Sectors

Highlights Duration: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Spread Product: Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for high-yield. Accommodative monetary conditions will ensure that the supply of credit remains ample for some time yet. This will keep defaults low and spreads tight. Monetary Policy: The Fed is in no rush to tighten policy, but has also set a high bar for further cuts. Investors should short August 2020 fed funds futures.  Yields Will Move Higher … But Not Yet Chart 1A Peak In New Cases? A Peak In New Cases? A Peak In New Cases? Uncertainty about the economic impact of the coronavirus – now officially called COVID-19 – is the cloud that continues to hang over financial markets. Last week, bond yields fell when a change in the definition of what constitutes a confirmed infection caused the number of reported cases to spike. However, even after revisions, the daily number of new cases looks like it may have peaked (Chart 1). The end result is that the 10-year Treasury yield sits at 1.58%, not far from where it was last week (Chart 2). Notably, the 10-year yield continues to shrug off the notable improvement in US economic data (Chart 2, bottom panel), taking its cues instead from COVID-19 headline risk. Even if the downtrend in new COVID-19 cases continues, it is too soon to be looking for higher bond yields. For one thing, the most up-to-date economic data releases were collected during January, before the outbreak. Weaker readings during the next 1-2 months are assured, and investors may not look through the weakness given that many were already skeptical about the prospects for global economic recovery. Our read of the data is that global growth was in the process of bottoming when COVID-19 struck. We therefore expect global growth to move higher once the virus’ impact abates. In terms of timing, using the 2003 SARS outbreak as a comparable, we expect bonds to remain bid until the daily number of new cases falls to zero, at which point a sell-off is likely. Yields continue to shrug off improvements in economic data. It’s not just the long-end of the curve that has responded to COVID-19. The front-end has also moved to price-in high odds of a rate cut in the coming months. Specifically, the overnight index swap curve is priced for a 42 bps decline in the fed funds rate during the next 12 months (Chart 2, panel 2), and the fed funds futures market is pricing a 74% chance of a rate cut by the end of the summer. As we discussed last week, given that any economic impact from COVID-19 will be temporary, we think the bar for a Fed rate cut this year is quite high.1 As such, our Golden Rule of Bond Investing dictates that investors should keep portfolio duration low on a 12-month horizon.2 We also recommend shorting August 2020 fed funds futures, a trade that will earn 23 bps of unlevered return if the Fed stands pat between now and August (Chart 2, panel 3). Turning to corporate credit, we see that, so far, COVID-19’s impact on spreads has been minor. The investment grade corporate bond index spread is only 3 bps wider than at the start of the year, and the junk index spread is only 8 bps wider (Chart 3). Value remains stretched in the investment grade space, but high-yield spreads look quite attractive. The sell-off in the energy sector has boosted the high-yield index spread considerably (Chart 3, bottom 2 panels). We view this as a medium-term buying opportunity for junk. Once the COVID outbreak abates and global growth ticks higher, the oil price is bound to increase, leading to some tightening in energy spreads. Chart 2Bond Yields Driven By COVID Bond Yields Driven By COVID Bond Yields Driven By COVID Chart 3HY More Attractive Than IG HY More Attractive Than IG HY More Attractive Than IG Will Bonds Feel The Bern? Beyond COVID-19, there is one more risk on the horizon this year. Specifically, the risk that Bernie Sanders is elected President in November. This outcome is far from certain. Sanders is currently leading all other candidates in the Democratic Primary, but fivethirtyeight.com’s model puts the odds of a brokered convention at 38%.3 This means that the race is still wide open and might only be settled at the convention in July. But given Sanders’ lead, it is worth considering the bond market implications if he were to become the next President. The most obvious implication is that risk assets (equities and corporate spreads) would respond to Sanders’ agenda of wealth redistribution by selling off. This could spur a flight-to-quality into government bonds, causing Treasury yields to fall. However, that flight-to-quality won’t occur if markets also start to price-in the long-run implications of Sanders’ agenda. I.e. the fact that the redistribution of wealth from capital to labor would lower the economy’s marginal propensity to save, and likely raise inflation expectations, leading to higher interest rates. It’s important to note that there are a lot of hurdles to overcome before Sanders’ full policy agenda is implemented. First he must secure the Democratic nomination, then defeat Donald Trump in the general election. Even after that, he will still need to convince the House and Senate to pass non-watered down versions of his proposals. With such a long road ahead, we don’t think Sanders’ momentum will push bond yields higher in 2020. Rather, the risk is that Sanders’ rise keeps bond yields low in 2020 as risk assets sell off. If Bernie Sanders looks poised to win the nomination, we will consider reducing our 6-12 month allocation to spread product and increasing our recommended portfolio duration. The outlook for the Democratic Primary should become clearer after Super Tuesday on March 3. If Sanders looks poised to win the nomination we will consider reducing our recommended 6-12 month allocation to spread product and increasing our recommended portfolio duration. Bottom Line: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for junk. Though the credit cycle is far from over (see next section), we may reduce our recommended allocation to spread product versus Treasuries if Sanders’ election chances rise.  Bank Lending Standards Won’t Push Credit Spreads Wider In 2020 The net change in commercial & industrial (C&I) bank lending standards, as reported in the Fed’s quarterly Senior Loan Officer Survey, is a vitally important indicator for the credit cycle. Easing lending standards tend to coincide with a low default rate and falling credit spreads, while tightening lending standards usually coincide with spread widening and a rising default rate. With that in mind, it is mildly concerning that bank lending standards have been fluctuating around neutral levels for quite some time, and have in fact tightened in two of the past five quarters (Chart 4). In this week’s report we consider whether tighter bank lending standards could pose a risk to our overweight spread product view in 2020. Chart 4Bank Lending Standards And Monetary Variables Bank Lending Standards And Monetary Variables Bank Lending Standards And Monetary Variables Bank lending standards are such an important credit cycle variable because they tell us about the supply of credit. A corporate default only occurs when credit supply is lower than the amount required for that firm’s survival. On a macro scale, we can think of two main reasons why lenders might restrict the credit supply: They perceive the monetary environment as restrictive. That is, they worry about higher interest rates and slower growth in the future. They perceive corporate balance sheets as being in poor health. That is, they worry that firms won’t be sufficiently profitable to make good on their debts. We find that monetary indicators do a very good job of predicting when lending standards will tighten. Looking back at the past two cycles, lending standards didn’t tighten until after: The yield curve inverted (Chart 4, panel 2). The real fed funds rate was above its estimated equilibrium level (Chart 4, panel 3). Inflation expectations were at or above target levels (Chart 4, bottom panel). Presently, all three of these monetary indicators are supportive. Some portions of the yield curve have been inverted at various times during the past year. But in general, the inversion signal from the yield curve has not been as strong as it was when lending standards tightened in prior cycles. For instance, the 3-year/10-year Treasury slope has not inverted this cycle, and it currently sits at +20 bps (Chart 4, panel 2). Further, the real fed funds rate is below most estimates of its neutral level and the Fed is signaling that it will keep it there for a long time yet. This dovish posture is justified by inflation expectations that remain well below target. It is conceivable that, despite the accommodative monetary environment, banks might be so concerned about poor balance sheet health that they are becoming more cautious with their lending. However, a survey of corporate health metrics doesn’t point to an imminent tightening of bank lending standards either (Chart 5). Chart 5Bank Lending Standards And Corporate Balance Sheet Variables Bank Lending Standards And Corporate Balance Sheet Variables Bank Lending Standards And Corporate Balance Sheet Variables In past cycles, tighter bank lending standards were preceded by: A trough in gross leverage (pre-tax profits over total debt) (Chart 5, panel 2). A peak in interest coverage (Chart 5, panel 3). Negative pre-tax profit growth (Chart 5, panel 4). A peak in profit margins (Chart 5, bottom panel). Currently, gross leverage is the only one of the above four variables that is clearly sending a negative signal. As for the other three, interest coverage and profit margins are barely off their cyclical highs, and profit growth has been fluctuating around zero for three years. If global growth rebounds during the next 12 months, as we expect, then profit growth will also move modestly higher. Bottom Line: Neither monetary nor balance sheet variables point to an imminent tightening of bank lending standards. We expect that the supply of credit will remain ample in 2020, keeping the default rate low and credit spreads tight. A Note On Falling C&I Loan Demand In addition to questions about lending standards, the Fed’s Senior Loan Officer Survey also asks banks to report whether they are seeing stronger or weaker demand for C&I loans. In response, banks have reported weaker C&I loan demand for six consecutive quarters, ending in Q4 2019. Historically, it is unusual for C&I loan demand to fall without a concurrent tightening in lending standards (Chart 6). Chart 6Explaining Weakening Loan Demand Explaining Weakening Loan Demand Explaining Weakening Loan Demand We also see the impact of weaker loan demand in the hard data. C&I loan growth has been falling since early 2019 (Chart 6, panel 2) and net corporate bond issuance had been on a sharp downtrend since 2015, before moving higher last year (Chart 6, bottom panel). So what’s going on with C&I loan demand? We can think of two reasons why firms might seek out less credit. First, they may face a dearth of investment opportunities, or alternatively, they might perceive some benefit from carrying less debt on their balance sheets. On the first point, we find that new orders for core capital goods do a very good job explaining the swings in C&I lending (Chart 7). Specifically, we see that the global growth slowdown of 2015/16 drove both investment spending and C&I lending lower. Then, both series recovered in 2017/18 before moving down again during last year’s slowdown. Surveys about firms’ capital spending plans also dropped last year, consistent with the deceleration in C&I lending, but remain at high levels (Chart 7, bottom three panels). All of this suggests that C&I loan growth will recover this year as global growth improves and the investment landscape brightens. Capital goods new orders do a good job explaining C&I lending. Corporate bond issuance has followed a different path from C&I lending during the past few years. Specifically, bond issuance slowed in 2015/16 as investment spending dried up. But it did not recover in 2017/18 the way that investment spending and C&I lending did. This appears to be a result of the 2018 corporate tax cuts and repatriation holiday. Chart 8 shows that the Financing Gap – the difference between capex spending and retained earnings – plunged in 2018 because firms suddenly received a huge influx of retained earnings. The influx came in part from the lower tax rate, but mostly from repatriated cash that had been stranded overseas. Simply, firms didn’t need to issue bonds to finance their investment plans in 2018 because they had a lot more cash on hand. Chart 7C&I Lending Follows ##br##Investment C&I Lending Follows Investment C&I Lending Follows Investment Chart 8A Negative Financing Gap Limits The Need For Debt A Negative Financing Gap Limits The Need For Debt A Negative Financing Gap Limits The Need For Debt What about the possibility that firms are demanding less debt because they are trying to clean up their balance sheets? Beyond a few anecdotes, we don’t see much support for this idea. In fact, an equity index of firms with low debt/asset ratios has been underperforming an index of firms with high debt/asset ratios (Chart 9). This suggests that there is currently little reward for firms that are paying down debt. Chart 9Firms Not Rewarded For Healthy Balance Sheets Firms Not Rewarded For Healthy Balance Sheets Firms Not Rewarded For Healthy Balance Sheets Bottom Line: Weaker demand for C&I loans is a result of the recent global growth downturn and decline in investment spending. It is not a harbinger of the end of the credit cycle. Loan demand should improve as global growth rebounds this year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 2 For further details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3 https://projects.fivethirtyeight.com/2020-primary-forecast/?ex_cid=rrpromo Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Stay on the sidelines on cyclicals versus defensives. While the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon. Recent Changes There are no changes to our portfolio this week. Table 1 Will The Fed Save The Day, Again? Will The Fed Save The Day, Again? Feature The SPX shrugged off the persistently negative coronavirus epidemic news and made fresh all-time highs last week (top panel, Chart 1). Domestic flush liquidity remains the dominant macro theme coupled with the expectation of a sizable fiscal and monetary easing out of China in the coming months. Importantly, according to the CME there is a 60% chance of a Fed interest rate cut priced in for the July 29, 2020 FOMC meeting which jumps to over 80% probability for the December 16, 2020 meeting. This is sustaining downward pressure on the 10-year Treasury yield, which in turn is boosting equities. A glum JOLTS report along with the 12-month fed funds rate discounter corroborate that additional Fed easing is likely nearing (middle & bottom panels, Chart 1). Chart 1Is A Fed Interest Rate Cut Looming? Is A Fed Interest Rate Cut Looming? Is A Fed Interest Rate Cut Looming? Chart 2Unsustainable Rise In “Tenuous Trio” Unsustainable Rise In “Tenuous Trio” Unsustainable Rise In “Tenuous Trio” The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently. Nevertheless, beneath the surface trouble is brewing. Chart 2 shows three asset classes rising concurrently. The “tenuous trio” as we have called stocks, Treasurys and the greenback in the past, cannot rise in tandem. When all three asset prices appreciate, it typically foreshadows equity market trouble. In this particular iteration, even the VIX is up for the year, representing a big break in historical correlations. Worrisomely, since 2018 every time the VIX and the SPX became positively correlated, the broad market subsequently suffered a setback (Chart 3).  While the SPX is making all-time highs, the VIX is neither making all-time lows nor cyclical lows. Importantly, equity market volatility is staying stubbornly close to 15, slightly below the ten-year average. As a reminder, a “VIX reading of 15 means that in 30 days the S&P 500 is expected to trade between 4.3% lower and 4.3% higher than its current level”.1 Chart 3Watch Out For Vol Watch Out For Vol Watch Out For Vol The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently.2 Chart 4 shows the percentage of GICS2 sectors with negative two-year relative share price momentum. The higher this diffusion rises the fewer the sectors that drive the SPX’s return. Historically, when our diffusion hits the 70% mark, it signals exhaustion in equity market returns. In fact, 70% readings in this diffusion indicator led both the 2000 and 2007 peaks in the SPX. Chart 4Heed The Diffusion Index’s Message Heed The Diffusion Index’s Message Heed The Diffusion Index’s Message This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Meanwhile on the economic front, the JOLTS report made for grim reading. Labor market softness was evident across the board and it was not squarely concentrated in the manufacturing sector. While this indicator only goes back two cycles, it is flashing yellow for the prospects of the broad equity market (top panel, Chart 5). Importantly, we will continue to monitor the job openings numbers as they are sending the exact opposite signal compared with unemployment insurance claims (job openings shown inverted, middle & bottom panels, Chart 5).  This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Chart 5Avoid Getting JOLTed Avoid Getting JOLTed Avoid Getting JOLTed Mixed Signals We have been neutral the cyclicals/defensives ratio for the past 8 months and continue to recommend investors stay on the sidelines for a while longer. It has been particularly difficult to distinguish a clear signal from noise lately for the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages and the recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels, Chart 6). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel, Chart 6). CEOs remain a depressed bunch and it is all but certain that for, at least, the next three months executives will put capex plans on the backburner. Basic resources are most at risk and keep in mind that relative capex growth was already decelerating prior to the coronavirus epidemic (top & second panels, Chart 7). Chart 6Trade Uncertainty… Trade Uncertainty… Trade Uncertainty… Chart 7… And Capex Softness Weighs On Cyclicals … And Capex Softness Weighs On Cyclicals … And Capex Softness Weighs On Cyclicals A soft sales backdrop coupled with inventory accumulation are firing a warning shot. Relative share prices will likely succumb to the still weak total business sales-to-inventories ratio (third panel, Chart 7). Importantly, an inventory liquidation phase will continue to exert downward pressure on relative profit margins (bottom panel, Chart 7). Chart 8Pricing Power Proxy Blues Pricing Power Proxy Blues Pricing Power Proxy Blues Our simple relative pricing power proxy for the cyclical/defensive ratio best encapsulates these relative selling price pressures. The CRB metals-to-gold price ratio is on the verge of a breakdown and warns that the wide gulf that has opened up between our pricing power proxy and relative share prices will narrow via a sell off in the latter (Chart 8). Nevertheless, this stands in marked contrast to the ISM manufacturing prices paid subcomponent of the Report On Business survey and actual cyclicals/defensives pricing power momentum (bottom panel, Chart 9). Chart 9The US Dollar Holds The Key The US Dollar Holds The Key The US Dollar Holds The Key Were the greenback to depreciate in the coming months as our FX strategists expect, then cyclicals selling prices would definitively regain the upper hand versus their defensives counterparts (top & middle panels, Chart 9). But, the jury is still out. Sell-side analysts remain optimistic that relative profits will stage a significant comeback in the next year, but on a short-term basis have been trimming cyclical versus defensive earnings revisions (middle & bottom panels, Chart 10). While our macro-factor relative profit growth models were staging a comeback all last year, they ticked down last month (second panel, Chart 10). Finally, relative technical and valuation conditions are both tracing out a bottom near the one standard deviation below the historical mean, a level that has marked prior recoveries in relative share prices (Chart 11). Chart 10Mixed Bag Mixed Bag Mixed Bag Chart 11Unloved & Undervalued Unloved & Undervalued Unloved & Undervalued Bottom Line: Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Remain on the sidelines on cyclicals versus defensives, but stay tuned. Clipped Wings? Airline stocks have taken it to the chin lately on the back of coronavirus demand destruction fears, but we reiterate our overweight stance as extreme bearishness appears overdone. Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however looking further out such demand destruction will likely prove transitory. Chart 12 shows that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices (bottom panel, Chart 12). US domestic and international passenger enplanements are running near the 5%/annum growth rate and the recent rebound in the global and US services PMIs suggests that any kink in demand will likely prove short-lived (Chart 13). Chart 12Firming Cyclical… Firming Cyclical… Firming Cyclical… Chart 13…Demand Backdrop… …Demand Backdrop… …Demand Backdrop… Importantly, this firm cyclical demand backdrop is reflected in accelerating airline selling price inflation both on domestic and international routes (second & third panels, Chart 14). However, profit margins have yet to reflect this encouraging top line growth backdrop. The airline load factor spread (calculated as load factor minus break-even load factor) also heralds a profit margin expansion phase (bottom panel, Chart 14). Chart 14…Is A Boon For Selling Prices …Is A Boon For Selling Prices …Is A Boon For Selling Prices Chart 15Lower Fuel Costs Should Turbocharge Profit Margins Lower Fuel Costs Should Turbocharge Profit Margins Lower Fuel Costs Should Turbocharge Profit Margins Tack on the roughly 16% year-to-date drubbing in oil prices and airline profit margins will expand in 2020. This is true especially for the bulk of the industry that does not hedge kerosene costs (jet fuel shown inverted, Chart 15). The analyst community has been pessimistic about the prospects of airline stocks. Revenue and profit growth expectations are slated to tail the SPX in the coming twelve months. This sets a low bar for the industry to surpass in coming earnings seasons (Chart 16). Finally, investors have thrown in the towel, pushing relative valuations to extremely depressed levels to the tune of nearly two standard deviations below the historical mean (middle panel, Chart 17). Relative technicals are also washed out and signal that, at least, a reflex rebound is in store in the coming months (bottom panel, Chart 17). Chart 16Low Bar To Surpass Low Bar To Surpass Low Bar To Surpass Chart 17Contrary Alert: Pessimism Reigns Supreme Contrary Alert: Pessimism Reigns Supreme Contrary Alert: Pessimism Reigns Supreme In sum, while the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon.      Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://us.spindices.com/vix-intro/ 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, and “When The Music Stops…”, dated January 27, 2020, both available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Will The Fed Save The Day, Again? Will The Fed Save The Day, Again? Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Cyclical & High-Conviction Overweights Both our cyclical and 2020 high-conviction large caps overweights versus small caps are in the black by 20% and 5%, respectively, since inception. Debt-saddled small caps have been left behind this cycle as they are more than twice as leveraged compared with their large caps peers on a net debt-to-EBITDA basis. Meanwhile, the narrative that small caps have cheapened versus large caps also does not hold as index providers omit negative profits from their forward EPS calculations. Adjusting for that, small caps are dearly priced versus the SPX. Finally, our relative sentiment proxy gauging the relative attractiveness of small caps versus large caps is on the verge of  crossing below the zero line, underscoring that investors should stick with a large cap bias. Bottom Line: We reiterate our large cap preference at the expense of small cap stocks. Stick With A Large Cap Bias Stick With A Large Cap Bias

Highlights Bulk commodity markets – chiefly iron ore and steel – could see sharp rallies once Chinese authorities give the all-clear on COVID-19 (the WHO’s official name for the coronavirus). These markets rallied sharply Tuesday, as President Xi vowed China would achieve its growth targets this year, which, all else equal, likely will require additional monetary and fiscal stimulus. China accounts for ~ 70% of the global trade in iron ore, and ~ 50% of global steel supply and demand. COVID-19-induced losses have hit Chinese demand for steel hard, forcing blast furnaces to sharply reduce output. However, this partly is being countered by transitory weather- and COVID-19-related disruptions that are reducing iron ore exports from Brazil and delaying Australian shipments. Iron ore inventories could be drawn hard in 2Q and 2H20 to meet demand as steelmakers rebuild stocks and construction and infrastructure projects restart (Chart of the Week). The Chinese Communist Party celebrates its 100th anniversary next year. To offset the COVID-19-induced drag on domestic growth this year, which could take GDP growth below 5%, and a weak GDP performance next year additional stimulus is an all-but-foregone conclusion. Feature When policymakers really want to jumpstart GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. There is a compelling case a strong rally in iron ore and steel will accompany the containment of COVID-19, reversing the 14% and 4% declines in both since the start of the year (Chart 2). Chief among the drivers of the rally will be the increase in fiscal and monetary stimulus required to restore Chinese GDP growth disrupted by the COVID-19 outbreak, which could reduce annual growth closer to 5% than the ~ 6% rate policymakers were targeting. Chart of the WeekLow Iron Ore Stocks Setting Up A Rally Low Iron Ore Stocks Setting Up A Rally Low Iron Ore Stocks Setting Up A Rally Chart 2Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices There are a number of reasons for expecting this. 2020 marks the terminus of the decade-long policy evolution that was supposed to end with the realization of the “Chinese Dream.” Chief among the goals that were to be realized by the end of this year – which will usher in the 100th anniversary of the founding of the Chinese Communist Party in 2021 – are a doubling of per capita income and of GDP.1 The Communist Party in China has numerous policy levers it can pull to respond to worse-than-expected growth and economic shocks. These policies consume a lot of bulk commodities and base metals. When policymakers really want to jump-start GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. This was clearly seen following the Global Financial Crisis (GFC) in 2008-09 (Chart 3). Even before the COVID-19 outbreak, policymakers made it clear they wanted to stabilize growth following the Sino-US trade war at the conclusion of the Central Economic Work Conference (CEWC) in December. Nominal wages and per capita income growth had been falling since 3Q18, imperilling one of the principal goals of the “Chinese Dream.” Chart 3Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q- 4Q20 if their goal is simply to achieve 6% p.a. growth this year. Following that CEWC meeting, our colleagues at BCA’s China Investment Strategy (CIS) anticipated policymakers would announce growth targets at the National People’s Congress (NPC) meeting next month in the range of 5.8 and 6.2% p.a. growth, noting, “the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms.”2 The growth rate required to put the economy on track to deliver on the “Chinese Dream” is now much higher following the COVID-19 outbreak, which could shave ~1% or more off China’s growth this year alone. This suggests policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q-4Q20 if their goal is simply to achieve 6% p.a. growth this year. This predisposes us to expect significant monetary and fiscal stimulus this year after the all-clear is sounded and the economy can return to its day-to-day activities. In addition – and by no means least of the concerns driving policymakers’ decisions – the 100th anniversary of the founding of the CCP will be celebrated next year, something policymakers at all levels have been looking forward to showcase the success of their revolution. A Boon For Bulks As monetary policy eases, the construction growth trajectory should pick up smartly. China accounts for ~ 70% of the global trade in iron ore. It is expected to import ~ 1.1 billion MT this year and next, based on estimates published by the Australian government’s Department of Industry, Innovation and Science in its December 2019 quarterly assessment (Chart 4). China will account for ~ 50% of global steel supply and demand, or roughly 900mm MT/yr in 2020 and 2021. The COVID-19 outbreak reduced utilization rates at the close to 250 steel mills monitored by Mysteel Global in China to 78%, a drop of 2.3pp.3 Platts estimates refined steel production could fall by 43mm MT by the end of February.4 Most of China’s steel output goes into commercial and residential construction (~ 35%), infrastructure (~20%), machinery (~ 20%), and automobile production (~ 7%), based on S&P Global Platts estimates.5 Residential construction began to recover last year, and residential housing inventories were declining relative to sales (Chart 5). In our view, once the COVID-19 infection rate falls outside Hubei Province – the epicenter of the outbreak – markets will begin pricing in a revival of commercial and residential construction in China. As monetary policy eases, the construction growth trajectory should pick up smartly (Chart 6). Chart 4China Dominates Iron Ore, Steel Markets Iron Ore, Steel Poised For Rally Iron Ore, Steel Poised For Rally   Chart 5Resumption Of Construction Will Lift Demand For Bulks Resumption Of Construction Will Lift Demand For Bulks Resumption Of Construction Will Lift Demand For Bulks Chart 6Easier Money And Credit Policy Will Revive Construction Easier Money And Credit Policy Will Revive Construction Easier Money And Credit Policy Will Revive Construction Infrastructure spending already was on track to increase prior to the COVID-19 outbreak, based on our CIS colleagues’ reading of the CEWC statement issued in December, which “suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year.”6 This fiscal push will be supported by additional spending at the local government level, and by the issuance of special-purpose bonds by these governments with proceeds earmarked for infrastructure development (Chart 7). “A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019,” according to our CIS colleagues. Chart 7Pump Priming Will Boost Infrastructure Spending Pump Priming Will Boost Infrastructure Spending Pump Priming Will Boost Infrastructure Spending Bottom Line: Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Whether it rises at double-digit growth rates remains to be seen, however. Expect Chinese Consumers To Come Out Spending Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Prior to the outbreak of COVID-19, consumer confidence was running high (Chart 8), and employment prospects have bottomed and turned higher, although they still indicate contraction. (Chart 9). This boded well for consumer-spending expectations, particularly for autos (Chart 10). Chart 8Consumer Confidence Was High Prior to COVID-19 Outbreak ... Consumer Confidence Was High Prior to COVID-19 Outbreak ... Consumer Confidence Was High Prior to COVID-19 Outbreak ... Chart 9... And Job Prospects Were Improving ... ... And Job Prospects Were Improving ... ... And Job Prospects Were Improving ... At ~ 7%, China’s automobile production remains a marginal contributor to overall steel consumption. Nonetheless, a meaningful pickup in automobile production following the depressed growth rate of the past 15 months would move steel demand upward. China’s share of world auto sales is ~30% (Chart 11). Chart 10... Thus Lifting Prospects For Chinese Auto Sales ... Thus Lifting Prospects For Chinese Auto Sales ... Thus Lifting Prospects For Chinese Auto Sales   Chart 11Policy Stimulus Will Revive Chinese Auto Sector Policy Stimulus Will Revive Chinese Auto Sector Policy Stimulus Will Revive Chinese Auto Sector Accommodative monetary and fiscal policies in China point toward higher growth for the auto sector. However, it is important to note the revival in auto production needs to be driven by consumer demand – if it is led simply by restocking, the rebound will not be sustainable. The recovery we are expecting will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. Bottom Line: Auto consumption and production were recovering in late 2019; however, the strength of the recovery did not match previous stimulus programs (2009 and 2016). The recovery we are expecting this year will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. If these other sectors remain constructive for metal demand (or at least are not contracting or slowing drastically), the boost from the auto sector will meaningfully contribute to higher iron ore and steel prices.   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 Oil prices halted their decline and rose 1% on Tuesday as the number of daily confirmed cases of the Wuhan coronavirus decelerated in China. As of Tuesday, the daily growth in cases dropped to 5%, down from 6% the previous day. Investors will closely monitor this number for any sign of a durable slowdown in daily confirmed cases. Separately, the US Energy Information Administration revised down its global demand growth estimates for 2020 to 1.0mm b/d from 1.3mm b/d last month, reflecting the effects of the coronavirus and warmer-than-expected January temperatures in the northern hemisphere. We will be updating our global oil balances next week. Base Metals: Neutral Iron ore prices fell 14% since the COVID-2019 outbreak in January. Investors are assessing how the iron ore market will balance weaker demand expectations in China amid lower supply – largely a result of falling Brazilian ore exports. Brazil’s total iron ore exports fell ~19% y/y in January due to heavy rainfall and lower production at Brazilian miner Vale. The company’s output never fully recovered from the 2019 dam incident and remains a risk to iron ore supply in 1Q20. Vale lowered its March sales guidance by 2mm MT. Low Chinese port inventories raise prices’ vulnerability to supply disruptions (Chart 12). Precious Metals: Neutral Gold remains well bid despite a strong US dollar, fueled by safe-haven demand. The yellow metal’s price fell slightly on Tuesday as investors’ concerns over the coronavirus eased. Based on our fair-value model, prices averaged $55/oz above our estimate in January. Investors – i.e. global ETF holders and net speculative positions reported by the US CFTC – have been important contributors to the latest gold rally. Investors’ total holding of gold reached a record high 113mm oz last week. Nonetheless, we believe there is still opportunity for this group to further support prices: the share of gold allocation vs. world equity-market capitalization is still low at 0.24%, vs. its peak of 0.42% in 2012 (Chart 13). Ags/Softs:  Underweight March wheat futures were down 1.8% at Tuesday’s close, settling at the lowest level of the year after the USDA called for ‘stable supplies’ of the grain for the 2019/2020 U.S. marketing year. For corn, ending stocks were unchanged relative to the January projection, while world production was revised slightly upwards. March corn futures finished 2¢ lower at $3.7975/bu. The USDA also estimated higher soybean exports on the back of increased sales to China. However, soybean price gains were limited by higher production and ending stocks abroad. Chart 12Low Iron Ore Inventory Raises Exposure To Supply Disruptions Low Iron Ore Inventory Raises Exposure To Supply Disruptions Low Iron Ore Inventory Raises Exposure To Supply Disruptions Chart 13A Higher Share Of Gold Holdings Could Support Prices Further A Higher Share Of Gold Holdings Could Support Prices Further A Higher Share Of Gold Holdings Could Support Prices Further   Footnotes 1     The “Chinese Dream” is a phrase coined by President Xi Jinping, following the 18th Party Congress of the Chinese Communist Party in 2012, when the overarching goal of transforming China into a “moderately well-off society” was memorialized in writing. These goals were crystalized in terms of progress expected in per capita income and GDP, both of which were to be doubled in the decade ending this year. Please see Why 2020 Is a Make-or-Break Year for China published by thediplomat.com February 13, 2015. 2     Please see A Year-End Tactical Upgrade, published by BCA Research’s China Investment Strategy December 18, 2019, for an in-depth analysis of policy guidance coming out of the Economic Work Conference last December. It is available at cis.bcaresearch.com. 3    Please see WEEKLY: China’s blast furnace capacity use drops to 78% published by Mysteel Global February 10, 2020. 4    Please see China steel consumption to plunge by up to 43 mil mt in February due to coronavirus published February 6, 2020, by S&P Global Platts. 5    Please see China Macro & Metals: Steel output falls, but property creates bright spots published by S&P Global Platts December 6, 2019. 6    Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Iron Ore, Steel Poised For Rally Iron Ore, Steel Poised For Rally Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Iron Ore, Steel Poised For Rally Iron Ore, Steel Poised For Rally

Regulatory Risks Abound Regulatory Risks Abound Cyclical & Secular Underweight We remain underweight the S&P interactive media & services (IM&S) subgroup on both cyclical and secular (ten-year basis) time horizons as increasing regulation will likely deal a blow to the industry. Early signs of regulation are already springing up around the globe as California and the European Union have already adopted strict privacy laws. This will likely pave the way for a federal bill aimed at protecting the consumer and his data. In our recent Weekly Report, we draw parallels between the US chemical industry in the 1970s and the present day S&P IM&S index. Specifically, the Toxic Substances Control Act (TSCA) of 1976 dealt a blow to chemical equity prices in absolute and relative terms (see chart) turning investments in chemical stocks into dead money for a whole decade. Bottom Line: Increasing odds for tougher regulation compels us to remain underweight the S&P IM&S index. The ticker symbols for the stocks in this index are: BLBG S5INMS – GOOGL, GOOG, FB, TWTR. For additional details, please refer to this Monday’s Weekly Report.  

Highlights An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted Chinese Households Are Indebted Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse China: Share Prices And Money Impulse China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact The US Dollar Rally Is Intact The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation Turkey: Rampant Money Creation Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging Turkey: Wages Are Surging Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese stocks made a comeback as soon as the speed of COVID-19 transmitting outside of the epicenter somewhat moderated. Inside the epicenter, the pandemic has not shown clear signs of easing, and could significantly prolong the region’s lockdown. Despite being a large manufacturing hub, Hubei-based companies represent relatively limited significance in China’s equity market. A protracted regional lockdown in Hubei may disrupt company-specific supply chains, but so far there is little evidence suggesting such disruptions will spill over to China’s broad equity market. Feature The stringent containment measures taken by China in its battle against the COVID-191  epidemic are indeed having economic consequences, both domestically and globally. However, the full extent of the repercussions remains to be seen. In the financial market, Chinese stocks regained significant ground following a sharp selloff when the financial markets reopened after an extended Chinese New Year holiday (Chart 1). The number of confirmed COVID-19 cases continues to rise. On the other hand, the number of new cases outside of Hubei province appears to have peaked on February 3rd and the official number within the province has plateaued (Chart 2). Chart 1Chinese Equities Rebounded Despite The Ongoing Epidemic Chinese Equities Rebounded Despite The Ongoing Epidemic Chinese Equities Rebounded Despite The Ongoing Epidemic Chart 2Has The Peak Arrived? Not Within The Epicenter The Evolving Crisis The Evolving Crisis The latest official data reinforces our view that the epidemic outside of Hubei is considerably less severe than within Hubei. While it is still too early to confirm that the number of new cases elsewhere in China has peaked, the epidemic in Hubei - particularly in Wuhan - is far from contained despite what the official data suggests. The near-collapsing municipal system in the epicenter leaves a large margin for error in recording and confirming the number of cases. The region’s strained medical resources also mean that the number of both new infections and fatalities may not reach a sustained peak in the weeks to come. Most cities in China’s 31 provinces and municipalities had partially resumed business activities by February 10, but we think that Hubei and especially Wuhan will likely remain in lockdown through the end of March, a month longer than scheduled by the provincial government. Will an extended lockdown of the Hubei province prevent a budding recovery in China’s economy from manifesting itself? In our view, the answer is no. And even in the case of a prolonged region-wide lockdown, our assessment is that the spillover effects from supply-chain disruptions in Hubei on the domestic equity market are unlikely to be significant. Quantifying The Potential Impact Of An Extended Lockdown In Hubei Hubei accounted for only 4.6% of China’s aggregate economy in 2019. If the majority of businesses in Hubei remain closed until March 20 and we assume no growth in the province in Q1 on an annual basis,2 it will shave 0.3 percentage points from China's total nominal growth in the quarter. Furthermore, if the manufacturing sector restarts production in Q2, but most activities in the service sector such as retail, hotel, transportation and real estate remain depressed, then China’s tertiary sector output growth in that quarter will be reduced by 0.4 percentage points. This will only reduce the country’s overall economic growth in Q2 by 0.2 percentage points. Hubei’s protracted but isolated lockdown will also have a minor impact on China’s overall financial market. Within the MSCI China Onshore Index, there are 16 Hubei-based companies representing only 1.2% of total market capitalization. In the offshore market, there are 14 listed companies registered in Hubei and their market value accounts for a mere 0.3% of the offshore MSCI China Index.3  Chart 3Chinese Equity Performance Rationally Reflects Economic Fundamentals So Far Chinese Equity Performance Rationally Reflects Economic Fundamentals So Far Chinese Equity Performance Rationally Reflects Economic Fundamentals So Far Given the small market capitalization of these Hubei-based companies, China’s index performance simply will not be affected on a fundamental basis by a longer shutdown of the province (Chart 3).   Bottom Line: We expect a more protracted shutdown of business in Hubei than is currently scheduled, which has the potential to weigh negatively on investor sentiment. But from a fundamental perspective, this will not derail the economic and stock market recoveries underway in China. Confirming Signals From The Equity Market Chart 4 shows that the relative performance of cyclicals versus defensives is improving in both China’s onshore and offshore markets, which suggests investors share our view that outbreak will subside to a Hubei-specific phenomenon, and that a longer-than-expected shutdown of the province is unlikely to threaten China's overall economic recovery. Chart 4Risk-On Sentiment Ticking Up Risk-On Sentiment Ticking Up Risk-On Sentiment Ticking Up Chart 5Auto And Tech Manufacturers Having Large Presence In Wuhan The Evolving Crisis The Evolving Crisis ​​​​​​​ Importantly, supply chain disruptions due to a shutdown of Hubei’s production plants have not had significant spillover effects on industry performance in China’s equity markets.  Hubei, and more specifically Wuhan-based manufacturers, is a manufacturing hub and key supplier in the automobile and electronic equipment industries (Chart 5). Despite the region’s significant manufacturing presence, Hubei-based manufacturers have relatively limited impact on the equity performance of their industry groups, both onshore and offshore: The stocks of Hubei-based automobile and tech companies have mostly been underperforming relative to their respective industries and the broad Chinese market. Nevertheless, these industries and their overall sectors have managed to outperform relative to the broad market, which indicates that the supply chain constraints have not spilled over to Chinese companies outside of Hubei.  For example, Dongfeng Motor Co., a leading state-owned auto manufacturer located in Hubei, is a key supplier for Nissan and Honda. Dongfeng represents 6% of the automobile and components industry in the MSCI China Index. Chart 6 shows that while Dongfeng has been underperforming the industry and the broad market since the onset of the COVID-19 epidemic, performance in the auto industry relative to the broad market picked up last week when the number of new cases in the epidemic peaked. This suggests that supply-chain constraints are limited to Dongfeng and Hubei, and the downside risks in the automobile and components industry elsewhere in China are abating. Hubei-based tech companies account for 5% of the technology, hardware, and equipment industry group in China’s onshore equity market. Due to production cuts and transportation constraints, four of the five companies listed in the MSCI China onshore index have significantly underperformed both the industry and the broad market since the start of the COVID-19 epidemic (Chart 7).  The only Hubei-based constituent in the sector that has had large gains is a company that produces thermal imaging systems, an equipment widely used in monitoring contagious diseases. But the company’s 1% weight in the industry equity group means the industry’s outperformance is mostly from gains in companies outside of Hubei.  This suggests that despite disruptions inside Hubei, China’s domestic supply chains in the tech industry are relatively agile with manufacturers outside of Hubei stepping in to fill production shortages. Chart 6Supply Disruptions In Hubei's Auto Sector Not Affecting China's Overall Auto Industry Performance Supply Disruptions In Hubei's Auto Sector Not Affecting China's Overall Auto Industry Performance Supply Disruptions In Hubei's Auto Sector Not Affecting China's Overall Auto Industry Performance Chart 7Flexible Supply Chains In China Domestic Tech Industry Help Offset Production Shortages In Hubei Flexible Supply Chains In China Domestic Tech Industry Help Offset Production Shortages In Hubei Flexible Supply Chains In China Domestic Tech Industry Help Offset Production Shortages In Hubei   Bottom Line: While it is too early to conclusively say that the risk of further contagion outside of Hubei has abated, we think the positive equity market performance over the past week is warranted.  The negative impact of supply-chain disruptions in Hubei on China’s domestic overall equity market and industry performance has been minor. Hence, in the case of a prolonged region-wide lockdown, we think the broad financial market implications will not be significant. Investment Conclusions Chart 8Chinese Stocks Are Still Priced At A Deep Discount Chinese Stocks Are Still Priced At A Deep Discount Chinese Stocks Are Still Priced At A Deep Discount We maintain our bullish view on Chinese stocks, both in the near term and in the next 6-12 months. Despite regaining considerable ground in the past week, onshore and offshore equities are still priced at deep discounts (Chart 8). Cities and regions outside of the Hubei epicenter have partially resumed business activities this week. This, coupled with a reduction in the number of new cases, should further boost investors’ confidence in the recovery of China’s economy and risk assets. The reopening of businesses in Hubei could be delayed as late as the end of March. While this will have a devastating impact on the region’s economy and corporate profits, the spillover effects will most likely be contained within the region and not derail China’s economy. In addition, for now the resilience at both China’s industry and broad level equity performance appears to be outweighing the risk of a longer-than-announced shutdown.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Previously labeled as coronavirus or 2019-nCoV, the disease was officially named COVID-19 by the World Health Organization (WHO) on February 11, 2020. 2   We consider this an overestimate of the economic damage caused by the COVID-19 epidemic. Even though manufacturing activities can potentially grind to a halt, healthcare-related investment and consumption will likely skyrocket. 3   As of February 10, 2020, according to the MSCI. Cyclical Investment Stance Equity Sector Recommendations

Realizing Gains Realizing Gains Neutral In this Monday’s Weekly Report we lifted the hard-hit S&P hotels index to neutral from previously underweight and cemented gains of 20% since inception. Relative retail sales have rebounded over the past several months with discretionary sales reclaiming the upper hand signaling that it no longer pays to be bearish the S&P hotels index (top panel). At the same time, while overall PCE is decelerating, relative consumer outlays on hotels is picking up momentum (middle panel). Importantly, our S&P hotels EPS growth model that encapsulates all the key industry macro drivers is also arguing that relative profit growth is slated to turn the corner in the coming quarters. Bottom Line: Lift the S&P hotels index to neutral and lock in gains of 20% since inception. Please refer to Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG S5HOTL – MAR, CCL, HLT, RCL, NCLH. ​​​​​​​

Highlights Portfolio Strategy Receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Lift exposure to neutral. An historical parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Recent Changes Lock in gains of 20% and augment the S&P hotels index to neutral. Table 1 Sell The Rip Sell The Rip Feature Equities ripped higher last week as the coronavirus scare subsided, the Senate acquitted President Trump and the PBoC and the Fed sustained the liquidity injections. From a macro perspective, bond yields have served as a suspension for the SPX, absorbing the economic shock and catapulting the broad equity market to fresh all-time highs. The usual suspects, tech stocks, led the charge as lower interest rates equate to higher multiples. Keep in mind that the SPX is trading near an eighteen-year high on a forward P/E ratio basis (Chart 1). Such investor complacency is worrisome, especially given the persistently soft economic backdrop. Importantly, the latest GDP release revealed that net exports had the largest contribution to real output growth – trumping even PCE – on the back of a collapse in imports (second & third panels, Chart 2). Chart 1Flush Liquidity Flush Liquidity Flush Liquidity Chart 2Net Exports Jump Is A Yellow Flag Net Exports Jump Is A Yellow Flag Net Exports Jump Is A Yellow Flag In fact, the quarter-over-quarter plunge in real imports is the steepest since the GFC, and on a par with both the 9/11 induced recession in the early-2000s and the Savings & Loan recession in the early-1990s (top panel, Chart 3). Historically, when imports crest they are a precursor of recession (bottom panel, Chart 3). While this may be a one quarter blip in the data as a result of the trade war, we will continue to closely monitor the US trade balance. Meanwhile, consumer outlays are also decelerating, corroborating last quarter’s real imports collapse (bottom panel, Chart 2). If this pillar of economic strength gives way in the coming quarters, it will stoke up recession fears anew and vindicate the bond market’s message. Ultimately, what matters for stocks, aside from interest rates, is EPS growth. On that front, the Street continues to expect 10% profit growth for calendar 2020 which is a tall order according to our analysis in mid-January, warning that the SPX is still 8% overvalued as per our base case EPS and multiple scenario.1 Chart 3Imports Flashing Red Imports Flashing Red Imports Flashing Red Chart 4Sector Contribution To 2020 SPX EPS Growth Sell The Rip Sell The Rip Chart 4 shows the sector contribution to profit growth for this year. The tech sector sits atop the table and leads its peers by a wide margin (Table 2). Health care and financials occupy the second and third spots. While these rankings are more or less in line with the sector profit and market cap weights, what stands out is the delta between the market cap and earnings weights (Table 2). Table 2Sector EPS And Market Cap Weights Sell The Rip Sell The Rip According to this valuation proxy, real estate, tech and consumer discretionary sectors are the most expensive, while energy, health care and financials are the cheapest (Table 2). As a reminder we remain neutral tech, and underweight both real estate and consumer discretionary, and overweight all three undervalued sectors: energy, health care and financials. This week we book gains and lift to neutral a niche consumer discretionary sub sector that the coronavirus epidemic has badly bruised, and update our view on the largest communication services sub-group. Crystalize Gains And Upgrade Hotels To Neutral Google trends data shows that peak interest in the coronavirus was registered on January 26 in China, January 30 in the US and one day later globally (Chart 5). These trends may change in the coming weeks, but it appears that the initial fears and interest on the coronavirus are quickly subsiding, highlighting that the worst may likely be behind us with regard to fear mongering. Thus, we are compelled to lift the hard-hit S&P hotels index to neutral and cement gains of 20% since inception. While Chinese, global and US outputs will likely take a hit in Q1, subsequently recover in Q2 in the aftermath of the epidemic and only Q3 will come in as a clean quarter, the beating down of this niche consumer discretionary sub-group is overdone. Macro headwinds are turning into mild tailwinds. Last week the ISM non-manufacturing report rebounded smartly, and consumer confidence remains resilient. The implication is that it no longer pays to be bearish the S&P hotels index (top & middle panels, Chart 6). Tack on our vibrant industry demand indicator underscoring that the two-year bear market will likely go on hiatus (bottom panel, Chart 6). Chart 5Risks Receding Risks Receding Risks Receding Chart 6Upbeat Demand Upbeat Demand Upbeat Demand A number of other indicators we track send a similar message. Relative retail sales are rebounding with discretionary sales reclaiming the upper hand (top panel, Chart 7). While overall PCE is decelerating (bottom panel, Chart 2), relative consumer outlays on hotels is picking up momentum signaling that the bar for positive relative profit surprises is low (middle panel, Chart 7). Importantly, almost all of the negative coronavirus news flow is likely reflected in the roughly 25% forward P/E discount to the broad market that the index is changing hands at. If the coronavirus epidemic is petering out, then such undervaluation is no longer warranted (bottom panel, Chart 7). Importantly, our S&P hotels EPS growth model does an excellent job in encapsulating all these moving parts and is currently signaling that relative profit growth is slated to turn the corner in the coming quarters (Chart 8). Chart 7Grim News Is Priced In Grim News Is Priced In Grim News Is Priced In Chart 8Model Points To A Turnaround Model Points To A Turnaround Model Points To A Turnaround Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Beyond the risk of a resurgence in the coronavirus epidemic, what prevents us from upgrading all the way to an above benchmark allocation is a challenging profit margin backdrop. Chart 9 highlights that not only are industry CEOs showing no restraint with respect to labor additions, but also lodging inflation is now contracting. Taken together, there are rising odds that the S&P hotels index may suffer from a profit margin squeeze (bottom panel, Chart 9). Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Bottom Line: Lift the S&P hotels index to neutral and lock in gains of 20% since inception. The ticker symbols for the stocks in this index are: BLBG S5HOTL – MAR, CCL, HLT, RCL, NCLH. Chart 9Margin Squeeze Is A Risk Margin Squeeze Is A Risk Margin Squeeze Is A Risk Regulation Is Coming While most mega cap tech stocks had a better-than-expected Q4 earnings season, GOOGL and FB were left behind. We reiterate our underweight stance in the S&P interactive media & services index (we still consider them tech stocks) which serves as a great hedge to our overweight S&P software index. As a reminder we remain underweight this communications services subgroup on a cyclical basis, and since mid-December also on a secular ten-year time horizon.2 Regulation is a powerful force. President Trump is only slightly favored for reelection and there is bipartisan support to toughen anti-trust regulation, which his own Department of Justice has pursued. Republican Senator of Missouri Josh Hawley has spearheaded the assault on tech companies from the right wing, while leading Democratic presidential contenders represent the push from the left wing. Indeed, if the Democrats take power, they are likely to enact a federal privacy law following in the footsteps of California and the European Union. Such a law would face court battles but would ultimately have popular tailwinds: corporate protectionism, wealth inequality, and social demands for privacy across the political spectrum. Looking back to the early- and mid-twentieth century with regard to US government regulation aimed at protecting the consumer is instructive. What catches our attention are the Biologics Control Act, the Pure Food and Drug Act and the Toxic Substances Control Act. The first two acts affected the pharmaceutical and food industries and the third act the chemicals industry. While we do not have sector data dating back to the early 1900s, we have chemicals equity prices since 1958. The Toxic Substances Control Act of 1976 dealt a blow to chemical equity prices in absolute and relative terms (Chart 10). In fact, investments in chemical stocks were dead money for a whole decade until 1985 when they broke out in absolute terms and troughed in relative terms (Chart 10). New regulation will cast a shadow over the S&P interactive media & services index. This is true especially if a privacy law is passed, but even if it is postponed or shot down by the Supreme Court, companies will have to contend with a higher regulatory burden in order to comply with California’s and Europe’s privacy laws. Beyond the threat of privacy regulation protecting the consumer, the monopolistic power these companies exert will also come under the microscope. While we doubt the government will break up these two companies given their industry dominance, and the need to maintain international competitiveness,3 anti-monopoly probes clearly pose a big risk. This is true even under a GOP administration. During times of inequality, especially during recessions, governments will seek popularity by punishing scapegoats. The firms that are the chief beneficiaries of the business cycle will be the first in line for scrutiny. Keep in mind, Ronald Reagan’s Republican administration broke up “Ma Bell” into seven regional “Baby Bells” on January 1, 1984. Interestingly, AT&T also had the largest market capitalization in the S&P 500 in 1982. What concerns us the most is a forced sale of “crown jewel” assets as the result of a court ruling in an anti-monopoly suit. This would jeopardize the companies’ ecosystems. Imagine if Alphabet were forced to divest their Google Marketing Platform (old DoubleClick) and Google Ads, or YouTube or Google Cloud. Facebook could be forced to sell WhatsApp or Instagram. Chart 10Regulation Hurts Stocks Regulation Hurts Stocks Regulation Hurts Stocks Chart 11Risks Are Neither Reflected In Profit Estimates… Risks Are Neither Reflected In Profit Estimates… Risks Are Neither Reflected In Profit Estimates… All of these risks pose a threat to EPS growth and still sky-high industry profit margins. Importantly, relative profit growth is climbing at a 13% rate (middle panel, Chart 11) and coupled with the drubbing in 10-year Treasury yields, have pushed valuations to overshoot territory. As we went to print the S&P interactive media & services index was trading at a 34% forward P/E premium to the broad market (Chart 12). Similarly on a forward P/E/G ratio basis this industry is trading at roughly a 30% premium to the SPX (bottom panel, Chart 12). In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Over the past year profit margins have been narrowing as costs have been creeping up for the industry, but are still more than twice the level of SPX margins (second panel, Chart 13). If federal regulation puts a price on consumer data in the coming years, especially through direct legislation, then this added cost will squeeze industry profit margins and dent profitability. Chart 12…Nor In Pricey Valuations …Nor In Pricey Valuations …Nor In Pricey Valuations Chart 13Margin Compression Looms Margin Compression Looms Margin Compression Looms The chief constraint on US government regulation is the desire to maintain international competitiveness in a world of great power competition, in which US rivals attempt to promote their own tech companies globally. However, neither colonialism nor the Cold War stopped earlier anti-monopoly crusades. Politicians primarily court domestic constituencies with such pursuits. Regulators would have to set the terms of any breakup with various interests in balance, but the point is that even a limited breakup that does not mortally wound the company would still come as a negative shock at first. In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Bottom Line: Stay underweight S&P interactive media & services index both on a cyclical and structural ten-year time horizon. The ticker symbols for the stocks in this index are: BLBG S5INMS – GOOGL, GOOG, FB, TWTR.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com.\ 2     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 3     Please see BCA US Equity Strategy Special Report, “Is The Stock Rally Long In The FAANG?” dated August 1, 2018, and Geopolitical Strategy Special Report, “Surviving A Breakup: The Investor's Guide To Monopoly-Busting In America,” dated March 20, 2019, available at uses.bcaresearch.com and gps.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The coronavirus is a real threat for the global economy and financial markets: We expect that the epidemic will be contained before it takes too much of a bite out of global output, but it has become the biggest market wild card. We are watching for a peak in new infections as a tell for when markets may move on from it. Earnings season was once again a ho-hum affair: S&P 500 earnings per share are on track to post 2% growth in 4Q19, about three percentage points above downwardly revised estimates. Profit margin contraction was in line with the previous three quarters. The biggest banks don’t see any immediate signs of credit problems, … : Net charge-off and non-performing loan ratios remain very low and the banks don’t see borrower performance worsening any time soon. … and think an uptick in business confidence is overdue: The banks’ calls occurred before the coronavirus broke out, but every management team saw the easing of trade tensions as a prelude to a pickup in corporate confidence. While We Were Out Chart 1Risk Off, Everywhere But Stocks Risk Off, Everywhere But Stocks Risk Off, Everywhere But Stocks We last published a Weekly Report on January 6th, and the ensuing five weeks have been anything but boring. The US assassinated Iran’s foremost military leader, escalating the two nations’ conflict; and the coronavirus burst forth in China’s ninth-largest city, sparking worldwide concerns. The VIX awakened, Treasury yields slid, crude oil swooned and the dollar surged, but the S&P 500 only declined 3% trough to peak, and now sits 2-3% above its January 6th close (Chart 1). The coronavirus is a significant threat to the global economy and global markets, and geopolitical tensions have escalated, but the underpinning of our market views has not changed. We continue to view monetary policy as the critical swing factor for financial markets and the macro cycles that influence them. Assuming the coronavirus or another exogenous event does not tip over the US economy, the next recession will not begin until monetary policy settings turn restrictive. Nothing that has happened since the beginning of year has changed our view that the Fed is almost certain not to hike rates before its November meeting, and we think it is unlikely that it will do so at all in 2020. As long as monetary policy remains accommodative, the economy will keep expanding, the equity bull market will roll on, and spread product will continue to generate excess returns over Treasuries and cash. When China Gets Locked Down It has long been said that when the US sneezes, the rest of the world catches a cold. Conversely, challenges in the rest of the world often fail to leave much of a mark on the US. Should US investors really be that concerned about a virus outbreak in China? The answer is yes, despite the S&P 500’s surge last week. There is no such thing as full-on decoupling, even for the US. The US may respond to global events with a longer lag than more export-oriented economies, but they eventually have an impact. Investors should bear in mind that the S&P 500 is considerably more attuned to global conditions than the domestic economy, given that more than a third of its revenues come from abroad. The coronavirus outbreak has turned into the main source of market uncertainty and is the largest risk to our bullish view on global growth and risk assets. For now, our base case is that the global growth recovery will be delayed, though we expect growth will pick up later this year, provided that the outbreak begins to recede by the end of March. That base case is heavily data-dependent, however, subject to the disease’s course and the Chinese government’s response. From a market perspective, tracking the number of new infections may provide a window on investor sentiment. In 2003, the bottom in equities coincided with the peak in the number of new SARS infections (Chart 2). However, a direct analogy between 2003 and 2020 may underplay the impact on growth. China exerts a lot more influence on the global economy than it did at the turn of the millennium (Table 1). A turn in investor sentiment may not be enough to support risk assets in the face of a significant growth headwind. Chart 2Infections Peak, Market Troughs Infections Peak, Market Troughs Infections Peak, Market Troughs Table 1China’s Importance Now And In 2003 Back To The Grind Back To The Grind Since it entered the World Trade Organization in 2001, China has grown from being the sixth-largest economy to the second, trailing only the US. It now accounts for 16% of global GDP in dollar terms. Its total imports of goods and services – the main growth transmission mechanism from China to the rest of the world – currently account for 13.5% of global trade, three times its 2002 share. The scale of the Chinese government response is also very different. While the SARS epidemic caused relatively mild disruptions to the travel and retail sectors, quarantines have put some areas in total lockdown, placing meaningful elements of the country’s overall production on indefinite hold. That’s bad enough from a domestic perspective, but it could swiftly lead to a sharp reduction in global manufacturing output if it derails global supply chains that depend on Chinese-produced components. Last week, Hyundai idled a production line in South Korea for lack of essential China-sourced parts, and Fiat Chrysler has warned that it might have to close a European factory in two to four weeks if critical Chinese suppliers are not able to operate. China exerts considerably more influence on the global economy today than it did in 2003.  Extended quarantines will have a readily observable impact. Chart 3Services Now Account For A Majority Of Chinese Output Services Now Account For A Majority Of Chinese Output Services Now Account For A Majority Of Chinese Output Moreover, this time around the outbreak coincided with the Lunar New Year celebration, when spending on services is usually elevated. Services engender less pent-up demand than durable goods; while demand for durables may merely be deferred until the epidemic is contained, demand for services is much more likely to be destroyed. Nonmanufacturing sectors’ increasing importance in the Chinese economy (Chart 3) implies that relative to 2003, less "lost" spending will be made up later. Using SARS’ impact on Chinese GDP to support a back-of-the-envelope estimate, our Global Investment Strategy colleagues judge that the coronavirus could zero out Chinese growth in the first quarter. Our Global Fixed Income Strategy service estimates that major country sovereign bonds are pricing in two months of lost Chinese growth. The prospect of a stagnant two to three months could well force policymakers to focus exclusively on encouraging growth. They have already signaled they will pull forward some scheduled infrastructure investments, and our China strategists note that 2020 is policymakers’ deadline for meeting their target to double GDP over the decade. Bottom Line: The coronavirus outbreak is a serious threat to the global economy and financial markets, but we do not expect that it will induce a US recession or S&P 500 bear market. The Same Old Earnings Song-And-Dance Chart 4A Typical Quarter Back To The Grind Back To The Grind With 305 of the companies in the S&P 500 having reported earnings through last Thursday’s open, the fourth quarter appears to be nearly exactly like the first three quarters. Earnings growth was nothing to write home about, but it’s tracking to be a few percentage points better than expected when the big banks kicked off reporting season (Chart 4). Revenue growth continues to be in step with nominal global GDP growth, but profit margins are contracting at about the same rate that they did in the first three quarters (Chart 5). The source of the margin contraction remains a mystery, and unraveling it is near the top of our research to-do list. Chart 5The Incredible Shrinking Profit Margin Back To The Grind Back To The Grind Earnings don't matter much in the near term, but they've been good enough to allay the undercurrent of worry that was a prominent feature of the equity market all of last year. We have previously written about earnings’ limited effect on equity prices.1 In the near term, moves in the S&P 500 exhibit little to no correlation with either earnings growth or the magnitude of earnings beats. Earnings do matter in the long term, and the uneventful 4Q19 reports at least suggest that stocks give no indication of falling off their currently projected path. As has been the case throughout 2019, the bears’ worst fears failed to come to pass in the fourth quarter. Once the coronavirus is contained, accommodative monetary conditions should help keep them at bay in 2020, as well. Follow The Money The big banks reported their fourth quarter earnings in mid-January, and the market reaction suggested their torrid fourth quarter run has fully played out, at least until long yields perk up again. Our review of their earnings calls is not meant to tell us anything about bank stocks, however. We review the calls to gain some insight into the lending market and where it might be headed, seeking color on banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. This time around, we also wanted to hear if the brand-new CECL (Current Expected Credit Loss) loan-loss provisioning standard could constrain lending. 4Q19 Big Bank Beige Book As a group, the banks were constructive on the economy.2 They agree that the consumer is in fine fettle, and they see signs that corporate confidence is returning as trade tensions recede. Overall loan growth has dipped to 4% on a year-over-year basis (Chart 6), while corporate and industrial (C&I) loan growth has contracted on a thirteen-week basis (Chart 7). The C&I contraction is not a sign that corporations are circling the wagons, however, it’s simply that they’ve turned to the corporate bond market instead (Chart 8). Businesses seeking credit generally have access to all they want at tight spreads, given the paucity of yield in the ZIRP/NIRP era. Chart 6Overall Bank Lending Is Decelerating, ... Overall Bank Lending Is Decelerating, ... Overall Bank Lending Is Decelerating, ... Chart 7... And C&I Lending Is Contracting, ... ... And C&I Lending Is Contracting, ... ... And C&I Lending Is Contracting, ... Chart 8... But The Bond Market Is Capable Of Picking Up The Slack ... But The Bond Market Is Capable Of Picking Up The Slack ... But The Bond Market Is Capable Of Picking Up The Slack Positive operating leverage was a mantra that all of the management teams recited. Branch footprints are being rationalized, and the biggest banks are successfully automating manual tasks and driving mundane activity to websites and apps and away from branches and ATMs. Shrinking branch counts could intensify the pressure at the margin for retail landlords, and automation could squeeze bank head counts. Every bank grew deposits faster than loans, furnishing them with dry powder for future lending, and padding their holdings of Treasury and agency securities in the meantime. Households And Businesses [S]entiment on the corporate side appears to be looking better. We’re going to be signing [the Phase I] trade agreement with China today, … and the US-Mexico-Canada agreement is well on its way. So I think that some of that uncertainty that might have been impacting discretionary spend on the commercial side of the equation has been alleviated. [W]e feel pretty good. (Dolan, USB CFO) Every bank cited trade tensions as a drag on corporate confidence last year, and pointed to USMCA and the Phase 1 agreement with China as a sign that it will rebound. [T]he US consumer remains in very strong shape, … from a credit perspective, sentiment, [and] spending, [and] obviously [the] labor market is very strong[.] [C]apital spending is still a bit soft, but sentiment is … certainly better than it was six months ago. [B]roadly speaking, [we have a] constructive outlook as we’re heading into 2020[.] (Piepszak, JPM CFO) [T]hroughout the year, we saw … a lot of things out there that [were] driving uncertainty, be it the lack of the China trade deal, USMCA, Brexit, Hong Kong and … now … the horizon looks like some of those things may clear[,] … and we [may] get a bit more action out of the C-suite. [T]he [capital markets] backlog looks pretty good[,] … [a]nd the forward calendar [does, too]. (Corbat, C CEO) [C]ustomers [in our consumer business] are coming off a strong [spending] finish in 2019. In addition, there’s good loan demand, … result[ing] from good employment levels and growing wages. We saw solid loan demand in our commercial client base throughout the year, [though it] moderated in the second half of the year as worries about global economic uncertainty … dragged on. Today we see some resolution of those issues and that combined with continued consumer strength leads us to expect to see businesses continue their solid activity and we’re hearing more optimism. All this provides a great backdrop[.] (Moynihan, BAC CEO) Borrower Performance Overall credit quality indicators in our commercial portfolio remained strong with our fourth quarter internal credit grades at their strongest levels in two years. Non-accrual loans … in the fourth quarter [were at] their lowest level in over ten years. (Shrewsberry, WFC CFO) [Credit quality metrics] show … that asset quality remained strong in [consumer and commercial] categories. (Donofrio, BAC CFO) [C]redit quality was stable in the fourth quarter. … The ratio of non-performing assets … improved linked quarter and year-over-year. (Dolan, USB) [CLO is] still an asset class that we feel comfortable with the risk/reward … in spite of where we are in the cycle[.] (Shrewsberry, WFC) [There’s nothing] we’re overly concerned about [in our own loan portfolio], given how [conservatively] we manage [lending], but we’re certainly paying attention to leveraged lending. We’re certainly paying attention to energy with respect to natural gas prices, we’re certainly looking at retail … malls. (Donofrio, BAC) CECL Impacts We would expect provisions to be a little higher than net charge-offs in 2020 due to CECL. … All else equal, [the new increased provision] would lower our Common Equity Tier 1 capital ratio by roughly 20 basis points[, but we have a sizable capital buffer, and the capital charge] is phased in … evenly through 2023. (Donofrio, BAC CFO) [I]t’s fair to say, under CECL, [that] you could have incremental volatility [of provisioning expenses]. [But] incremental volatility would [not] be material for us. … It’s just timing [of expense recognition, not any increase in expenses.] (Piepszak, JPM) [A]t this point, it’s not likely that [CECL would] change our appetite for longer-duration consumer loans[.] … [I]t hasn’t caused anything to drop below a hurdle level that says to us, we need to either meaningfully reprice it or … [consider] whether [we want to be] in the business. (Shrewsberry, WFC) Investment Implications Chart 9US Data Have Also Weighed On Yields US Data Have Also Weighed On Yields US Data Have Also Weighed On Yields The coronavirus outbreak is a serious threat, but its very seriousness is likely to provoke Chinese policy responses that may better ensure a turnaround once it can be brought under control. Our view is subject to the real-time course of events on the ground, but our base case is that the business cycle and the bull markets in risk assets remain intact, even if they may sputter here and there until the epidemic is brought to heel. While we acknowledge that economic data have been spotty, and the decline in Treasury yields has not solely been a function of coronavirus fears (Chart 9), we think that yields are near the bottom of their likely 2020 range and have more scope to rise than fall from current levels. We continue to recommend below-benchmark duration positioning. We also continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond portfolios. We would relish the chance to buy an S&P 500 dip to 3,000 if it were to occur when the coronavirus threat appeared to be manageable.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Footnotes 1 Please see the November 11, 2019 US Investment Strategy Weekly Report, "Why Bother With Earnings?" available at usis.bcaresearch.com. 2 The calls were all held before the coronavirus outbreak.