Sectors

This week we upgraded the S&P railroads index to neutral locking in 6.4% in relative gains since inception. The defensive nature of rails is most evident in industry pricing power (third panel). Railroad selling prices are holding their own despite a sizable drop in volumes. Moreover, CEOs exercised caution and refrained from adding to headcount. Taken together, they are boosting our profit margin proxy, which can serve as a catalyst to lift relative share price momentum out of its recent funk (second panel). Similarly, our three factor S&P rail EPS growth model is heralding a pickup in profits in the back half of the year (bottom panel). Bottom Line:  Lift the S&P railroads index to neutral. Please refer to the most recent Weekly Report for the headwinds that prevent us from going overweight rail stocks.  

Special Report

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

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

In lieu of the next weekly report I will be presenting the quarterly webcast ‘Leaving The Euro Would Be MAD, But Mad Things Can Happen’ on Thursday 14 May at 10.00AM EDT (3.00PM BST, 4.00PM CEST, 10.00PM HKT). As usual, the webcast will take a TED talk format lasting 18 minutes, followed by live questions. Don’t miss it. Highlights For the time being, stick with the very successful strategies of: Overweighting higher yielding US T-bonds versus negative yielding German bunds and Swiss bonds. Overweighting technology and healthcare versus banks and materials. Overweighting growth versus value. Overweighting the S&P 500 versus the Eurostoxx 50. Overweighting Germany, France, and Switzerland in a European equity portfolio. The big caveat is that these strategies are highly correlated. Fractal trade: long euro area personal products versus healthcare. Feature Chart I-1Bond Yields And Commodity Prices Are Correlating To One Chatting with friends, family and clients it seems that our lives under lockdown and social distancing have lost much of their differentiation across time and space. Wherever in the world we live, whatever we do, our days and lives are correlating to one. Interestingly, the financial markets have experienced a similar loss of differentiation. In the coronavirus world, markets are also correlating to one. Financial Markets Are Not Complicated One of our abiding investment mantras is that: Financial markets are complex, but they are not complicated. The words complex and complicated are sometimes used synonymously, but they mean different things. Complex means something that is not fully predictable or analysable. Complicated means something that is made up of many parts. Financial markets are not complicated. The financial markets are not complicated because a few parts drive the relative prices of everything, though these parts themselves are complex. Identify and understand these few parts and you will get all your investment decisions right: asset allocation, sector allocation, style allocation, regional allocation, country allocation. This has become even more so this year as our response to the coronavirus has correlated all our lives and economic behaviour to one. One fundamental part is the bond yield. The collapse in commodity prices, more than any other real-time indicator, illustrates the demand destruction resulting from coronavirus-induced lockdowns and social distancing. Bond yields have plunged in lockstep with this demand destruction, given the implications for higher unemployment as well as lower inflation – the two key tenets that drive central bank policy (Chart of the Week). The plunging bond yield, in turn, has driven the underperformance of banks (Chart I-2), for two reasons. First, to the extent that a depressed bond yield reflects a low-growth economy, it also reflects a poorer outlook for bank credit growth, which effectively constitutes a bank’s ‘sales’. Second, a depressed bond yield means a flat or inverted yield curve, which squeezes bank net interest (profit) margins. Chart I-2Banks And Bond Yields Are Correlating To One Conversely, the plunging bond yield has signified an environment in which big tech and healthcare equities outperform (Chart I-3 and Chart I-4), also for two reasons. First, big tech and healthcare sales are more protected against a sudden dip in the economy. Second, their cashflows are weighted further into the future, and so their ‘net present values’ rise more when bond yields plunge. Chart I-3Tech (Inverted) And Bond Yields Are Correlating To One Chart I-4Healthcare (Inverted) And Bond Yields Are Correlating To One A declining bond yield also signifies an environment in which basic materials equities underperform, as our first chart powerfully illustrates. So, if you call the bond yield right, you will get your asset allocation between cash and bonds right, but you will also your equity sector allocation right. And if you get your equity sector allocation right you will automatically get your value versus growth style allocation right too. At an overarching level, the value versus growth allocation is nothing more than the performance of value sectors, like banks, versus growth sectors, like big tech and healthcare (Chart I-5). Chart I-5Value Versus Growth = Banks Versus Tech Furthermore, you will also get your regional and country allocation right. This is because each major stock market has distinguishing ‘long’ sectors in which it contains up to a quarter of its total market capitalisation, as well as distinguishing ‘short’ sectors in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint which drives relative performance (Table I-1): Table I-1The Sector Fingerprints Of Major Regional Stock Markets FTSE 100 = long financials and energy, short technology. Eurostoxx 50 = long financials, short technology and healthcare. Nikkei 225 = long industrials, short financials and energy. S&P 500 = long technology and healthcare, short materials. MSCI Emerging Markets = long financials, short healthcare. Specifically, the distinguishing fingerprints of the Eurostoxx 50 and the S&P 500 mean that the Eurostoxx 50 has a 12 percent over-representation to financials and materials at the expense of an 18 percent under-representation to technology and healthcare. It follows that if banks and materials underperform technology and healthcare, the Eurostoxx 50 must underperform the S&P 500. Everything else is irrelevant (Chart I-6). Chart I-6Euro Area Versus US = Banks Versus Tech The same principle applies to the stock markets within Europe. Relative performance comes from nothing more than the stock market’s long and short sector fingerprint combined with sector performance (Table I-2 and Table I-3). Table I-2The Sector Fingerprints Of Euro Area Stock Markets Table I-3The Sector Fingerprints Of Non Euro Area European Stock Markets For example, if healthcare outperforms then its overrepresentation in the stock markets of Switzerland and Denmark means that they must outperform too (Chart I-7 and Chart I-8). Likewise, if technology outperforms, then the technology-heavy Netherlands stock market must outperform (Chart I-9). Chart I-7Long Switzerland = Long Healthcare Chart I-8Long Denmark = Long Healthcare Chart I-9Long Netherlands = Long Tech All Investment Strategies Are Highly Correlated To repeat, financial markets are not complicated. If you get the over-arching decision(s) right, you will get everything right. The unfortunate corollary is that if you get the over-arching decision wrong you will get everything wrong. Asset allocation, sector allocation, style allocation, regional allocation, and country allocation are correlating to one. We really wish that financial markets were more complicated – because then asset allocation, sector allocation, style allocation, regional allocation and country allocation would be independent investment decisions which offered diversification at the total portfolio level. But the charts in this report should make it crystal clear that all these separate decisions are correlating to one. They are all really the same decision. Today, the decision on where bond yields are headed is particularly tough because they have already come down a lot in a very short space of time. Yet we do not foresee a sustained backup in yields for three reasons: First, even if governments ease lockdowns and reopen economies, demand will remain depressed. Most people are isolating themselves or socially distancing not because their governments are forcing them to, but because they fear infection. The easing of lockdowns, per se, will not remove that fear. And if workers are forced back into jobs when it is unsafe, then infection rates will start to rise again. Second, unless commodity prices rise sharply in the coming months the base effect of commodity prices will put downward pressure on 12-month inflation rates later in the summer (Chart I-10). To the extent that central banks focus on – and target – these totemic annual inflation rates, it will be very difficult to turn hawkish. On the contrary, there may be pressure to turn even more dovish. Chart I-10The Base Effect Will Weigh On Inflation Later This Year Third, our most trusted technical indicator is not flashing the red signal that bonds are dangerously overbought, as they were in January 2019, August 2019, and early-March 2020 (Chart I-11). Chart I-11Bonds Are Not Yet At A Technical Tipping Point So, for the time being, we are sticking with the very successful strategies of: Overweighting higher yielding US T-bonds versus negative yielding German bunds and Swiss bonds. Overweighting technology and healthcare versus banks and materials. Overweighting growth versus value. Overweighting the S&P 500 versus the Eurostoxx 50. Overweighting Germany, France, and Switzerland in a European equity portfolio. The big caveat is that these strategies are highly correlated. Fractal Trading System* With markets correlating to one, it is becoming more difficult to find trades which are not correlated with the over-arching driver. Hence, this week’s recommended trade is a pair-trade between two defensive sectors: long euro area personal products versus healthcare. The profit target is 7 percent, with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-12Euro Area Personal Products Vs. Health Care When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

​​​​​​​We reiterate our mid-April upgrade of the early-cyclical S&P home improvement retail (HIR) index to overweight that is off to a flying start.1 Our three-pronged thesis was predicated upon: the rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics. Last week’s real GDP release made for grim reading, with one notable exception: real residential investment. While business capex took it to the chin, housing related outlays spiked over 20% on a quarter-over-quarter annualized basis, and signal that DIY same store retail sales will prove resilient this spring season (bottom panel). As a reminder, these Big Box retailers are highly levered to the ebbs and flows of residential investment and the latest GDP print will sustain the recent bid under S&P HIR prices (top and middle panels). Tack on the roughly $100/tbf jump in lumber prices since the early-April trough and a profit driven outperformance phase looms.  Bottom Line: We reiterate our recent upgrade to overweight in the S&P HIR index. 1  Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.  

Highlights The current pace in the recovery of China’s domestic demand has not been robust enough to fully offset the impact from the collapse in exports. The level of industrial inventory jumped to a five-year high, but it will likely be transitional. We expect the inventory overhang to subside when the recovery speed in demand catches up with supply in H2.  While the gap is widening between stock prices and economic fundamentals in the US, Chinese equity prices have been more “well behaved” in the past month. We continue to overweight Chinese stocks in the next 6 to 12 months and favor Chinese onshore corporate bonds overall and SOEs in particular. Feature China’s Caixin and official PMIs in April highlighted the knock-on effects on the Chinese economy from a collapse in external demand. Although China’s domestic economy continued its rebound, the pace of the improvement has not been robust enough to offset rapidly weakening exports. This was evident in the widening gap between supply and demand in April. The sharp contraction in the global economy in Q1 will likely deepen in Q2 because the lockdowns in Europe and the US started in the later part of Q1 and have mostly remained in place through end-April. We expect global demand to significantly worsen in April and May, generating strong headwinds to China’s near-term recovery. Chinese authorities have been prompted to step up their stimulus efforts due to a fast deterioration in global growth. The government recently approved an additional 1-trillion yuan in local government special-purpose bond issuance, which is scheduled to be fully dispersed by the end of May. China’s stimulus, strongly focused on boosting investment and economic growth, should fuel Chinese stock and industrial metal prices in the next 6 to 12 months. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Chart 1Construction Sector Has Seen The Strongest Rebound China’s domestic demand partially offset a collapse in exports in April. The official manufacturing PMI slipped to 50.8 in April from 52 in the previous month. The Caixin PMI survey, which is skewed towards smaller and more export-oriented firms, returned to contractionary territory in April following a brief rebound in March. The retreat in both PMI readings highlights how a worldwide lockdown of businesses has shaken China’s manufacturing sector (Chart 1, top panel). This exogenous negative impact will likely worsen in Q2. China's domestic economy continued its slow recovery through April. The official PMI’s new orders subcomponent declined by only 2 percentage points, despite a collapse of new export orders to 33.5. Moreover, the new orders subcomponent of the non-manufacturing PMI survey increased from 49.2 to 52.1, with the construction subcomponent reverting to its pre-pandemic level. The construction employment subcomponent also confirms that the industry has shown the strongest rebound among sectors in the Chinese economy (Chart 1, middle and bottom panels). Chart 2Home Sales Are Likely To Accelerate China’s housing market also continued to improve in April. Chart 2 (top panel) shows that the demand for both residential housing and floor space started rebounding in March. The high frequency data indicate the year-over-year growth rate in home sales in China’s 30 large- and medium-sized cities turned positive in April (Chart 2, middle panel). The rapid expansion in home sales in the past weeks may be due to recent discount promotions, but we anticipate housing prices to remain stable this year in line with the Chinese leadership’s policy direction (“houses are for living, not for speculation”). We also expect that the number of home sales will accelerate.  Local governments will significantly ramp up land sales this year to make up for their large revenue shortfalls.  The central government will continue to gradually relax real estate purchase restrictions. The more property market-friendly policies, coupled with extremely accommodative monetary conditions, will encourage a healthy rally in property market investment and housing demand in H2 (Chart 2, bottom panel). So far most improvement in China’s domestic demand seems to be concentrated in the construction sector.  The slow pace of manufacturers’ capacity utilization suggests that China’s industrial output growth is unlikely to return to its pre-pandemic rate in Q2. As of April 25, among the official PMI surveyed enterprises, the resumption rate of large- and medium-sized enterprises was 98.5%. However, only 77.3% of them reported that they were operating at 80% or higher of their usual capacity utilization rates.1 Chart 3Pressure On Inventory Should Start To Ease In H2 The imbalance in the recoveries of China’s supply and demand has led to a pileup in inventory, the highest level in five years (Chart 3).  The combination of excessive inventory and low demand has weakened China’s factory pricing power and profit growth. However, in our view, the inventory overhang will be temporary, and the factory price contraction is unlikely to turn into a deep deflation such as the one in 2009 or the long-lasting deflationary cycle from 2012-2015. The level of industrial inventory has been much lower than it was during the four years leading to the 2008/2009 global financial crisis (GFC) and the 2015/2016 deep deflationary cycle. The deflation in factory prices also has been relatively mild compared with the two previous phases. Moreover, an extremely tight monetary policy and protracted inventory destocking period that contributed to the collapse in global raw material prices in 2012 are not present. Declines in China’s manufacturing, raw material and mining prices are synchronized, echoing the GFC when global demands nose-dived and pushed international oil and raw material prices into deep contractions. Our baseline scenario of an incremental re-opening of the global economy, a peak in the US dollar, and a recovery in the oil market in H2, all support our view that the deflation in China’s producer prices should not last beyond Q3. Given that exports’ share to China’s GDP is currently half of what it was in 2008, the weakness in global demand will be much less of a drag on China’s domestic manufacturing sector than during the GFC. Chart 4Logistics Bottleneck Still In Place Additionally, the drawdown in April’s raw material inventory and an increase in the official PMI’s supplier delivery subcomponents suggest that some lingering logistical bottlenecks may be at play, preventing China’s domestic business operations from recuperating at full speed (Chart 4). We expect a further relaxation of intra- and inter-provincial travel restrictions following the National People’s Congress (NPC) on May 22 in Beijing. This easing should help to accelerate the normalization in both manufacturing activities and inventory levels. The outperformance of Chinese equity prices versus global stocks has eased significantly in the past month (Table 3 and Chart 5). The moderation suggests that investors may be starting to factor in a slower-than-expected economic recovery in China. Near-term risks are still high for further selloffs in both Chinese and global stocks. Nevertheless, we think the rapid advancement in global stock prices in the past month, particularly the SPX, means that Chinese stocks are not as overbought as in February and March. The widening gap between US equity prices and economic fundamentals makes the SPX more vulnerable to near-term uncertainties surrounding global economic recovery. We maintain our view that a combination of massive Chinese stimulus and the momentum in China’s economic recovery in H2 should support an outperformance in Chinese stocks in the next 6 to 12 months. Table 3Chinese Stocks Advanced Much Less Than SPX In April Chart 5Chinese Stocks Less Overbought Now The bull steepening in the government bond yield curve since March 23 flattened a bit in the last week of April, but it remains heightened with the short end of the yield curve falling much faster than the long end (Chart 6). This suggests that domestic investors expect China’s ultra-easy monetary policy to remain in place in the near term due to uncertainties surrounding the global pandemic and a slow economic upturn. At the same time, investors do not believe the weakness in the Chinese economy will persist long enough to warrant a sustained easy monetary policy regime. In addition, China’s 10-year government bond yield fell by 60bps so far this year, about half of the drop in the 10-year US Treasury bond yield (Chart 6, bottom panel). Even though we think the long end of the government bond yield curve has yet to bottom,2 the relatively stable return and RMB exchange rate make Chinese government bonds a safe bet for global investors seeking less risky assets. Chart 6Chinese 10-Year Government Bond Yield Has Not Capitulated Chart 7Chinese Onshore Corporate Bonds Still Offer Solid Returns Chart 7 highlights that the ChinaBond Corporate Bond total return index remains in a solid uptrend in both local currency and USD terms, despite the incredible strength in the USD since March. We continue to recommend onshore corporate bond positions in the coming 6-12 months.For domestic investors, we favor a diversified portfolio of SOE corporate bonds. Even though bond defaults will likely rise in the next 6-12 months, they will probably remain lower than what the market is  currently pricing in.     Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1NBS’s interpretation of China April PMI.  http://www.stats.gov.cn/tjsj/sjjd/202004/t20200430_1742576.html  2Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Yesterday our 10% rolling stop got triggered on the long S&P oil & gas exploration & production (E&P)/short global gold miners pair trade. We are compelled to reinstate this intra-commodity pair trade, despite the explosive one week return, as neither the macro backdrop nor relative profit fundamentals changed. Importantly, the Fed’s determination to quash volatility is a powerful source of further gains in the relative share price ratio as the oil/gold ratio should regain its footing (volatility shown inverted, bottom panel). In addition, more and more states and a rising number of countries are setting the groundwork to reopen their economies. This should absorb some of the excess oil supply and also push real yields higher, both of which are a boon for relative share prices.  Bottom Line: While we locked in gains of 10% in a mere week on the long S&P E&P/short global gold miners pair trade, we are compelled to reinstate this intra-commodity pair trade. When it hits the 20% return mark anew, it will trigger a 10% rolling stop as a way to protect profits for our portfolio. For additional details please refer to the April 27th Weekly Report.  

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