (Chart 19). Historically, stronger global growth and a softer dollar have translated into outperformance of non-US stocks relative to their US peers (Chart 20). Thus, investors should prepare to add international equity exposure to their portfolios later this year.   Chart 19Commodity Prices Usually Rise When The Dollar Weakens Chart 20Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening   Box 1The Dynamics Of R Box 2Why Herd Immunity Is Not Enough Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 2 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 3 Philip Anfinrud, Valentyn Stadnytskyi, et al., “Visualizing Speech-Generated Oral Fluid Droplets with Laser Light Scattering,” nejm.org (April 15, 2020); Jeremy Howard, Austin Huang, Li Zhiyuan, Zeynep Tufekci, Vladmir Zdimal, Helene-mari van der Westhuizen, et al., “Face Masks Against COVID-19: An Evidence Review,” Preprints.org, (April 12, 2020); and Liang Tian, Xuefei Li, Fei Qi, Qian-Yuan Tang, Viola Tang, Jiang Liu, Zhiyuan Li, Xingye Cheng, Xuanxuan Li, Yingchen Shi, Haiguang Liu, and Lei-Han Tang, “Calibrated Intervention and Containment of the COVID-19 Pandemic,” arxiv.org (April 2, 2020). 4 “COVID-19 – Research Evidence Summaries,” Royal College of Paediatrics and Child Health; and Alison Boast, Alasdair Munro, and Henry Goldstein, “An evidence summary of Paediatric COVID-19 literature,” Don’t Forget The Bubbles (2020). 5 Hiroshi Nishiura, Hitoshi Oshitani, Tetsuro Kobayashi, Tomoya Saito, Tomimasa Sunagawa, Tamano Matsui, Takaji Wakita, MHLW COVID-19 Response Team, and Motoi Suzuki, “Closed environments facilitate secondary transmission of coronavirus disease 2019 (COVID-19),” medRxiv (April 16, 2020). 6 “Coronavirus: Arrests as California beachgoers defy lockdown,” Skynews (April 26, 2020); and “High-risk sex offender rearrested days after controversial release from OC Jail,” abc7.com (May 1, 2020). 7 Sun Hee Lee, Hyunjin Son, and Kyong Ran Peck, “Can post-exposure prophylaxis for COVID-19 be considered as an outbreak response strategy in long-term care hospitals?” International Journal of Antimicrobial Agents (April 25, 2020). 8 Brendan Borrell, “New York clinical trial quietly tests heartburn remedy against coronavirus,” Science (April 26, 2020). 9 In the simplest models, the herd immunity threshold is reached when P = 1-1/Ro, where P is the proportion of the population which has acquired immunity and Ro is the basic reproductive number. Assuming an Ro of 3.5, heard immunity will be achieved once more than 71.4% of the population has been infected (1-1/3.5). For further discussion on this, please refer to Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. 10 It is easiest to understand this point by considering a closed economy where savings, by definition, equals investment. Savings is the sum of private and public savings. Suppose the economy is depressed and the government increases public savings by either raising taxes or cutting spending. Since this action will further depress the economy, private investment will fall even more. But, since investment must equal total savings, private savings must decline more than proportionately with any increase in public savings. This happens because tighter fiscal policy leads to lower GDP. It is difficult to save if one does not have a job. To the extent that lower GDP reduces employment, it also tends to reduce private-sector savings. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights Base metals are rebounding faster than oil in 2Q20, reflecting China’s first-in-first-out recovery from the global GDP hit caused by the COVID-19 pandemic (Chart of the Week). By 3Q20, the rebound in oil markets could be stronger than expected and surpass the base metals’ recovery, if the IMF’s latest EM GDP growth projections prove out. We examine a higher-growth scenario for non-OECD oil consumption – our proxy for EM demand – using the Fund’s projections. In it, EM oil consumption rises to 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021, if realized. Stronger EM consumption, coupled with global crude-oil production cuts would cause crude and product inventories to draw sooner and faster than expected, if these trends continue. Global policy uncertainty – economic and political – remains the critical risk to our metals and oil price outlooks, as it could retard a revival of growth and trade. The US and China appear to be on a collision course once again. Serious risks to global public health remain, particularly in light of a recently disclosed mutation to COVID-19. Feature Base metals are rebounding faster than oil in 2Q20, reflecting China’s first-in-first-out recovery from the global GDP hit caused by the COVID-19 pandemic. Prices for base metals likely will continue rebounding from the global hit to GDP caused by COVID-19 and its associated lockdowns, recovering more of the ground lost to the pandemic in 2Q20 than crude oil prices. This is largely a reflection of China’s first-in-first-out recovery from the global pandemic and the aggregate demand destruction following in its wake. This is the signal coming from our updated market-driven indicators shown in the Chart of the Week.1 China accounts for ~ half of the demand for refined base metals worldwide, and a comparable share of the supply side for refined metals and steel (Chart 2). Chart of the WeekBase Metals Rebounding Faster Than Crude Oil We use principal components analysis to extract common factors driving industrial commodity prices in real time from trading markets, which allows us to get a preliminary estimate of the recovery in base metals and crude oil demand. The two indicators shown in the Chart of the Week use daily stock and commodity prices, and other daily economic data. These indicators are called the Metals Demand Component and the Oil Demand Component. The former is largely dependent on the recovery in China/EM industrial activity, and also affects all cyclical commodities, including oil. Chart 2China Dominates Base Metals Supply And Demand Chart 3Policy Stimulus Will Restore Profitability In China The base metals’ rebound likely will continue throughout 2H20 as China’s economic activity gradually normalizes, fiscal and monetary stimulus kick in, and firms’ profitability recovers (Chart 3). “China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3,” based on the analysis of our colleagues in BCA’s China Investment Strategy.2 A weaker USD will start showing up in stronger indications of global growth – particularly in the EM markets – which will reverse the downtrend in our data-driven indicators of economic activity (Chart 4). However, given the lags in the release of these data, this will take time. Currently, our Metals Demand Component suggests the trend in base metals demand is upward and established, while our Oil Demand Component is still quite volatile and not yet decisively upward. Nonetheless, our oil indicator does highlight what appears to be a bottom in oil demand. Chart 4A Weaker USD Will Reverse Lagging Indicators Of Activity EM Demand Surge Will Revive Oil Prices The EM oil-demand growth forecast derived from the IMF’s GDP projections indicate growth could rise to as much as 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021, if realized. Over the short term, oil prices could diverge from demand until storage builds are contained and the market moves into a deficit. The logistics of moving and storing oil remains the primary driver of its price over the very short term, especially for landlocked crudes. The drain in storage could occur earlier than we expected in our forecast last month, if the IMF’s global growth trajectory play out in line with its latest projections.3 Using the Fund’s projections for EM GDP, we examine a scenario in which non-OECD oil demand grows significantly more than we estimated last month. Indeed, the EM oil-demand growth forecast derived from the IMF’s GDP projections indicate growth could rise to as much as 54.9mm b/d by 4Q20 and 56.4mm b/d by 4Q21. This would exceed our current estimates by 6.6% this year and 2.1% in 2021 (Chart 5), if realized. EM growth is the critical variable for global oil-demand growth, accounting for ~ 80% of global consumption growth in the past five years. As we’ve noted for some time, the massive fiscal and monetary stimulus being deployed globally will fuel the recovery of commodity demand (Chart 6). The oil-demand scenario driven by the IMF’s latest GDP projections, and the EIA’s April forecast share a common view of a sharp recovery in the level of non-OECD demand, with the former seeing demand destruction reversed by September, and the latter expecting EM consumption to return to pre-COVID-19 levels toward the end of this year, slightly ahead of us.4 Chart 5EM Oil Demand Could Surge On The Back Of Massive Global Stimulus Chart 6Global Fiscal and Monetary Stimulus Will Surge In 2020 And 2021 A surge in EM oil-demand growth – should it play out as expected – will occur against the backdrop of sharply lower global production levels this year. OPEC 2.0 pledged to cut ~ 8mm b/d starting this month vs. its 1Q20 levels, with its putative leaders – KSA and Russia – accounting for ~ 1.5mm b/d and 2mm b/d, respectively, of the reductions. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to almost 10mm b/d for May-June, and 7.7mm b/d for 2H20).5 In addition, the US likely will lose close to 2.5mm b/d from involuntary cuts between now and the end of 2021 due to the global oil price collapse (Chart 7).6 Chart 7US Shale-Oil Output Could Fall ~ 2.5mm b/d OPEC 2.0 Might Have To Lift Production The demand surge implied by the IMF’s expected EM GDP recovery this year and next almost surely would be met by higher output in OPEC 2.0 production. The demand surge implied by the IMF’s expected EM GDP recovery this year and next almost surely would be met by higher output in OPEC 2.0 production, to keep prices from charging ahead too sharply in 2H20 and in 2021. The increase in the coalition’s spare capacity – consisting of the production taken off the market through production cuts and the 2.5mm b/d or so that it had prior to the COVID-19-induced demand destruction – will allow OPEC 2.0 to quickly meet any supply shortfalls as demand recovers before the US shale-oil producers can ramp production. All the same, the market could experience episodic volatility on the upside, if our EM demand calculations based on IMF GDP projections and those of the EIA are correct. It is highly likely, in our view, OPEC 2.0 will be the direct beneficiary of the massive fiscal and monetary stimulus of the DM and EM economies– oil being a derived demand that depends on the income available to firms and households. This means the odds of seeing $80/bbl Brent is more likely than not next year: Importantly, EM and DM consumers will be better equipped to absorb higher oil prices with the massive stimulus sloshing around the global economy next year. For now, we are maintaining our expectation of $65/bbl average prices for Brent next year, but we will continue to watch EM GDP growth in upcoming World Bank and IMF research (Chart 8). Chart 8Upside Risks in Oil Prices As GDP Growth Prospects Improve Oil Price Risks Abound An upside surprise in EM oil-demand growth – consistent with the IMF’s revised GDP projections – could cause us to increase our demand expectation when we update balances and forecasts this month. Two-way price risk abounds in the oil markets. Even if options volatility on the CBOE is considerably lower than its recent record-setting peak, it still is close to 100% on an annualized basis (Chart 9). On the upside, as we’ve discussed above, if EM GDP growth is in the neighborhood projected by the IMF, demand could surge, based on our calculations. We have no doubt OPEC 2.0 can cover any shortfall, but it can’t do it immediately, so we would expect episodic volatility this year and next. Chart 9Oil Price Risk Abounds On the downside, the COVID-19 pandemic could enter a second wave just as governments around the world are removing lockdown orders and phasing in a return to normal commerce. Of particular note in this regard is the emergence of a mutation of the original strain of the COVID-19 virus that is more contagious, and now constitutes the dominant strain in the world. The mutated form of the virus appeared in Europe and quickly spread to the US east coast, and then the rest of the planet.7 Also, the risk that “animal spirits” will not re-emerge in businesses and consumers globally remains elevated. Despite the large increase in global money supply, confidence needs to be restored for the money multiplier to move up. In addition to that, signs of another round in the Sino-US trade war in the offing could restrain growth and trade. Bottom Line: Our base case remains a resumption in global growth in 2H20, with base metals recovering most of their lost ground in 2Q20 and oil following in 3Q20. An upside surprise in EM oil-demand growth – consistent with the IMF’s revised GDP projections – could cause us to increase our demand expectation when we update balances and forecasts this month. However, serious risks to global public health remain, and trade tensions between the US and China once again are percolating.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Refinery runs in the US collapsed by 25% this year in the wake of the COVID-19-induced economic shutdown. Still, WTI prices rose 30% this week – from a very low level – as oil supply in the US – and globally – is adjusting rapidly to lower demand (Chart 10). Wells shut-ins are accelerating throughout North America. In the Bakken Basin, shut-ins reportedly reached 400k b/d this week.8 Moreover, the effect of the 50% YTD decline in US rig count will be visible over the coming weeks. The rig count is now well below the level necessary to keep production flat. Precious Metals: Neutral Gold prices remained above $1,700/oz as of Tuesday’s close, supported by elevated economic uncertainty. Virus-related uncertainty will gradually wane as economies reopen. This could pull gold down temporarily as safe-asset demand is reduced. Nonetheless, our Geopolitical team believes risk and uncertainty will partly shift to the geopolitical arena in the run-up of the US election.9 Additionally, the massive stimulus by the US Fed and Treasury will become an important driver of the yellow metal’s price going forward. Gold will trend higher as US rates remain stuck at zero, as it did in 2008 (Chart 11). Ags/Softs:  Underweight Following lockdown easing measures in different parts of the world, hopes of a rebound in ethanol demand helped push CBOT Corn futures 0.5% higher on Tuesday. Additionally, continuing drought conditions in Brazil will limit the country’s yields and support corn prices in the near term. Soybeans climbed 3¢/bu on Tuesday, backed by China’s booking of 378k tons of the oilseed as it seeks to fulfill the US trade deal obligations. Gains throughout corn and soybeans were mitigated by a strong planting progress as reported by the USDA. Wheat ended slightly higher after field assessments conducted by Oklahoma State University Extension projected the state harvest down by 13.5 Mn bushels year-on-year. Chart 10Crude Recouping Some Ground Chart 11Fed Rates Stuck At Zero Will Push Gold Higher   Footnotes 1     Given the importance of the daily prices in these indicators, we are explicitly assuming trading markets are continually processing fundamental information on supply, demand, inventories, and financial and economic conditions in industrial commodity markets and reflecting them in prices. This is especially important when an exogenous event like the COVID-19 pandemic hits global markets. Market participants have to work out the implications of the shock and its resolution in real time, which can make for exceptionally volatile prices. Lags in the economic data provided by the likes of the World Bank, the IMF, EIA, IEA and OPEC make the time series we typically rely on to model fundamentals and their expected evolution less effective in estimating the current state of commodity markets. Their forecasts, however, remain extremely useful, as they are developed by analysts with particular expertise in global macroeconomic forecasting, in the case of the World Bank and IMF, and oil markets, in the case of the EIA, IEA and OPEC. 2     Please see A Slow And Rocky Path To Recovery published by BCA Research’s China Investment Strategy April 29, 2020. It is available at cis.bcaresearch.com. 3    Please see US Storage Tightens, Pushing WTI Lower for our most recent supply-demand balances and oil price forecasts, which were published April 16, 2020. We use the global growth forecasts of the IMF and the World Bank as inputs to our fundamental modeling to estimate oil demand. In particular, we’ve found a parsimonious relationships between OECD, non-OECD and world oil demand and DM and EM GDP. Chapter 1 of the Fund’s advance forecast was published last month in its World Economic Outlook under the title “The Great Lockdown.” 4    Assuming the Fund’s projections of EM GDP are approximately correct, the impact on oil demand is quite large as can be seen in the comparisons shown in Chart 5. However, the IMF’s estimate for oil prices is sharply below our estimate, which was made last month assuming lower levels of EM oil demand. We expect Brent crude oil prices to average $39/bbl this year and $65/bbl next year, vs. the Fund’s estimate of $35.61/bbl in 2020 and $37.87/bbl in 2021. The EIA’s estimate of non-OECD demand is comparable to our, as seen in Chart 6, but its price forecasts for this year and next – $33/bbl and $46/bbl – also are below ours. 5    Please see US Storage Tightens, Pushing WTI Lower, where we outline OPEC 2.0’s cuts. 6    Please see our April 30 report entitled Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl for additional discussion. 7     Please see The coronavirus has mutated and appears to be more contagious now, new study finds published by cnbc.com May 5, 2020. 8    Please see 'Like watching a train wreck': The coronavirus effect on North Dakota shale oilfields published by reuters.com May 4, 2020. 9    Please see #WWIII published by BCA Research’s Geopolitical Strategy 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