U.S. SECURITIES AND EXCHANGE COMMISSION

U.S. SECURITIES AND EXCHANGE COMMISSION

Division of Economic and Risk Analysis

DERA

Economic

and Risk

Outlook

S.P. KOTHARI

Director and Chief Economist

and

DERA Research Staff

JULY 15

2020

Table of Contents

Key Highlights...................................................................................................................................1

The Path of New COVID-19 Cases Is Uncertain.............................................................1

The Impact of COVID-19 Across Sectors Remains Uneven......................................1

The Recent Paths of the Economy and the Stock Market Have Diverged........2

Market Signals Suggest Sustained Low Interest Rates Going Forward.............3

Financial Market Risk Proxies Remain Elevated.......................................................... 4

Macro-Financial Overview...........................................................................................................5

Economic Fundamentals and Growth.............................................................................5

Monetary Policy and Interest Rates..................................................................................8

Financial Market Signals..................................................................................................... 12

Market Segments.......................................................................................................................... 15

Markets...................................................................................................................................... 15

Mutual Fund, ETF and Money Market Fund Investors............................................. 17

Borrowers, Securities Issuers, and Capital Formation............................................20

Spotlights........................................................................................................................................ 25

Credit Ratings, Procyclicality and Related Financial

Stability Issues: Select Observations............................................................................ 25

U.S. Investors’ Exposure to Domestic Chinese Issuers............................................ 31

The Division of Economic and Risk Analysis (DERA) advances the Commission’s statutory mission to protect

investors, maintain fair, orderly, and efficient markets, and facilitate capital formation through sound economic

analysis and rigorous data analytics. DERA engages across the entire range of the agency’s functions, including

rulemaking, examination, and enforcement. Its multi-disciplinary analyses are informed by research insights and

they rely on the knowledge of institutions and practices when examining regulatory and risk-related matters. DERA

assists the Commission in its efforts to identify, analyze, and respond to economic and market issues, including

those related to new financial products, investment and trading strategies, systemic risk, and fraud. DERA’s data

analytics work develops a variety of financial and market data analysis tools, gathers economic statistics, and

promotes data standards. DERA economists publish regularly in top peer-reviewed journals, including the Journal

of Financial Economics, the Journal of Labor Economics, and the Review of Financial Studies.

DERA Research Staff: Chandler Lutz (Lead Economist), Giulio Girardi, Chunfang Yang, Gregory Allen, Daniel

Hiltgen, Vladimir Ivanov, Andy Kim, Igor Kozhanov, and Pamela Urban.

OPA Design Team: Chris Gamboa-Onrubia, Zehra Sikandar, and Jennifer White.

Disclaimer: The SEC disclaims responsibility for any private publication or statement of any SEC employee or

Commissioner. This article expresses the authors’ views and does not necessarily reflect those of the Commission,

the Commissioners, or members of the staff. This report contains a non-exhaustive aggregation of information and

is one of several elements of the SEC’s risk and market monitoring efforts.

sec.gov/dera

Key Highlights as of June 30, 2020

U.S. Economic Activity Is Resuming Following the COVID-19 Induced Economic Slowdown:

As the rate of new confirmed U.S. COVID-19 cases fell in April and May 2020, policymakers

began a phased-in reopening of certain local economies. This reopening has allowed

economic activity to resume in the hardest hit industries, with employment recovering

slightly in these sectors. Moreover, since peak financial market distress in March 2020, the

S&P 500 increased 35% from March 23 to June 26, equity market volatility as proxied by

the VIX index fell from March highs, and credit conditions eased. Yet material uncertainties

remain: New confirmed COVID-19 cases are rising again after previously trending downwards,

unemployment remains high, and financial risk proxies, such as the VIX index and the

corporate default spread, remain elevated.

The Path of New COVID-19 Cases Is Uncertain

After Falling for Several Weeks, the Rate of New U.S.

COVID-19 Cases is Again Trending Upwards: The number

of new confirmed COVID-19 cases peaked at over 210,000

per week in April 2020 and then dropped to a weekly rate of

less than 150,000 by mid-June (Figure 1.1). Similarly, newly

reported deaths dropped to a rate below 5,000 per week

after reaching more than 15,000 per week in mid-April. The

declining rate of new COVID-19 cases and deaths allowed

policymakers to begin a phased-in reopening of certain local

economies. Yet data as of June 26 show that the number of new confirmed COVID-19 cases has risen to

a weekly rate of more than 250,000, highlighting uncertainty over the impact of COVID-19 going forward

and prompting some local and state authorities to revert or delay reopening protocols as a response.

The Impact of COVID-19 Across Sectors Remains Uneven

The Industries that Suffered the Largest Employment Losses

Through April 2020 Gained Back More Jobs as Local

Economies Began to Reopen in May: Employment in food

services, one of the hardest hit sectors in the wake of

COVID-19 public health restrictions, fell nearly 50% during

March and April 2020, compared to a 14% decline for U.S.

employment overall (Figure 1.2). In historical context, these job

losses are staggering: During the Great Recession, food service

and total employment fell by just 8.4% and 6.3%, respectively. Other industries suffering from outsized

COVID-19 impacts and severe employment losses include the leisure and hospitality and retail trade sectors.

As local economies have lifted COVID-19 related restrictions and partially resumed activity in displaced

DERA ECONOMIC AND RISK OUTLOOK | 1

sectors, the most affected industries experienced the largest job gains. Food services employment

grew 21.9% during May, compared to 1.9% for U.S. employment overall. Yet employment across

all industries remains substantially below its pre-COVID-19 levels, with overall employment down

12.5% and food services employment having fallen over 35% from January to May 2020.

The COVID-19 Economic Fallout Has

Had An Outsized Negative Effect on the

Equity Returns for the Energy, Financial,

Industrial, Transportation, and Metals

and Mining Sectors, But It Has Had a

Positive Effect on Sectors that Facilitate

Physical Distancing such as Online

Retail: Figure 1.3 proxies COVID-19

equity market impacts by sector, using

exchange-traded fund (ETF) returns

from February 10 to June 26, 2020. The

hardest hit sectors (red lines) include the

energy, financial, industrial, metals and

mining, and transportation sectors. The

energy, industrial, and metals and mining

Figure Notes: Red lines are the five industries with the lowest (most negative)

sectors have faced large demand declines,

returns from February 10 to June 26, 2020. Green lines are the top performing

while oil firms have been further impacted

industries in terms of returns from February 10 to June 26, 2020. Data source:

Datastream.

by increased price and supply competition.

Financial companies are facing uncertainty related to borrower debt service, the ability to generate

new business due to COVID-19 induced economic turmoil, and Federal Reserve mandated dividend

and share buyback restrictions intended to boost bank capital. Likewise, physical distancing is directly

reducing travel and transportation across the country. In contrast, physical distancing and remote

work have benefited companies in several sectors such as online retail, technology, and telecom.

Indeed, ETF prices for these sectors have recovered to at least their pre-pandemic levels, with an

online retail ETF gaining more than 20% from aggregate market highs in February 2020.

The Recent Paths of the Economy and the Stock

Market Have Diverged

S&P 500 Performance Increasingly Depends on the Largest Firms: The S&P 500 is a value-weighted

index that is rebalanced quarterly, meaning each company’s share in the overall index depends on

its market cap during the previous quarter. As a result, larger firms receive higher initial weights,

and better-performing firms are rewarded with increased importance in the index. Thus, when large

firms outperform smaller ones, large firms’ weight in the overall S&P 500 index soars. Indeed, Figure

1.4 documents that the relative market cap share for the 10 largest companies calculated by each

year-quarter rose from 18.1% in 2015Q1 to 27.1% in 2020Q1. Hence, larger firms have recently

outperformed smaller ones, and so the 10 largest firms’ performance is currently responsible for

about one-quarter of the overall S&P 500 returns. Moreover, the sectoral makeup of large firms may

2 | U.S. SECURITIES AND EXCHANGE COMMISSION

contribute at least in part to their recent outperformance in

2020Q1 and 2020Q2. The largest firms in the S&P 500 by

market cap are technology companies with business models

that may be well suited, at least in the near term, to cope

with the economic effects of the COVID-19 pandemic. The

health policies implemented to battle COVID-19 have altered

broader production and consumption patterns towards

remote work, internet shopping, and physical distancing—all

trends that could favor large technology companies, at least in

the short run. Moreover, the largest companies maintained strong balance sheets in the lead-up to the

pandemic, which may have allowed them to avoid seeking short-term funding during the March 2020

tightening in corporate credit markets and to position themselves for strong financial performance.

The Paths of Recent Economic Indicators and Equity Prices

Have Diverged: Although recent economic data have been

weak, with employment down 12.5% from February to

May 2020 (Figure 1.2), equity market performance coming

off recent lows in March 2020 has been notable. Figure 1.5

highlights the divergence between the real economy and the

equity market by plotting the growth in actual values and

forecasts of GDP tabulated by MarketWatch (panel A) and

the S&P 500 (panel B) from 2019Q4. GDP forecasts from

MarketWatch suggest that economic output is expected to

fall about 7.5% by 2020Q2. A rapid GDP decline of this

magnitude is unprecedented; in comparison, during the Great

Recession, GDP fell only 4% from peak to trough over a 2-year period. In contrast, the S&P 500 has

nearly recovered from its March lows, increasing 35% from March 23 to June 26. Several factors in

isolation or in combination may have contributed to the recent run-up in equity prices, including (1)

expectations of a rapid economic recovery in the latter half of 2020, as evinced by the sharp increase

in forecasted economic output (Figure 1.5, panel A); (2) COVID-19 induced increases in the frequency

of internet shopping and remote work—trends that favor large technology firms (Figure 1.3), which

constitute a substantial portion of value-weighted equity indices (Figure 1.4); (3) low expected interest

rates (Figure 1.6) that increase the present value of future profit streams; and (4) perhaps elevated

equity market purchases by retail investors.

Market Signals Suggest Sustained Low Interest

Rates Going Forward

Low Expected Short-Term Interest Rates and Unprecedented Monetary Stimulus Have Coincided

with Historically Low Interest Rates for Governments, Firms, and Households: Since the Federal

Reserve (Fed) lowered the target fed funds rate by 1.5 percentage points to a range of 0–0.25%,

futures market traders now expect the fed funds rate to stay at its zero lower bound into 2022 (Figure

1.6). These low expected interest rates reflect market participants’ expectations that the Fed will hold

DERA ECONOMIC AND RISK OUTLOOK | 3

interest rates low in both the short- and medium-term to

counter the COVID-19 induced economic slowdown. Along

with low short-term interest rates, the Fed has announced

unprecedented monetary stimulus via unlimited purchases

of U.S. Treasury and agency mortgage-backed securities

(MBS), as well as numerous facilities to provide liquidity

and further monetary stimulus in corporate credit and other

markets. Following these actions, a broader easing of credit

market conditions and perhaps concerns over the path of

the economic recovery, borrowing rates for governments,

households, and firms are now historically low (Figure 1.7).

Indeed, after spiking at the height of COVID-19 induced

economic distress, both mortgage rates and corporate bond

yields have returned to their pre-pandemic levels, with

mortgage rates reaching all-time lows. In Treasury markets,

the yield on the 10-year Treasury declined over 50 basis points

relative to early February, perhaps reflecting an investor flight

to safety as well as Fed monetary actions.

Financial Market Risk Proxies Remain Elevated

The Corporate Default Spread and the VIX Index Have

Declined from their COVID-19 Induced Highs but Have

Not Returned to their Pre-COVID-19 Levels: After spiking

during the peak of COVID-19 related financial distress in

late March, two broad proxies of financial market risk, the

corporate default spread (Baa - Aaa bond yields) and the VIX

index (equity market uncertainty) have recently fallen (Figure

1.8). The reduction in these risk proxies indicates that previous

financial market tightness and uncertainty have eased. Yet

both indices remain well above their pre-COVID-19 levels,

suggesting that material uncertainties remain.

Data Sources: Figure 1.1: The New York Times, based on reports from state and local health agencies (available at https://

github.com/nytimes/covid-19-data); and Johns Hopkins University CSSE (available at https://github.com/CSSEGISandData/

COVID-19). Figure 1.2: Bureau of Labor Statistics (BLS), retrieved from The Federal Reserve Economic Database

(FRED) (IDs: PAYEMS, CES7072200001). Figure 1.3: Datastream. Figure 1.4: Compustat and Wharton Research Data Services

(WRDS). Figure 1.5: Bureau of Economic Analysis (BEA), retrieved from FRED (ID: GDPC1), and “Marketwatch Economic

Calendar” available at https://www.marketwatch.com/economy-politics/calendar. Figure 1.6: Fed Board, retrieved from FRED

(ID: DFF), and Datastream. Figure 1.7: Moody’s, retrieved from WRDS; Freddie Mac and Fed Board, retrieved from FRED (IDs:

MORTGAGE30US, DGS10). Figure 1.8: Moody’s, retrieved from WRDS; Chicago Board Options Exchange (CBOE), retrieved from

FRED (ID: VIXCLS).

4 | U.S. SECURITIES AND EXCHANGE COMMISSION

Macro-Financial Overview

The macro-financial environment is encapsulated in three key aggregate drivers of financial

decisions: (1) economic fundamentals and growth; (2) monetary policy and the interest rate

trajectory; and (3) financial market signals and credit conditions.

Economic Fundamentals and Growth

Key Takeaway: In the wake of peak of COVID-19 related financial distress in late March,

the U.S. unemployment rate increased to 14.7% in April 2020, and economic output

declined substantially. The U.S. reached peak business cycle activity in February 2020

before entering a COVID-19 induced recession that has had outsized adverse

employment effects on the leisure and hospitality and retail trade sectors. Likewise,

consumer confidence has tumbled, and proxies for durable consumption purchases

remain weak. Economic growth is forecasted to turn positive again by 2020Q3.

The number of new confirmed COVID-19 cases peaked at over

210,000 per week in April 2020 and then dropped to a weekly

rate of less than 150,000 by mid-June (Figure 2.1). Similarly, newly

reported deaths dropped to a rate below 5,000 per week after

reaching more than 15,000 per week in mid-April. The declining

rate of new COVID-19 cases and deaths allowed policymakers to

partially reopen certain local economies. Yet data as of June 26 show

that the number of new confirmed COVID-19 cases has risen to a

weekly rate of more than 250,000, highlighting uncertainty over the

impact of COVID-19 going forward.

To fight the COVID-19 pandemic, local and federal U.S. policymakers

issued stay-at-home guidelines for nonessential workers and

encouraged physical distancing. Although health experts deemed

such actions as necessary for public health, they severely limit

everyday economic activities. Figure 2.2 plots real quarterly gross

domestic product (GDP) dating back to the Great Recession, as well

as forecasted GDP for 2020Q2–Q4 (median forecasts tabulated by

MarketWatch). While the U.S. economy was consistently expanding

at a 2–3% annual rate prior to COVID-19, during the first half of 2020 forecasters expect GDP to fall

over 7.5% from its peak in 2019Q4. Indeed, the National Bureau of Economic Research (NBER) Business

Cycle Dating Committee announced that the peak in U.S. economic activity occurred in February 2020

and that a recession began thereafter. Assuming that the economy would have otherwise grown at 2%, the

lost economic output due to the COVID-19 outbreak just through 2020Q2 will be nearly $460 billion. In

historical terms, a two-quarter GDP drop of this magnitude is unprecedented. During the Great Recession

of 2008–09, GDP from peak to trough fell only 4%.

DERA ECONOMIC AND RISK OUTLOOK | 5

As local economies reopen, the severity of the COVID-19 economic damage will hinge on how

quickly the United States and its principal trading partners can resume normal economic activity

in whole or in part. Many factors will determine the time for recovery, including frictions in labor

market search and matching, firm failures, housing and mortgage market activity, consumer

confidence and spending, as well as behavioral changes that are a direct result of the pandemic.

Indeed, the resumption of economic activity will require a recommencement of both supply and

demand. As firms restart production, households might be hesitant to venture out to consume

available output, while physical distancing practices may alter both production and consumption

patterns with cascading effects across various industries. For example, when restaurants reopen,

unless customers walk in to dine in those establishments in the same numbers or with the same

frequency as before the slowdown, economic activity will not match pre-COVID-19 levels.

Likewise, an acceleration of remote work, for example, may move production from urban

clusters to suburban areas, with geographic implications for real estate prices, local retail and

restaurant spending, as well as travel and transportation. Households may also not quickly

return to their normal pre-COVID-19 consumption patterns because of the economic fallout of

the pandemic. If severely affected consumers only slowly regain employment or if their savings

dwindled as the economy contracted, they may forego some durable purchases immediately after

the crisis. Nonetheless, forecasts as of mid-June collected by MarketWatch (see Figure 2.2) expect

the United States to register robust economic growth at an annual rate of 18% in 2020Q3 and

10% in 2020Q4, but with output remaining below pre-COVID-19 levels at year-end.

The sudden and unprecedented impact of the COVID-19 shock

immediately surfaced via the sharp rise in initial unemployment

claims, which reached over 6 million per week in late March and

early April (Figure 2.3). As local economies have reopened and

financial market stress has ameliorated, initial unemployment

claims have fallen to about 1.5 million per week but remain above

their pre-COVID-19 levels.

The substantial number of initial jobless claims corresponded with

a large reduction in total employment and a higher unemployment

rate. Figure 2.4 shows that after non-farm U.S. payrolls peaked at

about 152 million in February 2020, the U.S. subsequently lost over

22 million jobs during March and April. U.S. employment bounced

back somewhat during May, but non-farm payrolls remain 20

million off their February peak. The adverse impact of the recent

economic downturn is also seen in the sharp rise in the U.S.

unemployment rate (Figure 2.5). Following its historically low

levels in 2019 and early 2020, the unemployment rate jumped to

14.7% during April as COVID-19 induced job losses mounted. As

local economies partially reopened in May, the unemployment rate

fell slightly to 13.3% but remains at its highest rate since the Great Depression.

6 | U.S. SECURITIES AND EXCHANGE COMMISSION

COVID-19 has also impacted industries

unevenly, as seen in Figure 2.6, which

plots the growth in employment by

industry from February 2020. The

hardest hit industries (red lines) include

the traditional information (e.g., noninternet publishing, motion picture,

and non-internet broadcasting), leisure

and hospitality, mining and logging,

and retail trade sectors. Employment

growth in the leisure and hospitality

industry is especially depressed, falling

50% with little recovery to date. Because

the number employed and the number

rendered unemployed differ greatly

across industries, each industry has a

Key Figure Takeaway: The COVID-19 induced

different weight in the computation of

recession had the largest adverse employment

U.S. total employment growth. Thus, the

impacts on the information, leisure and hospitality,

classification of U.S. total employment

and retail trade industries.

growth as a bottom performing category

Figure Notes: Red lines are the 5 industries with the lowest (most negative)

in Figure 2.6 (top-left panel) means that job

total employment growth from February to May 2020. Green lines are

losses were highly concentrated in certain

the top performing industries in terms of total employment growth

from February to May, 2020. Data source: BLS, retrieved from FRED

COVID-19 affected industries that employ

(IDs: PAYEMS, USMINE, USCONS, MANEMP, USWTRADE, USTRADE,

a substantial number of people, leading to

CES4300000001, USINFO, USFIRE, USPBS, USEHS, USLAH).

larger employment declines for the United

States overall than for the median industry. The key implication is that in order for the United

States to return to full employment, employment will have to grow markedly from its current low

base in severely affected industries, the share of employment in less affected industries will have to

increase relative to the overall labor force, or a combination of the two. Policies that limit labor

market frictions along these two dimensions will speed economic recovery.

The large employment declines may have also tempered consumer

confidence and stymied durable consumption. Figure 2.7 shows

that the consumer confidence index dropped from 130 to 90, a

35% decline in the wake of the onset of the COVID-19 recession,

with no rebound to date. Similarly, motor vehicle sales, a proxy

for durable goods consumption, sank nearly 50% during February

and April, as jobs losses accumulated and as physical distancing

limited onsite shopping (Figure 2.8). Vehicle sales have recovered

partially in May, but remain substantially below their preCOVID-19 levels. Moreover, a greater reliance on remote work,

which might continue for quite some time, might permanently

dent the demand for automobiles.

DERA ECONOMIC AND RISK OUTLOOK | 7

Monetary Policy and Interest Rates

Key Takeaway: Due to COVID-19 induced financial market distress, the Fed lowered the

target range for the fed funds rate to 0–0.25% and announced unlimited purchases of

Treasury securities and agency MBS. In addition, the Fed, in conjunction with the U.S.

Treasury, initiated various liquidity and purchasing facilities targeting corporate bonds,

small-and medium-sized businesses, municipal securities, asset-backed securities (ABS),

dollar swaps, commercial paper, and repo markets, among others, to provide further

monetary stimulus and battle market illiquidity. As of June 24, 2020, the size of the

Fed’s balance sheet has already surpassed $7 trillion, with U.S. Treasuries constituting

the bulk of the purchases. In line with accommodative monetary policy and a flight

to safety, the Treasury yield curve suggests a low risk-free rate for the foreseeable

future. At the height of COVID-19 induced financial market stress, yields on a variety

of lower rated debt instruments rose as default probabilities increased and market

liquidity fell. Yet as credit conditions eased, yields across debt securities fell and credit

spreads have narrowed but remain higher than pre-pandemic levels.

As the COVID-19 pandemic unfolded, the Fed lowered the

fed funds rate initially by 50 basis points to a target range

of 1–1.25% on March 3, 2020 and then to a target range

of 0–0.25% on March 15, 2020. Figure 2.9 plots the recent

path of the fed funds rate, along with the expected fed funds

rate as implied in futures market prices. Futures traders

expect the fed funds rate to stay at its zero lower bound

into 2022; hence, the Fed’s monetary stance is expected

to remain accommodative as the economy recovers from the

COVID-19 crisis.

Note: More information and term sheets

associated with the Fed’s extraordinary monetary

policy actions can be found at https://www.

federalreserve.gov/newsevents/pressreleases/

monetary20200323b.htm.

To support market liquidity and provide monetary stimulus,

For the most recent Fed press releases,

the Fed also announced unlimited purchases of Treasuries and

see https://www.federalreserve.gov/newsevents/

pressreleases.htm.

agency MBS (both commercial and residential). These largescale asset purchases coincided with the formation of numerous facilities. The Fed programs

include facilities to support liquidity in various markets and target corporate bonds and ETFs in

the primary and secondary markets (rated BBB-/Baa3 or higher as of March 22, 2020, and BB-/

Ba3 at the time of purchase). The programs also target AAA-rated ABS backed by certain loans,

including student loans, auto loans, credit card loans, loans guaranteed by the Small Business

Administration (SBA), commercial mortgages, (leveraged) corporate loans through collateralized

loan obligations (CLOs), or related securities; money market funds; municipalities; and loans to

small- and medium-sized businesses. Fed measures also have consisted of dollar liquidity swap

lines with foreign central banks and lowering the primary credit rate to 0.25% to encourage

banks to borrow from the discount window.

8 | U.S. SECURITIES AND EXCHANGE COMMISSION

With the onset of the

pandemic, the size of the

Fed’s balance sheet rose

substantially. Figure 2.10

plots the change in Fed assets

by category from February

3 to June 24, 2020. While

total assets increased by

$2.8 trillion, the bulk of the

increase has consisted of

Treasury purchases (60%),

agency MBS purchases

Key Figure Takeaway: In response to the COVID-19 pandemic,

(20%), and central bank liquidity

the Fed has increased its balance sheet by about $2.8 trillion.

swap lines (10%). Together,

The increase in Fed assets has consisted mostly of Treasury

these three categories constitute

and agency MBS purchases as well as liquidity swaps with

90% of the total increase in

foreign central banks.

the Fed’s balance sheet. New

unconventional monetary

Figure Data Source: Fed Board

policy tools, such as the purchase

of corporate bonds (“Corporate Credit Facilities”), make up a relatively tiny portion of Fed assets to date.

However, the mere announcement of such Fed programs can have a large impact on markets, even if

purchases have yet to materialize.

While the recent asset

purchases are sizable,

Figure 2.11 places the data

in historical perspective by

showing data going back to

the Great Recession. Following

the Great Recession, Fed

assets grew from just under $1

trillion to approximately $4.5

trillion, an addition of $3.5

trillion, which is larger both

in absolute and relative terms

Figure Data Source: Fed Board, retrieved from FRED (IDs: WALCL, TREAST,

WSHOMCB, WORAL).

than the Fed’s recent actions.

Also, in response to the housing crash and Great Recession, the Fed purchased both MBS and Treasuries in

large numbers, whereas during the response to the current COVID-19 pandemic the increase in Fed assets

has been due mostly to Treasury purchases. As the economic effects of the COVID-19 crisis linger, the Fed

may further increase asset purchases. Indeed, the former head of the New York Fed, Bill Dudley, speculated

that the size of the Fed’s balance sheet may reach $10 trillion by the end of 2020.

DERA ECONOMIC AND RISK OUTLOOK | 9

Despite the recent Fed stimulus, inflation expectations have plummeted. To provide historical

context, Figure 2.12A shows that the core inflation rate rarely reached the Fed’s symmetric 2%

inflation target over the last decade, with the annual inflation rate falling to just 1% in April

2020. Figure 2.12B plots inflation expectations over the next 5 and 10 years from a given point

in time computed from Treasury nominal and inflation protected securities. The graph documents

that prior to the crisis the expected inflation rate typically fluctuated between 1.3% and 2.1%.

However, with the onset of the pandemic, inflation expectations sank; as of April 2020 market

participants expected an average annual inflation rate below 1% over the following 5 years. Since

then, expected inflation has rebounded somewhat, but the anticipated annual inflation rate over

the next 10 years still remains well below the Fed’s 2% target.

Key Figure Takeaway: Following the COVID-19 outbreak, inflation expectations

have declined sharply.

Figure Data Source and Notes: U.S. Treasury, retrieved from FRED (IDs: PCEPILFE, T5YIE, T10YIE). Breakeven inflation rates are

computed from Treasury Inflation-Protected Securities (TIPS) and Nominal Treasury Securities.

The dramatic decline in economic

activity after the COVID-19 outbreak,

the Fed’s large monetary stimulus,

and diminished inflation expectations,

coupled with perhaps an elevated

demand for U.S. Treasury securities,

collectively presage exceptionally

low U.S. Treasury interest rates. Figure

2.13 plots the current yield curve for

U.S. Treasury securities (blue line)

versus its average over the past 10 years

(red line) by maturity horizon. Not only

are rates historically low at the short

end of the yield curve (e.g., for shortterm securities), but they are also low

for longer maturities. Long-term yields

Figure Notes: The blue line is the current Treasury yield curve; the red line

represents the past 10-year average, computed by taking the mean by each

maturity date. For more on Term Premia, see newyorkfed.org/research/data_

indicators/term_premia.html.

Figure Data Source: U.S. Treasury, retrieved from FRED (IDs: DGS1MO, DGS3MO,

DGS6MO, DGS1, DGS2, DGS3, DGS5, DGS7, DGS10).

10 | U.S. SECURITIES AND EXCHANGE COMMISSION

comprise the current short-term rate plus the sum of market participants’ expectations of future

interest rate changes, as well as a term premium (the additional interest that investors demand

in exchange for being locked into a longer-term bond rather than just continuously investing in

short-term bonds). The relatively flat current yield curve suggests that the term premium and

investors’ expectations of future interest rate increases are low.

Although Treasury yields have fallen to historic lows, interest rates

on other assets have not all experienced comparable declines. The

likely reason is that credit risk has risen because of diminished

economic activity following the slowdown. Figure 2.14 documents

that yields on Baa-rated corporate bonds increased beginning in

late March, likely because of elevated default probabilities. From

there, Baa yields fell as market credit conditions loosened and the

Fed, along with Treasury, announced corporate credit liquidity

facilities. Yet the spread between Baa yields and Treasuries remains

well above pre-pandemic levels, congruent with lingering credit

risks. Likewise, Figure 2.15 plots the average 30-year U.S. mortgage

rate and its spread relative to the 10-year Treasury. The 30-year

mortgage rate has declined from about 3.5% in mid-February to

just over 3% in the most recent data.

Mortgage rates represent a key link between financial markets and the real economy, as a

decline in mortgage rates spurs mortgage refinance and purchase activity that often translates

into durable consumption purchases and follow-on real economic activity. While mortgage rates

have fallen, the spread between the average 30-year mortgage rate and the 10-year Treasury

yield jumped more than one-half of a percentage point between February 15 and April 1. This

increase in the spread between the mortgage rate and the Treasury yield is due in part to a glut of

mortgage refinance demand immediately after rates declined and greater uncertainty about the

employment prospects for many mortgagees. In addition, a lack of financial market liquidity also

likely contributed to higher borrowing costs, at least initially following the pandemic outbreak,

across a number of debt instruments, including MBS. Following Fed announcements of further

large-scale purchases of agency MBS and a broader easing of credit conditions, the mortgage-rate

Treasury spread has fallen modestly but is still about a half percentage point above its preCOVID-19 levels.

DERA ECONOMIC AND RISK OUTLOOK | 11

Financial Market Signals

Key Takeaway: In mid-March 2020, at the peak of COVID-19 financial market distress,

the VIX equity market volatility and uncertainty index reached levels last seen during

the Great Recession of 2008-09. The VIX has retreated since then, but remains at

elevated levels. Similarly, the corporate default spread (Baa – Aaa yields), a broad credit

market risk proxy, rose sharply before trending downwards beginning in mid-April, as

credit conditions eased. Yet the corporate default spread remains well above its preCOVID-19 levels. The corresponding higher interest rates for lower rated bonds reflect

higher expected default probabilities from the perspective of bond market investors, but

also perhaps market illiquidity. Indeed, credit ratings downgrades increased substantially

in March 2020, but the pace of downgrades slowed markedly during 2020Q2.

The impact of the COVID19 pandemic on financial

markets is apparent in the

path of the VIX volatility

index. During the height of

COVID-19 induced financial

market stress in mid-March,

the VIX reached values

Key Figure Takeaway: The VIX Index reached levels last

around 80, corresponding

seen during the Great Recession, suggesting high levels of

to historical highs last seen

uncertainty over expected economic output and firm profits,

during the Great Recession

but recently it has retreated.

(Figure 2.16A). These peak

VIX realizations signaled

Figure Data Source: Chicago Board Options Exchange, retrieved from FRED (ID: VIXCLS).

extreme investor uncertainty

about firms’ future profits and economic output related to the COVID-19 recession. Recently,

uncertainty proxied by the VIX index has retreated (Figure 2.16B), owing to fiscal and monetary

stimulus, as well as hopes that the total duration of the COVID-19 pandemic might not be

too long. However, current

VIX realizations are higher

than pre-pandemic values,

suggesting that material

uncertainties remain.

Figure 2.17 plots the corporate

default spread, Baa – Aaa

corporate bond yields, an

aggregate proxy of credit

risk in the corporate bond

market. After the onset of the

COVID-19 crisis, corporate

Key Figure Takeaway: The corporate default spread (Baa –

Aaa corporate bond yields) increased in the wake of

COVID-19 induced financial market stress but has not reached

levels last seen during the Great Recession.

Figure Data Source: Moody’s, retrieved from WRDS.

12 | U.S. SECURITIES AND EXCHANGE COMMISSION

default spreads rose sharply in March, meaning that yields on lower rated corporate debt increased

relative to those on higher rated bonds. This widening credit spread was due largely to increased

default probabilities on lower rated corporate debt. Specifically, as economic activity faltered with

the COVID-19 slowdown, investors feared that various income streams might dry up and firms

might find it difficult to refinance their debt obligations. These factors make debt service difficult

and costly, boosting the likelihood that a borrower may miss a payment and subsequently default.

Figure 2.17A also shows that while the recent rise in the corporate default spread is notable,

current values remain well below those seen during the Great Recession and perhaps suggest credit

markets are less strained than in 2008-09. Figure 2.17B plots the recent path of the corporate

default spread. Like the VIX index (Figure 2.16B), the corporate default spread fell in mid-April.

This trend reversal in the corporate default spread tracks various Fed announcements regarding

liquidity facilities, suggesting that credit conditions ameliorated with Fed actions along with

a broader reduction of financial market stress. Yet Figure 2.17 also shows that the corporate

default spread remains above pre-COVID-19 levels and thus that material credit risks or material

uncertainties persist. Indeed, investors may expect lower rated corporate borrowers to struggle

to service and repay debt in the upcoming months, relative to higher rated borrowers, as the

economic fallout from the COVID-19 recession unfolds.

The economic downturn has affected credit ratings that reflect

long-term views on the credit quality of fixed income instruments

(rating through the cycle). Credit rating agencies, which are

important intermediaries in providing information in securities

markets, started to change their views in March 2020, in response

to rapidly changing economic conditions. As recently as February

2020, rating agencies anticipated a modest slowdown with a low

recession likelihood. However, the events of March 2020 have

changed their views. As shown in Figure 2.18, rating agencies lowered U.S. corporate debt issuers’

ratings at a rapid clip following COVID-19 induced financial market distress. As credit conditions

improved, the pace of downgrades slowed. Yet downgrades still outnumbered upgrades as of June

1, perhaps indicating continued uncertainty as regards borrower debt service going forward.

The probability of debt default also varies across sectors. Figure 2.19 plots the change in prices for

credit default swaps (CDS) from February 1, 2020, by category. CDS prices, often referred to as

spreads and quoted in basis points, track the cost to insure an entity’s debt against future default.

Thus, a CDS spread of 200 basis points indicates that the cost to insure $100 million dollars of

debt would cost $2 million per year (100 * 0.02). Broadly, rising CDS spreads signal

increased expectations in the probability of default.

DERA ECONOMIC AND RISK OUTLOOK | 13

While CDS spreads have increased across

a wide range of entities, the magnitude

of these changes varies starkly across

the categories listed in Figure 2.19. The

categories with the largest increases in

CDS spreads and hence expected default

probabilities (red lines) are those of

sectors whose future revenue streams

may be most threatened by the economic

fallout from the COVID-19 recession.

The most affected debt instruments

emanate from emerging markets and

developing sovereigns, as well as the

oil and gas industry. Other entities

experiencing an increase in expected

default probabilities span the consumer

cyclical industry, financial firms, along

with U.S. states, counties, and cities.

Key Figure Takeaway: The COVID-19 induced

recession has greatly increased expected default

probabilities for emerging market and sovereign

debt, the oil and gas industry, and consumer

cyclical sectors.

Figure Notes: Red lines are the five categories with the largest (most positive)

CDS price changes from February 1 to June 24, 2020. Green lines are the top

performing categories in terms of total price change (lowest price change)

from February 1 to June 24, 2020. Data source: S&P Capital.

Data Sources Not Previously Mentioned: Figure 2.3: U.S. Employment and Training Administration, retrieved from FRED (ID:

ICSA); Figure 2.4: BLS, retrieved from FRED (ID: PAYEMS); Figure 2.5: BLS, retrieved from FRED (ID: UNRATE); Figure 2.7:

Datastream; Figure 2.8: Bureau of Economic Analysis (BEA), retrieved from FRED (ID: TOTALSA); Figure 2.15: Freddie Mac, and

Fed Board retrieved from FRED (IDs: MORTGAGE30US, DGS10); Figure 2.18: Refinitiv DataScope.

14 | U.S. SECURITIES AND EXCHANGE COMMISSION

Market Segments

The U.S. Securities and Exchange Commission’s mission is to protect investors, maintain

fair, orderly, and efficient markets, and facilitate capital formation. Below we examine the

underpinnings of economic growth through the lens of these three mission areas and study

(1) markets; (2) investors; and (3) borrowers, securities issuers, and other entities that raise

capital. The chart below illustrates the interlinkages between these three segments.

Markets

Key Takeaway: Because of the COVID-19 pandemic, key equity indices plunged

between 30-40% from January to March 2020. Investor expectations of weak

corporate earnings following the COVID-19 induced economic slowdown likely led to

this fall in equity prices. Then the S&P 500 nearly recovered from March lows, while

indices of smaller companies have underperformed. In fixed income markets,

AAA-rated corporate securities have outperformed other lower rated bonds, where

the yields on AAA-rated securities are below their pre-pandemic levels. Yields on

non-investment grade debt have climbed substantially during the period of COVID-19

induced financial market distress, likely reflecting investor concerns over increased

default probabilities, but also perhaps market illiquidity. Recently, yields on lower rated

debt have fallen but spreads relative to higher rated securities remain elevated, perhaps

indicating that investors are identifying material risks among these borrowers.

Asset Values

After a historically long bull market, equity market prices fell sharply

in the immediate wake of the COVID-19 induced economic recession. Figure 3.1 plots equity returns from January 2020 for the S&P

500 and the Russell 2000, an equity index of smaller companies.

Both the S&P 500 and the Russell 2000 fell in late February as investors increasingly anticipated a decline in economic activity that would

ultimately depress corporate profits. Thus, valuations as measured by

the cyclically adjusted price-to-earnings ratio (CAPE) fell relative to

historical earnings but remained higher than they were at the depths

of the Great Recession (Figure 3.2). By mid-March, the S&P 500 had

fallen over 30%. In comparison, the Russell 2000 declined nearly

40%, coinciding with COVID-19’s likely outsized impact on the

DERA ECONOMIC AND RISK OUTLOOK | 15

often more volatile income and revenue streams of smaller companies. By June, the S&P 500 nearly

fully recovered from its earlier lows, while as of July 1 the Russell 2000 index remains 14.3% below its

January 1, 2020 level. As noted in our Key Highlights section, the relative outperformance of the S&P

500 may be related to the outperformance of large technology firms that constitute a notable share of

the S&P 500 index and the strong financial position of large firms in the lead up to the pandemic.

For fixed income markets, Figure 3.3 displays total bond market returns and yields by credit rating.

First, Figure 3.3A shows that bonds across asset classes have appreciated considerably since 2010,

coinciding with a broad decline in interest rates. In particular, lower rated B and CCC (or lower) bonds

nearly doubled in value before the COVID-19 outbreak. However, lower rated bond prices are more

volatile, as seen by the large drops in late 2011, 2016, 2018, and, most recently, in 2020. Because of

an expected decline in economic activity due to the COVID-19 slowdown and thus increasing credit

risk concerns and default probabilities, total returns on the lower rated B and CCC bonds fell between

15% and 25% by mid-March (Figure 3.3B). These credit risk concerns likely outweighed a broader

decline in the risk free interest rate (e.g., U.S. Treasuries). Indeed, the poor returns for lower rated

securities through March coincide with a spike in yields (Figures 3.3C and 3.3D) that began to abate

in April 2020. Yet yields on lower rated securities remain elevated, especially compared to the recent

declines in higher rated bonds. The high yields on lower rated bonds signal that investors likely expect

a greater incidence of defaults for lower rated debt, but diminished liquidity may have also impacted

interest rates immediately following COVID-19 induced financial distress in late March and early

April. Conversely, AAA-rated bonds have outperformed and, as of June 26, their yields were about

one percentage point below their pre-COVID-19 levels in early January 2020. The combination of

persistently high yields for lower rated bonds but declining interest rates on higher rated debt translates

into wide credit spreads between lower and higher rated securities. These wide credit spreads may

signal higher than usual default risks for lower rated debt. Last, while BBB-rated corporate bonds

experienced a drop in total returns and an uptick in yields, the changes are relatively smaller than those

for lower rated debt. Yields on BBB-rated bonds returned to their pre-COVID-19 levels as of June 26.

16 | U.S. SECURITIES AND EXCHANGE COMMISSION

Mutual Fund, ETF and Money Market Fund Investors

Key Takeaway: With COVID-19 induced financial market volatility, investors

increasingly moved assets away from bond and equity market investments, including

those held through mutual funds and ETFs, and into assets like cash and money

market funds backed by U.S. government agency or Treasury securities beginning in

March 2020. Then, as credit conditions eased and the Fed implemented unprecedented

monetary stimulus, investments returned, particularly into taxable bond funds, though

total net fund flows for 2020 remain negative for both equity and taxable bond funds

as of June 16, 2020.

Figure 3.4 presents weekly

net fund flows into select

classes of mutual funds and

ETFs from January 7 to

June 16, 2020. Prior to the

COVID-19 pandemic, there

were substantial fund inflows

into taxable and municipal

bond funds, outflows

from domestic equity funds,

and slight inflows into commodity funds. Then as

the COVID-19 pandemic

unfolded and the corresponding economic

slowdown became imminent,

investors in net redeemed assets

from both bond and domestic

equity markets.

Key Figure Takeaway: Both equity and bond funds experienced

outflows following COVID-19 induced financial market stress.

However, capital flowed back into funds, particularly taxable

bond funds, which had seen the most significant decrease, as

credit conditions eased and the Fed expanded its various

monetary policy and liquidity programs.

Net withdrawals from equity

funds following COVID-19

Figure Data Source: Investment Company Institute (ICI), retrieved from Datastream.

induced financial market distress

Other Notes: Taxable bonds include, for example, corporate bonds. ETFs sell large

continue a longer-term trend.

blocks of shares to redeem them from authorized participants, who may transact on

their own behalf or act as agent for others, while individual ETF shares trade on the

In contrast, taxable bond funds

secondary market.

experienced sizable inflows until

late February 2020. Then, investors withdrew approximately $300 billion from taxable bond

funds, as default probabilities increased for lower rated bonds and as investors may have sought

to increase their cash positions. Investors’ preference to move assets away from this market may

have resulted in their selling bonds held directly. Outflows may have also indirectly prompted

funds to sell assets in response to redemption requests. This trend, however, reversed beginning

in April as credit market stress attenuated and as the Fed, in conjunction with the Treasury,

DERA ECONOMIC AND RISK OUTLOOK | 17

announced corporate bond liquidity facilities. Indeed, net fund flows into taxable bond funds

increased by about $130 billion from mid-April to mid-June 2020. A similar, albeit muted trend

occurred in municipal bond funds.

Money Market Funds

A money market fund (MMF) is a type of mutual fund that invests in short-term, high quality

debt securities. Investors in the main categories of MMFs (prime, Treasury and government

agency), which invest in different asset types, react differently to changing market conditions.

For example, at the height of the Great Recession, dollars flowed out of institutional prime

MMFs and into institutional Treasury MMFs, while retail prime MMFs saw comparatively little

outflows. In March, COVID-19 induced financial market dislocation also, broadly speaking, saw

an initial period during which institutional prime MMFs saw outflows while Treasury MMFs

saw inflows, as described below.

Indeed, as the COVID-19 economic slowdown began and financial conditions worsened, prime

MMFs, which invest in assets such as commercial paper as well as certificates of deposits, saw

aggregated outflows of $160 billion ($120 billion from institutional prime MMFs) from March 9

to April 3. In contrast, net inflows into Treasury and government agency MMFs during this same

period exceeded $800 billion.

Furthermore, in response

to deteriorating liquidity

conditions in short-term

funding markets, the Fed

also created three liquidity

facilities, including the

Money Market Mutual

Fund Liquidity Facility

(MMLF) on March 18,

which makes available

funding to U.S. depository

institutions and bank

holding companies to

finance their purchases of

certain types of assets from

money market mutual funds

under certain conditions.

The MMLF helped support

liquidity in the markets for the

assets held by money market

mutual funds. As of June

30, only around $20 billion

in MMLF loans remained

Key Figure Takeaway: Since March 2020, net asset inflows

to government agency and Treasury money market funds

have stabilized, while net outflows from prime institutional

money market funds reversed.

Figure Data Source: Crane Data

Other Notes: Government money market funds invest in securities such as government

agency debt. Prime money market funds invest in a broad range of short-term, high

quality debt securities, such as commercial paper issued by corporations.

18 | U.S. SECURITIES AND EXCHANGE COMMISSION

outstanding, down from $51 billion on April 14. Prime MMFs reduced their holdings of

commercial paper and certificates of deposits from 56% of their portfolio in February to 44%

in May and increased their holdings of Treasury securities. In mid-April, investors started to

return to prime MMFs, and so aggregate AUM of prime MMFs as of May 21 exceeds the

pre-pandemic levels seen in March.

After 2 months of rapid inflows, the size of the MMF industry as a whole peaked at the end

of May with $5.2 trillion in AUM, but then new headwinds started to emerge for MMFs.

After the Fed’s March interest rate cuts, the net yields for MMFs and short-term Treasury

yields are near zero in June, as seen in Figure 3.6, while the equity market indices such as the

S&P 500, for example, have rallied, recovering most of their March losses as the broader credit

conditions eased. Although media reports speculated that investors pulled approximately $100

billion from Treasury and government MMFs in June for possibly higher yielding securities,

most of the inflows since remain, which may signal continued market uncertainty surrounding

the COVID-19 pandemic.

Operationally, the volatile flows and the low interest rate environment for MMFs have had

several consequences. First, a few Treasury MMF advisers have temporarily closed their funds

to new investors since cash received from new investors would be invested in lower yielding

securities, reducing further a fund’s yield. Second, some prime institutional MMF advisers have

decided to liquidate their funds, citing shrinking assets and investors fleeing during times of

stress. Third, advisers are beginning to waive fees to keep net yields at zero or positive.

The average expense ratio in 2019

was 0.25%, which is higher than

the current yields on many eligible

MMFs securities. According to

the Investment Company Institute

(ICI), aggregated fee waivers

for MMFs peaked in 2014 at

$6.3 billion at the end of the

low interest rate environment

after the Great Recession, only

to fall to $1.2 billion in 2019 as

interest rates increased. Lastly,

some advisers to Treasury and

Key Figure Takeaway: Taxable MMF net yields have fallen

government MMFs, which have

to near zero. Short-term Treasury yields briefly went

stable NAVs, may be thinking

negative in March.

about how their funds would

operate in an environment where

Figure Data Source: Fed Board, retrieved from FRED (IDs: DTB3, DTB4WK)

interest rates go negative, as they

and Crane Data.

did briefly in March (Figure 3.6).

Other Notes: MMF net yields are 7-day SEC yields.

DERA ECONOMIC AND RISK OUTLOOK | 19

Borrowers, Securities Issuers, and Capital Formation

Key Takeaway: Money in bond markets flowed to the industries hardest hit by the

COVID-19 downturn and also to the safest and financially strongest borrowers within

each industry. These patterns are consistent with increases in corporate demands for

precautionary savings, increases in borrowing among financially healthy firms to obtain

cash to make future transactions, and increases in investors’ demands for safe lending

opportunities. In equity markets, established firms whose stock prices had been the

least negatively affected by the downturn rushed to raise funds in seasoned equity

offerings (SEOs). Markets for initial public offerings (IPOs) were relatively quiet.

U.S. Corporate Bond Issuance

Corporate demand for cash increased substantially in the first quarter of 2020, especially among

firms in the industries hit hardest by the pandemic-related disruption and among firms that were

financially strong before the pandemic. In the first 5 months of 2020, public corporations issued

bonds at nearly twice the pace of 2019, with more than 80% of that activity occurring from

March to June. During the first quarter of 2020, the cash holdings of nonfinancial corporations

also increased at the fastest year-over-year rate since 2010.

One important motivation for holding cash is precaution—having rainy day savings in case of

unexpected increases in expenses or decreases in revenues. Accordingly, the data show that more

bonds were issued by the industries most exposed to the pandemic. The following figures plot

the total amount of bonds issued during 2020, by industry, against two stock market measures

of each industry’s exposure to the pandemic. The first measure is the industry’s stock return from

March to mid-June, which captures investors’ beliefs after about 16 weeks of learning about the

risks of COVID-19 in general and the possible risks specifically with respect to particular industries. The second measure is the industry’s stock return during the initial market downturn from

February 19 to March 23, 2020, when the S&P 500 lost more than one-third of its value. This

measure captures investors’ initial reaction to the COVID-19 outbreak.

Figure Data Source and Notes: Data are from S&P Capital IQ. Data points are computed for two-digit SIC industry codes, and

industry stock returns are value-weighted.

20 | U.S. SECURITIES AND EXCHANGE COMMISSION

Figure 3.7A plots bond issuance during 2020 by stock price performance over the longer period.

Stock prices in the real estate industry fell 17% between March and mid-June, and the industry

issued bonds equal to 18% of enterprise value, or the value of debt plus equity. In contrast, miscellaneous retail—including drug stores, liquor stores, and stores selling books, jewelry, and sporting goods—enjoyed a 36% stock price appreciation and sold bonds equal to less than 0.25% of

enterprise value.

Figure 3.7B plots issuance during 2020 by stock price performance during the initial downturn.

Real estate stocks lost more than 50% of market value over this period and issued the most bonds

relative to total enterprise value. In contrast, grocery store stock prices were flat, and this sector’s

issuance amounted to only 1.1% of enterprise value.

During times of uncertainty, investors generally prefer to lend to safe borrowers in what is known

as flight to quality. Figure 3.8A shows that within each of six major industry groups, firms with

investment-grade ratings (BBB- or higher) raised much more money in bond markets than firms

with speculative-grade ratings or no rating.

Figure Data Source and Notes: Data are from Capital IQ. Credit ratings are current as of bond issuance date, and market-to-book

ratios are computed at the end of calendar year 2019.

Along with credit rating, another characteristic associated with firm quality is a firm’s marketto-book ratio, or the ratio of the market value of assets to the book value of assets. A high value

means investors consider the firm to be worth much more than accounting statements reflect,

possibly because important assets do not appear on accounting statements or because investors

believe the firm will grow faster in the future than other firms. Figure 3.8B shows that firms with

higher market-to-book values issued more bonds than lower market-to-book firms in all industries except finance/insurance, where low market-to-book firms issued slightly more.

DERA ECONOMIC AND RISK OUTLOOK | 21

A second important motivation for holding cash is having it available for transactions, such as

acquisitions or share buybacks. Cash (internal capital) is often a faster and easier way of making

transactions than borrowing (external capital) or using other forms of payment (like stock shares).

A firm may believe that if a wave of bankruptcies is indeed coming, then many corporate assets

will be available for purchase or acquisition. Building up cash is one way that a firm can prepare to

acquire these assets. Figures 3.8A and 3.8B are also in line with this motivation, as they show the

firms most likely to be buyers in the future (that is, financially strong firms) raising more debt in

bond markets than the firms most likely to be sellers (that is, financially weak firms).

Between December 31, 2019 and March 31, 2020, U.S. corporations raised money in public bond

markets at the fastest rate in a decade. Patterns in the data suggest that the surge in borrowing was

related to both changes in firms’ demand for cash and changes in investors’ demand for safe lending opportunities.

U.S. Equity Issuance

Equity markets also witnessed a surge in issues, perhaps as firms saw a need for cash to cope with

the pandemic-induced slowdown. From May 1 to June 26, 2020, U.S. corporations raised more

funds in SEOs than in the previous 10 months combined (Figure 3.9A). This increase in fundraising

activity was confined to firms with which investors are already familiar (via SEOs), as IPO markets

were relatively quiet (Figure 3.9B), with the possible exception of June 2020.

Figure Data Source: Capital IQ

While firms with negative stock returns during the pandemic were more likely to issue bonds, the

opposite was true for SEOs. Firms were less likely to raise money by issuing stock after their share

price fell, possibly because managers believed their stock was undervalued. These firms may have

chosen to raise capital in bond markets instead of equity markets (Figures 3.7A and 3.7B). Figure

3.10A plots firm-level SEOs during May and June by stock-price performance from February 19

to April 30, 2020. Figure 3.10B plots SEOs by stock price performance during the initial market

downturn from February 19 to March 23. In both figures, SEO amounts are scaled by the firm’s

market capitalization as of December 31, 2019, in order to make data points comparable.

22 | U.S. SECURITIES AND EXCHANGE COMMISSION

Figure Data Source: Capital IQ.

The regression line is positively sloped in both figures, especially in Figure 3.10B. This indicates

that firms were less likely to raise cash by selling stock when their share prices had been depressed.

Data Sources Not Previously Mentioned: Figure 3.1: Datastream. Figure 3.2: Datastream. Figure 3.3: Ice Data Indices, LLC,

retrieved from FRED (IDs: BAMLCC0A1AAATRIV, BAMLCC0A3ATRIV, BAMLCC0A4BBBTRIV, BAMLHYH0A1BBTRIV,

BAMLHYH0A2BTRIV, BAMLHYH0A3CMTRIV, BAMLC0A1CAAAEY, BAMLC0A3CAEY, BAMLC0A4CBBBEY, BAMLH0A1HYBBEY,

BAMLH0A2HYBEY, BAMLH0A3HYCEY.

DERA ECONOMIC AND RISK OUTLOOK | 23

Spotlights

Credit Ratings, Procyclicality and Related Financial

Stability Issues: Select Observations

COVID-19 Market Monitoring Group*

July 15, 2020

On April 24, the SEC announced the formation of an internal, interdisciplinary COVID-19 Market

Monitoring Group.1 This temporary, senior-level group was formed to assist the Commission and

its various divisions and offices in (1) developing Commission and staff analyses and actions related

to the effects of COVID-19 on markets, issuers and investors—including in particular our longterm Main Street investors, and (2) responding to requests for information, analyses and assistance

from fellow regulators and other public sector partners on market matters arising from the effects

of COVID-19.

One of the COVID-19 Market Monitoring Group’s initial initiatives2 has been the exploration

of whether credit assessments and credit rating agency downgrades—and market anticipation of,

and responses to, those ratings actions—may (1) contribute to negative procyclicality in certain

circumstances and (2) have implications for financial stability. The interrelationships between

ratings actions, procyclicality and financial stability is a topic that other members of the global

financial regulatory community are also examining,3 and we have benefitted from our ongoing

coordination and sharing of analysis and observations with them.

While our work on this topic—and more broadly, other issues relating to COVID-19’s effects on

markets, issuers and investors—is ongoing, we have several initial observations concerning ratings

actions, procyclicality and financial stability issues that we believe would be helpful to share with

the public. Specifically, and as discussed in more detail further below, our initial observations are:

1. Analysis of potential effects of ratings actions should focus on current circumstances. Given

the idiosyncratic nature of the health and economic effects and consequences of COVID-19,

we believe that analogies to the role of rating agencies in the 2008 global financial crisis should

be approached with caution. We note that, in addition to substantially differing economic

conditions and stresses, the relevant analytical assumptions and methodologies used by rating

agencies in that period also were substantially different.

2. Cost of debt capital is driven by a wide range of financial and non-financial factors and forces;

ratings downgrades are generally lagging indicators of cost of debt capital.

3. Observable bunching just above and below the investment grade level may be attributable to

various macroeconomic trends, including policy, regulatory and investor choices.

DERA ECONOMIC AND RISK OUTLOOK | 25

4. When considering the effects of credit ratings on market structure, including potential

procyclicality of ratings downgrades, it is important to take into account the wide and diverse

spectrum of our credit markets and all major credit market participant types.

5. The procyclical effects of credit ratings used in bilateral specialty finance also are appropriate

areas for continued monitoring.

We welcome information, data and comments from market participants and members of the

general public—both on this specific topic and other matters and issues relating to COVID19’s effects on our capital markets. Submissions can be made by email to COVID-19.Market.

Monitoring.Group@sec.gov.

1. Analysis of potential effects of ratings actions should focus on current circumstances. Given

the idiosyncratic nature of the health and economic effects and consequences of COVID-19,

we believe that analogies to the role of rating agencies in the 2008 global financial crisis should

be approached with caution. We note that, in addition to substantially differing economic

conditions and stresses, the relevant analytical assumptions and methodologies used by rating

agencies in that period also were substantially different.

In response to the broad and varied effects and unparalleled response to COVID-19, rating agencies

have made, and continue to make, adjustments to the analytical assumptions and other inputs that

they use when assigning and maintaining ratings. This includes, for example, adjusting the baseline

macroeconomic scenarios and sector outlooks that their models and analysts apply, as well as

modifying other key qualitative and quantitative assumptions used in their methodologies. Also,

speaking more generally, rating agency models and methodologies—as well as the marketplace’s use

of ratings—have evolved significantly in the years following the 2008 global financial crisis.

In light of these differing factors and changes, as well as the significant post-financial crisis changes

to the marketplace itself and the regulatory scheme governing ratings and financial services

generally, we believe that analogies to the 2008 global financial crisis era—including the analytical

assumptions and methodologies rating agencies used in that period—should be approached with

caution and, in themselves, are not likely to provide useful decision-oriented analyses or insights.

In our view, it is a more effective use of regulatory resources to focus, in the first instance, on (1)

identifying and understanding the policies, procedures, methodologies and practices of rating

agencies today (including the economic forecasts and assumptions applied) and (2) the ways in

which all significant classes of investors and other market participants use ratings in their asset

allocation, credit provision and other decisions.

When exploring the role of credit ratings in today’s market structure, including potential regulatory

actions, it is important to understand a key aspect of the U.S. legal and regulatory construct.

26 | U.S. SECURITIES AND EXCHANGE COMMISSION

Congress explicitly prohibited the SEC and the states from regulating the substance of credit

ratings or the procedures and methodologies by which they are determined.4 The statute and

rules applicable to SEC-registered rating agencies require rating agencies to establish, maintain,

enforce, and document an effective internal control structure governing the implementation of and

adherence to policies, procedures and methodologies for determining credit ratings, and provide the

SEC staff with authority to examine rating agencies’ compliance with such provisions. Operating

within this framework, the SEC staff has focused its recent efforts in this area on, among other

things: (1) understanding how rating agencies are responding to the economic effects of COVID-19,

including monitoring ratings actions and related public disclosures to understand the overall

market impact of the actions, and (2) examining rating agencies’ adherence to their own policies,

procedures and methodologies for determining credit ratings.

2. Cost of debt capital is driven by a wide range of financial and non-financial factors and forces;

ratings downgrades are generally lagging indicators of cost of debt capital.

We have observed in discussions with other regulators, that there are perceptions that the

procyclical effects of increases in the cost of debt capital are the result of ratings downgrades. This

is unlikely to be a strong or dominant causal relationship in, for example, the bank lending or

the new issue bond market. A firm or issuer’s cost of debt capital—be it through bank/non-bank

financing and/or debt capital markets—is driven by a wide array of geopolitical, economic and

credit conditions and other industry- and firm-specific factors. Rating agency actions—including

(1) changes in rating outlook, (2) placement on or changes in “watch” status and (3) changes in

ratings—are generally lagging indicators of cost of debt capital.

Generally speaking, before a rating downgrade occurs, market participants observe—and take

into account by commanding (generally) higher credit spreads—the relevant conditions and

circumstances that eventually contribute to the ratings action—e.g., (1) broad conditions and

factors, such as the state of the business climate and credit markets, the regulatory environment, and

the competitive landscape affecting the firm or its industry, and (2) firm-specific information and

circumstances, such as the demand for the firm’s goods and services, as well as the entity’s growth

prospects, asset quality, funding and profitability, and management approach—some of which is

commonly available in public financial statements and regulatory filings.

Indeed, most of the credit spread widening for downgraded issuers occurs before the downgrade.5

As the Coronavirus spread globally in early 2020, the cost of debt capital for many companies shot

up, as the marketplace observed the virus’ effects on economic activity—before the rating agencies

began to drop companies’ ratings.

We do, however, recognize that in certain circumstances an adverse ratings action may have some

negative effects on the cost of debt capital. For example, in the case of collateral-based financing

such as a receivables facility, if the ratings of the borrower or the entities that owe the borrower

the receivables is downgraded, additional collateral may be required which would increase the

borrower’s cost of capital. In addition, while we would expect the market to anticipate the ratings

DERA ECONOMIC AND RISK OUTLOOK | 27

action and adjust accordingly, a move from investment grade to below investment grade could have

significant effect on cost of debt capital (see below for further discussion of issues related to the

potential investment grade / below investment grade discontinuity in the market).

3. Observable bunching just above and below the investment grade level may be attributable to

various macroeconomic trends, including policy, regulatory and investor choices.

There has been observable segmentation of the credit investment universe for certain types of

investors, including between investment grade and non-investment grade credits. There also has

been observable concentration of credit in the area around the line between investment grade

credit and below investment grade credit. It is important to note that this segmentation and

concentration (as well as, in some cases, a relatively significant credit spread differential between

low investment grade and high non-investment grade credits) is attributable, in large part, to

various fundamental business differences, investor demand, macroeconomic factors and monetary

and regulatory policies.

The factors that have driven this segmentation and concentration of credit in the area around the

line between investment grade credit and below investment grade credit include, among others:

(1) a market-wide recognition (and incorporation into investment strategies) of the significant

differences in historical default rates6 between the highest non-investment grade and lowest

investment grade ratings, (2) long-running accommodative monetary policy, which caused

investors to seek increased yield within their mandates and, in turn, provided corporates with the

opportunity to increase their debt financing at low absolute rates, (3) investor demand focused

on the highest yielding investment grade credits, (4) regulatory capital requirements on banks,

insurance companies and other entities that pushed lower investment grade and below investment

grade credits off regulated balance sheets and (5) investment guidelines and index investing that

themselves incorporate segregation. Over the period following the 2008 global financial crisis,

these policy positions and regulatory actions, coupled with relatively stable investor preferences,

facilitated easier and predictable credit conditions, which incentivized borrowers in various

segments to optimize their balance sheets to achieve ratings in the low investment grade range.7 This

type of balance sheet optimization may have significantly contributed to the current concentration

of credit in and immediately above (as well as immediately below) the BBB-/Baa3 categories. In

other words, examining ratings and ratings actions in isolation from these other factors is unlikely

to provide meaningful insight.

4. When considering the effects of credit ratings on market structure, including potential

procyclicality of ratings downgrades, it is important to take into account the wide and diverse

spectrum of our credit markets and all major credit market participant types.

Certain portions of our credit markets, including fixed income mutual funds and ETFs, leveraged

loans and CLOs, have grown significantly in recent years and attracted increased regulatory

attention.8 We believe that these aspects of the credit markets are worthy of continued monitoring

and examination, including in particular whether they will continue to grow in absolute and

28 | U.S. SECURITIES AND EXCHANGE COMMISSION

relative terms. Other issues that warrant monitoring in these portions of the market include where

leveraged loans and CLOs are held (i.e., who are the principal investors), the purposes for which

they are being held (e.g., long term or short term investing) and their relative credit and liquidity risk

tolerances (e.g., how willing or able are they to withstand periods of price dislocation and/or limited

liquidity). At the SEC, we are monitoring these areas, and are engaging in related inter-agency

discussions to gain a better understanding of these evolving issues.

However, when considering credit markets generally, and the extent and effects of reliance

on ratings within areas of our credit and financial markets, including procyclicality of ratings

downgrades, we believe that the broad spectrum of credit markets and institutional investor types

active in these markets must be considered—including insurance companies and pensions, among

others. For example, registered investment companies (a category that includes money market

funds and other mutual funds, as well as ETFs) account for approximately: 21% of the U.S. and

foreign corporate bonds market, 14% of the U.S. and government agency securities market, 29%

of the U.S. municipal securities market and 25% of the commercial paper market.9 Other types of

institutional investors, therefore, both individually and collectively, play a significant role in these

markets. It is only with a wide lens—that looks across all significant market participant types—that

we can collectively identify, monitor and evaluate the key trends, developments and risks across

these markets, including potential procyclical effects of credit ratings. We recognize that data

availability for these other significant market participants may be more limited but data availability

should not drive the focus of our analysis.

5. The procyclical effects of credit ratings used in bilateral specialty finance also are appropriate

areas for continued monitoring.

Many members of the global financial regulatory community have focused on the procyclicality

of investment guidelines, performance benchmarks and other rating-oriented portfolio

construction rules.10

While these areas deserve ongoing attention, we also believe that the potential procyclical effects

of credit ratings used in bilateral specialty finance also are worthy of continued monitoring.

Fundamentally, these types of financing arrangements are asset-backed and secured.

While industry has made significant strides to reduce the use of credit ratings especially in broadly

distributed asset-backed financing deals,11 some types of bilateral financing, short term funding and

supply chain financing arrangements continue to rely in various ways on credit ratings, at times

directly, but in most cases indirectly. For example, in receivables financing arrangements, or other

similar arrangements where the reference collateral pool or borrowing base itself has ratings, there

are usually contractual provisions to post additional or substitute collateral if posted collateral no

longer maintains a specified rating, so as to maintain the borrowing base and the advance rate. In

other cases, there is an indirect, but tangible impact of a downgrade of the corporate entity related

to the bilateral asset-backed financing agreement as result of (1) servicing obligations of the entity,

(2) serving as a counterparty to the financing trust (such as a swap counterparty), or (3) general

DERA ECONOMIC AND RISK OUTLOOK | 29

confidence of the financing provider on the ability of the entity to access the non-secured financing

markets. In addition, market participants, especially in bilateral settings, usually impose credit

rating style financial criteria, which while not mechanistically linked to ratings, are likely to mimic

ratings outcomes.

In all of these examples, ratings downgrade or other credit events could result in increased financing

costs or reduced access or liquidity pressures on the corporate entity.12 These and similar types

of scenarios could contribute to negative procyclicality and market disruptions. We believe these

matters are worthy of continued examination.

*

This document expresses the views of the SEC’s COVID-19 Market Monitoring Group and does not

necessarily reflect the views of the Commission or the Commissioners.

1

SEC Press Release, “SEC Forms Cross-Divisional COVID-19 Market Monitoring Group” (April 24,

2020), available at https://www.sec.gov/news/press-release/2020-95.

2

SEC Press Release, “COVID-19 Market Monitoring Group – Update and Current Efforts” (May

13, 2020), available at https://www.sec.gov/news/public-statement/statement-clayton-kotharicovid-19-2020-05-13.

3

See Financial Stability Board, COVID-19 Pandemic: Financial Stability Implications and Policy

Measures Taken – Report submitted to the G20 Finance Ministers and Governors (July 15, 2020),

available at https://www.fsb.org/wp-content/uploads/P150720-2.pdf (noting the FSB’s plans to

continue its analysis of certain vulnerabilities, including those relating to procyclicality of credit rating

downgrades).

4

Exchange Act Section 15E(c)(2).

5

See generally Morgan Stanley, Corporate Credit Research – North America, “The Nature of the

BBBeast” (October 5, 2018), available at https://www.sec.gov/spotlight/fixed-income-advisory-committee/morgan-stanley-nature-of-the-bbbeast.pdf.

6

See generally Moody’s Investors Service, Sector In-depth, “Annual default study: Defaults will edge

higher in 2020” (January 30, 2020).

7

See generally BlackRock, Policy Spotlight – “US BBB-Rated Bonds: A Primer” (August 2019), available at https://www.blackrock.com/corporate/literature/whitepaper/policy-spotlight-us-bbb-ratedbonds-a-primer.pdf and Capital Advisors Group, Inc., Investment Research – “Corporate Leverage:

Par for the Course or Harbinger of an Upcoming Crisis?” (February 22, 2019), available at http://www.

capitaladvisors.com/wp-content/uploads/2019/03/Corporate-Leverage-Par-for-the-Course-or-Harbinger-of-an-Upcoming-Crisis.pdf.

8

See generally Financial Stability Oversight Council, 2019 Annual Report, available at https://home.

treasury.gov/system/files/261/FSOC2019AnnualReport.pdf.

9

Investment Company Institute, 60th edition – 2020 Investment Company Fact Book, available at

https://www.ici.org/pdf/2020_factbook.pdf.

10 See, e.g., European Systemic Risk Board, “Issues note on liquidity in the corporate bond and commercial paper markets, the procyclical impact of downgrades and implications for asset managers and insurers” (undated), available at https://www.esrb.europa.eu/pub/pdf/reports/esrb.

report200514_issues_note~ff7df26b93.en.pdf.

11

We recognize that financing agreements have evolved significantly in the wake of the 2008 global

financial crisis—and their direct reference to, and/or use of, credit ratings has diminished.

12 Because credit ratings are generally lagging indicators of cost of capital, counterparties in financing

agreements may in some cases amend the terms of their agreements in advance of a downgrade

(although we do not know how often that occurs in practice).

30 | U.S. SECURITIES AND EXCHANGE COMMISSION

U.S. Investors’ Exposure to Domestic Chinese Issuers1

Introduction

More than 150 China-based companies with a combined market value of $1.2 trillion2 were listed on

U.S. stock exchanges at the end of 2019. As more China-based companies have listed in the U.S., there

has been growing concern about the lack of transparency into accounting and governance standards

of Chinese firms, which policymakers and certain market participants have warned put U.S. investors

at increased risk because of the inability of the Public Company Accounting Oversight Board (PCAOB)

to inspect audit work and practices of PCAOB-registered auditing firms in China (including Hong

Kong-based audit firms, to the extent their audit clients have operations in mainland China) with respect

to their audit work of U.S.-listed companies with operations in China.3

Policymakers and market participants are discussing how to address these issues.4 This note highlights

an important area for those policy discussions: the increasing exposure of U.S. investors to the Chinese

domestic issuer market. Compared with China-based companies listed in the U.S., Chinese domestic

companies present potentially greater risks. The domestic Chinese financial markets have historically

not been very accessible to non-Chinese investors, but that is changing, with accessibility increasing

for, among others, U.S. investors. Over the past two years, providers of global financial market indexes

have increased the weight on those indexes of Chinese domestic stocks and bonds. Accordingly, U.S.

investors holding shares in investment products that track those global indexes are now increasingly

holding Chinese domestic stocks and domestic bonds. Other than passive index investors, active

fund managers, including pension funds and private funds, may also have access to Chinese domestic

securities. U.S. investors, and especially U.S. retail investors, might not be fully aware of these increased

weightings or how such changes may be substantively changing the risk profiles of their international

investments. In addition to the risks regarding an inability to conduct due diligence to verify the

soundness of accounting and governance standards noted above, the design and control of the Chinese

financial market by Chinese authorities creates a series of potential concerns for U.S. investors related to

disclosure, liquidity, volatility, fraud, and risk management. This risk spotlight sheds light and provides

data on the exposure of U.S. investors to Chinese domestic markets.

U.S. Investors’ Exposure to A Shares and Domestic Bonds

Companies that are incorporated in China can issue three different classes of shares: A Shares, B Shares,

and H Shares.5 A Shares are listed on either the Shanghai or Shenzhen stock exchanges and are traded

in renminbi (CNY). B Shares are listed on the Shanghai stock exchange and are traded in U.S. dollars

(USD), or they are listed on the Shenzhen stock exchange and are traded in Hong Kong dollars (HKD).

H Shares are listed on the Hong Kong exchange and are traded in Hong Kong dollars (HKD).6

U.S. investors have always been permitted to purchase and sell B Shares and H Shares, but A Shares

were limited to mainland Chinese investors until the launching of the Qualified Foreign Institutional

Investor (QFII) program in 2002.7 Controls on A Shares have been periodically relaxed since the launch

of QFII, including the 2014 introduction of the Stock Connect and the Bond Connect trading programs

that permit two-way trading between Hong Kong and China.8

DERA ECONOMIC AND RISK OUTLOOK | 31

As the Chinese domestic financial market became more accessible to foreigners, in recent years,

providers of global financial market indexes started to increase the weight of Chinese markets in some

of their indexes.9 For example, as of June 2020 all three major equity index providers (MSCI, FTSE,

and S&P) have included A Shares in their emerging markets indexes. Between May and November

2019, the MSCI Emerging Markets index increased its coverage of A shares listed on the Shanghai

and Shenzhen stock exchanges from 5% to 20%, and as of November 2019 its resulting overall index

weight in A Shares became approximately 4%.10 By adding A Shares, the MSCI Emerging Markets

index weight on China rose from about 28% to about 33%.11 Other indexes beyond these three have

also started to include A Shares, with different degrees of weights depending on their geographical

focus and/or risk profile.

Foreign investors also have easy access to certain parts of the fixed income markets in China thanks

to the inclusion of Chinese sovereign and policy bank bonds12 by some major global financial market

indexes. Chinese corporate bonds and other types of bonds13 are also available through QFII or Bond

Connect. Panel B of Table 1 reports statistics for select indexes that include Chinese domestic bonds

(hereafter, Domestic Bonds).

Table 1. Selected Global Indexes’ Weights on A Shares and Domestic Bonds

Panel A. A Shares

Index

Inclusion Process

Stock Inclusion Change

New Weight of A Shares

MSCI Emerging Markets

May 2019 - Nov 2019

from 5% to 20%

4%

FTSE Emerging Index

Jun 2019 - Jun 2020

from 0 to 25%

5.4%

S&P Emerging BMI

Sept 2019

from 0 to 25%

5.5%

a

b

c

Panel B. Domestic Bonds

Inclusion Process

Securities Type/Quantity

New Weight of

Domestic Bonds

Bloomberg Barclays

Global Aggregate Indexd

Apr 2019 - Nov 2020

386 Chinese government

and policy bank bonds

from 0 to 5.5%

JPM GBI-EM Global

Diversifiede

Feb 2020 - Nov 2020

9 Chinese

sovereign bonds

from 0 to 10%

FTSE Government Bond

Index (WGBI)f

Inclusion decision

expected in Sept 2020g

Unknown number of

Chinese sovereign bonds

from 0 to 6% (expected)

Index

a https://www.msci.com/www/blog-posts/emerging-markets-since-china-a/01662775315

b https://www.ftserussell.com/blogs/china-shares-inclusion-seven-key-points

c https://www.indexologyblog.com/2019/03/28/are-you-ready-for-china-a-share-inclusion/

d https://www.bloomberg.com/company/press/bloomberg-add-china-bloomberg-barclays-globalaggregate-indices/

e https://www.reuters.com/article/china-markets-bonds/update-2-jpmorgan-adds-china-to-emergingbond-index-from-february-2020-idUSL5N25V3F4

f https://markets.jpmorgan.com/research/email/fhqqi299/EVQJuomMYOQFhWtrQNiDkA/GPS3120982-0#research-document-GPS-3120982--section_16

g FTSE Russell would keep China on its watch list until a planned review in September 2020.

https://research.ftserussell.com/products/downloads/Fixed_Income_Country_Classification_

March_2020_Results.pdf

32 | U.S. SECURITIES AND EXCHANGE COMMISSION

In Table 2, we estimate the dollar exposure of U.S. mutual funds to A Shares and Domestic

Bonds. We identify $43.5 billion of these securities held across 664 funds at the end of April

2020, out of which there were $37.2 billion in A Shares and $6.3 billion in Domestic Bonds.

This dollar exposure will likely increase as A Shares and Domestic Bonds are included in more

global indexes in the coming months and years.

Table 2. U.S. Mutual Funds’ Current Exposure to A Shares and Domestic Bonds

Security

# of U.S. Funds

AUM ($ billion)

Exposure ($ billion)

A Shares

586

2,477

37.2

Domestic Bonds

95

673

6.3

Total

664

2,959

43.5

Source: Morningstar holdings reported at the end of April 2020 and DERA staff calculations. The exposure is

based on holdings tagged by Morningstar as Chinese and traded in local currency only. (A Shares trade in renminbi.) The sum of number of funds and AUM across A Shares and Domestic Bonds does not add up to the total

because some funds have exposures to both A Shares and Domestic Bonds.

Table 3 reports our estimated 2020 year-end size of U.S. mutual funds’ investments in A Shares

(Panel A) and Domestic Bonds (Panel B). Our estimates are simply the product of current fund

size (as of April 2020) and the expected year-end index weights of the index chosen by the fund

as its benchmark.14 These figures are imprecise for several reasons. First, we include only funds

that use as their benchmarks certain indexes from the six index providers listed in the table.

Second, the index providers might not implement the changes that they have announced. Third,

mutual funds might not allocate their Chinese investments in the same proportion as the index.

By the end of 2020, we estimate that there will be $38.9 billion of investment in A Shares across

the three major equity indexes (Panel A). We also estimate that there will be $15.8 billion of

U.S. mutual funds’ exposure to the Domestic Bond market via Bloomberg, JP Morgan, and

FTSE global market indexes (Panel B). The IMF estimates that the expected inclusion of Chinese

domestic securities into major global indexes will generate up to $450 billion net inflow into the

Chinese economy, which equals 3 to 4% of China’s GDP, in the next two years.15

Table 3. U.S. Mutual Funds’ Estimated 2020 Year-End Exposure to A Shares and

Domestic Bonds via Selected Indexes

Panel A. Exposure to A Shares

Index

# of US Funds

AUM ($ billion)

Exposure ($ billion)

1,179

1,851

27.6

FTSE Russell

25

492

10.4

S&P

72

62.7

0.9

Total

1,277

2,346

38.9

MSCI

a

b

c

DERA ECONOMIC AND RISK OUTLOOK | 33

Panel B. Exposure to Domestic Bonds

Index

# of US Funds

AUM ($ billion)

Exposure ($ billion)

Bloomberg Barclays

Globale

95

114.0

7.4

JPM GBI-EMf

34

15.9

1.6

FTSE WGBI

47

110.4

6.9

Total

176

240.4

15.8

g

Source: Morningstar holdings reported at the end of April 2020 and DERA staff calculations.

a Expected weights of A Shares in different MSCI indexes are as follow: ACWI = 0.4%, ACWI ex US =

0.9%, EM = 4%, Asia Pacific = 2.5%, Asia ex Japan = 4.0%, Golden Dragon = 7.4%, China All = 10.3%,

China A = 100%.

b Expected weights of A Shares in different FTSE Russell indexes are as follow: Global (All World) =

0.6%, Global ex US = 1.3%, EM = 5.4%, EM All cap = 5.7%, China All = 15%, China A = 100%.

c Expected weights of China A shares in different S&P indexes are as follow: Global (BMI or property) =

0.6%, Global ex US = 1.3%, Emerging BMI = 5.5%, China (Total China or BMI or 500) = 15.1%.

e Expected weight in Bloomberg Barclays Global Aggregate = 5%, Bloomberg Barclays Global Aggregate Ex US = 9%.

f Expected weight in JPM GBI-EM Global Diversified = 10%.

g Expected weight in FTSE World Government Bond Index = 6%. (The following indexes included China

in 2017, but no funds are currently following them: 52.6% in the FTSE EMGBI, 10.0% in the EMGBICapped, 58.9% in AGBI and 20.0% in AGBI-Capped)

In addition to mutual funds, there are a number of other large U.S. investors that might look to

global financial market indexes when making investment decisions, including public and private

pension funds, endowments, foundations, and hedge funds. For example, the Federal Thrift

Retirement Investment Board (FTRIB) that oversees retirement savings for U.S. government

employees voted last year to change the benchmark index on one of its large funds from an index

that excludes A Shares to one that includes A Shares,16 though implementation of that decision

has since been delayed.17

As shown in the Appendix, out of the ten largest state level public U.S. pensions, we identify

that nine have allocated some of their funds to track one or more benchmark indexes that have

exposure to A shares (mainly MSCI indexes with A exposure) or their investments include

holding A Shares directly. For one of the pension funds we examined, such information is

not available, based on the latest financial reports of these funds.18 As of September 2019, the

federally administrated Pension Benefit Guaranty Corp. (PBGC)’s portfolio includes a sizable

emerging market allocation that has exposure to A Shares because that allocation tracks the

MSCI Emerging Market Index.19 Other public pension funds may also have exposure to Chinese

companies via investments in venture capital funds that invest in A Shares.20

34 | U.S. SECURITIES AND EXCHANGE COMMISSION

Risks of Investing in A Shares and Domestic Bonds

Various market participants have identified certain heightened risks associated with investing in

A Shares and Domestic Bonds, including the following:

Fraud. Fraud is a commonly expressed concern with respect to Chinese firms, whether

incorporated inside or outside China. With frequent government intervention and limits on

credible standards in corporate governance, the risk of insider dealings, market manipulation and

other misconduct increases.21

Default Risk. China’s debt ratios are steadily increasing. Its non-financial debt-to-GDP ratio

rose from approximately 150% in 2008 to approximately 250% in September 2018.22 With the

recent slowdown in economic growth, this material debt load poses an increased default risk.

Over the last two years, China reached back-to-back record years of bond defaults with the

2019 level ($18.6 billion) being four times higher than the 2017 level. Defaults are concentrated

among privately owned enterprises, which are facing tightening in credit conditions and lower

levels of government support. The default rate on bonds was over 4% in the first 11 months of

2019, up from 0.8% in 2017.23

Volatility. Compared with the U.S. equity market, which with the size of mutual funds and

ETFs is largely an institutional market, the mainland Chinese equity market is dominated by

retail investors who account for over 80% of the trading volume.24 These investors tend to have

shorter holding periods for their investments and are more likely to respond to short-term price

movements than institutional investors. The different nature of China’s investor base, along

with the underlying riskier nature of Chinese issuers, is viewed as having contributed to trading

activity that, in turn, led to episodes of high volatility in the Shanghai and Shenzhen markets,

especially during market stress.25, 26

Corporate Incentives. Article 19 of China’s Corporate Law stipulates that “In companies,

Communist Party organizations shall…be set up to carry out activities of the Party.”27 Thus,

Chinese companies’ priorities may be different from those of U.S. shareholders. As an example

cited by market participants, the Industrial and Commercial Bank of China (ICBC), which is

the world’s largest bank in terms of total assets and is included in the MSCI Emerging Market

Index, deployed $430 million (RMB 3 billion) to shore up the Bank of Jinzhou in response to

governmental direction. ICBC’s investor announcement regarding this transaction provided only

a very brief and general explanation for the investment.28

Lack of Transparency in Bond Markets. Bond ratings in China have been characterized as

systematically skewed upward, reflecting both minimum rating requirements for issuance

and implicit guarantees. More than 80 percent of all Chinese bond issuers are rated AA and

above.29 Many accounting or market practices with respect to bond issuers are not in line

with international standards. For example, firms that appear stable or growing may in reality

be exposed to large, undisclosed risks. Without access to accurate market and accounting

information, investors are limited in their ability to accurately assess asset values.

DERA ECONOMIC AND RISK OUTLOOK | 35

Lack of Hedging Tools. Regulatory constraints, capital requirements, and operational costs

are among the reasons few hedging products are currently available to investors wanting to

protect against downside risk in the Chinese market. The lack of a Chinese stock-index futures

market that covers medium and small-cap stocks is particularly problematic for foreign investors

seeking to protect their positions. Given that the Chinese government concluded that much of

the 2015 market turmoil was due to derivative products,30 it is an open question as to whether

developments are forthcoming in this regard.

Macroeconomic Shocks. Other than the long-term inherent risks in China’s financial system,

there are also economic shocks that may interrupt China’s (and sometimes the global) economy,

like the COVID-19 pandemic. Given the country’s large, low-income population with limited

purchasing power,31 and a growth model that relies heavily on fixed investments and exporting,32

the economic impact of global macroeconomic shocks can have more significant consequence

for the Chinese economy and its domestic financial market and capital flow than for those of

other countries.33

National Security Risk. The increasing exposures of U.S. investors to Chinese financial markets

that are intertwined with the Chinese government’s political agenda has raised national security

questions for the U.S.34, 35 For example, certain domestic Chinese companies are included in

global financial market indexes, despite being directly involved in activities contrary to U.S.

interests. Table 4 reports Chinese companies that are in the MSCI China A Index and that are

also either in the U.S. government’s Entity List or have been designated as a “national security

threat” by certain U.S. agencies. Companies on the Entity List are deemed to have been “acting

contrary to the national security or foreign policy interests of the United States” or are a “threat

to the national security of the U.S.”36 Despite official U.S. policies banning a number of these

companies from doing direct business with U.S. persons, their increasing index inclusion has led

to an indirect flow of investments from U.S. investors into these companies.

Table 4. MSCI China A Index Companies that Are on the Entitle List or Have Been Banned

Company

Entity List or Banned

Dahua Technology

Entity List

Hikvision

Entity List

IFLYTEK

Entity List

FiberHome

Entity List

ZTE

FCC Designates it as National Security Threat*

Source: https://www.msci.com/index-consultations and https://www.bis.doc.gov/index.php/policyguidance/lists-of-parties-of-concern/entity-list and https://www.fcc.gov/document/fcc-designateshuawei-and-zte-national-security-threats

* Currently banned by the Federal Communications Commission from purchase of equipment using

U.S. public funds

36 | U.S. SECURITIES AND EXCHANGE COMMISSION

U.S.-China Policy Adjustment. Over the last few years, U.S.-China trade relationships have taken

a center stage. Recently, the president issued a memorandum directing the President’s Working

Group on Financial Markets, which includes officials from the Commission, the Treasury

Department, the Federal Reserve Board, and the Commodity Futures Trading Commission,

to study issues relating to, among other things, risks to U.S. investors and financial markets

posed by differing practices of Chinese companies listed on U.S. markets.37 Following Beijing’s

decision to impose its national security law in Hong Kong, the administration also announced

plans to revoke the special trade status of Hong Kong, as it is deemed no longer maintaining a

high degree of autonomy from China. Table 5 shows that at the end of April 2020, U.S. mutual

funds’ exposure (equities and bonds) to Chinese firms available in different exchanges totals

approximately $385 billion, with $183 billion available via Hong Kong’s market. Total U.S.

mutual funds’ exposure to Hong Kong dollar denominated security holdings are approximately

$264 billion. These holdings may be subject to increased volatility to the extent that Hong

Kong’s special trade status is revoked.

Table 5. U.S. Mutual Funds’ Exposures to Chinese Securities and HKD Denominated Securities

Panel A. Exposure to Chinese Firms Headquartered in China

Currency

Exposure ($ billion)

Renminbi (Shanghai, Shenzhen)—

A Shares and Domestic Bonds

43.5

Hong Kong Dollars

(Hong Kong)

183.2

U.S. Dollars (New York)

156.5

Other Currencies

2.1

Total

385.2

Panel B. Exposure to Hong Kong Dollar Denominated Securities

Location of Headquarters

Exposure ($ billion)

China

183.2

Hong Kong

71.8

U.S.

4.0

Others

4.8

Total

263.7

Source: Morningstar holdings reported at the end of April 2020 and DERA staff calculations.

DERA ECONOMIC AND RISK OUTLOOK | 37

Conclusion

The inclusion of Chinese domestic securities (A Shares and Domestic Bonds) into global financial

market indexes has raised a series of concerns for U.S. investors related to the transparency,

functioning, and integrity of the Chinese market. With the increasing number of Chinese

domestic securities becoming eligible for inclusion in various global financial market indexes,

there is significant risk of U.S. investors becoming more exposed to companies potentially subject

to U.S. policies, sanctions, and/or tariffs. While many of these issues are geopolitical in nature,

it is nevertheless important for U.S. investors to be cognizant of the risks. The evolution of

weighting in these indexes and the broader considerations discussed above warrant continued

monitoring. The issues discussed above are further complicated by the ongoing COVID-19

global pandemic, which has already caused significant effects in global financial markets and

global policy discussions.

Appendix: Large U.S. Public Pension Funds’ Exposure to China A Shares

Pension

AUM ($ bil)

Benchmark with China A Share Exposure

(in bold)

Link to Recent

Financial Report

California Public

Employees

$376.86

Five out of its seven sub-funds track

MSCI ACWI IMI (Net) (among other

benchmarks).

https://www.calpers.ca.gov/

docs/board-agendas/

202006/invest/item06c01_a.pdf

California State

Teachers

$230.209

International equity include 55 China A

share companies, with a total market value

of $332 mil

https://www.calstrs.com/

investment-table/international-equities

$213.241

Public Equity fund is benchmarked to MSCI

All Country World Index (ACWI). Its Total

Non U.S. Equity Composite fund ($27 bil)

tracks the MSCI ACWI Ex U.S. IMI (MSCI

ACWI Ex U.S. to 1/1/17)

https://www.osc.state.ny.us/

sites/default/files/retirement/

documents/pdf/2019-11/comprehensive-annual-financialreport-2019.pdf

$163.135

Its Global Equity Fund tracks a custom

version of the MSCI All Country World

Investable Market Index (ACWI IMI), in

dollar terms, net of withholding taxes on

nonresident institutional investors, adjusted

to reflect the provisions of the Protecting

Florida’s Investments Act.

https://www.sbafla.com/fsb/

Portals/FSB/Content/

Performance/Annual/

2018_2019_AIR.pdf?ver=

2020-02-20-125811-027

$153.126

External Public Total World Equity - Invests

in equity securities in countries represented

in the MSCI ACWI Value Index, as well as

certain other global markets

https://www.trs.texas.

gov/TRS%20Documents/

cafr_2019.pdf

$122.5

Its international equity portfolio, which represented 17.2% of System assets, generated

a return of 1.3%, in line with its benchmark,

the MSCI ACWI Ex-U.S. index. The global

equity portfolio, which represented 2.1% of

System assets and is exclusively actively

managed, returned 1.2% trailing its benchmark, the MSCI ACWI index, by 4.5%.

https://www.nystrs.org/

Library/Publications/AnnualReports/2019CAFR.pdf

New York State

Common

Florida State

Board

Texas Teachers

New York State

Teachers

38 | U.S. SECURITIES AND EXCHANGE COMMISSION

Wisconsin

Investment

Board

Washington

State Board

North Carolina

Ohio Public

Employees

$114.63

na

https://7ffb9e60-f2dc4359-b148-1db6b9d76c71.

filesusr.com/ugd/69fc6d_e0c

664dc85964d78953e358163

b6a534.pdf

$112.47

Its Collective Investment Trust Funds are

composed by three parts, each tracking 1)

Morgan Stanley Capital International (MSCI)

U.S. Investable Market Index (passive); 2)

the MSCI Emerging Markets Investable

Market Index (passive); 3) MSCI Emerging

Markets Investable Market Index (active)

https://www.sib.wa.gov/

financial/pdfs/annual/ar19.pdf

$111.37

Its Equity Collective Investment Trusts follows five equity index funds. Out of which,

the BlackRock International Index Fund

seeks to replicate the composition and performance of the MSCI ACWI Ex-USA Index.

https://files.nc.gov/retire/

documents/files/Reports/

June_30_2019NC_CAFR.pdf

$100.71

As of December 31, 2019, its Non-U.S.

Equity Benchmark (net) include: 55%

MSCI World Index x U.S. Standard (net),

31% MSCI Emerging Markets Standard

Index (net).

https://www.opers.org/

pubs-archive/financial/

cafr/2019-OPERS-Comprehensive-Annual-FinancialReport-CAFR.pdf

Source: The 2018 AUMs are based on this research paper, https://www.thinkingaheadinstitute.org/en/Library/Public/Research-and-Ideas/2019/09/P_I_300_2019_research_paper. New York City Retirement System is excluded in

the above table, as the AUM reflected in its financial report is less than $100 billion (the AUM in the research paper

may have included a few other pensions in New York City).

1

This is a spotlight by the staff of the Division of Economic and Risk Analysis (DERA) of the U.S. Securities and Exchange Commission (Commission). The Commission, as a matter of policy, disclaims

responsibility for any private publication or statement of any of its employees. The views expressed

herein are those of DERA staff and do not necessarily reflect the views of the Commission or other

members of the Commission staff.

2

Some of those listed companies are very large. For example, Alibaba Group Holding Ltd (BABA.N),

Baidu Inc. (BIDU.O) and JD.com Inc. (JD.O), have a combined U.S. market capitalization of more than

$500 billion (https://www.uscc.gov/sites/default/files/Chinese%20Companies%20on%20U.S.%20

Stock%20Exchanges.pdf).

3

Critics have also argued that China-based companies listed in the U.S. have an unfair advantage

compared with U.S. corporations as they de facto circumvent the accounting and governance

standards to which U.S. corporations are subject. See, e.g., https://www.cnbc.com/2020/04/03/

luckin-coffee-debacle-is-a-painful-reminder-of-fraudrisk.html and https://www.realclearpolitics.com/

articles/2019/10/19/why_are_american_investors_funding_chinese_fraud_141540.html and https://

tax.thomsonreuters.com/news/president-trump-criticizes-chinese-firms-refusal-to-follow-auditrulesseeks-solutions/. As of April 2020, out of the 269 unique issuers that PCAOB identifies on its website

as being public companies whose PCAOB-registered auditor is located in a jurisdiction having

obstacles to PCAOB inspections, 239 have auditors based in mainland China or Hong Kong (https://

pcaobus.org/International/Inspections/Pages/IssuerClientsWithoutAccess.aspx).

4

See, e.g., https://www.sec.gov/news/public-statement/emerging-market-investments-disclosurereporting

5

Shares in Chinese companies that are incorporated and listed outside of China are referred to by

other names, including Red Chips, P Chips, S Chips, N Shares, L Shares, and G Shares. In prior years,

U.S. investors who wanted exposure to China got it by investing in N Shares or American Depositary

Receipts, both of which trade on U.S. exchanges. See https://research.ftserussell.com/products/

downloads/Guide_to_Chinese_Share_Classes.pdf

DERA ECONOMIC AND RISK OUTLOOK | 39

6

Before 19 February 2001, domestic Chinese citizens were prohibited from trading B Shares.

See http://www.lehmanlaw.com/resource-centre/faqs/securities/what-are-b-shares.html

7

See http://www.szse.cn/enqfii/aboutqfii/

8

The QFII program’s initial capital controls have been relaxed over the years, and the quotas were

removed on 07 May 2020. See https://www.safe.gov.cn/en/2020/0507/1677.html, https://www.

law360.com/articles/1279403/china-s-relaxed-financial-sector-may-aid-foreign-investors. See also

https://www.hkex.com.hk/Mutual-Market/Stock-Connect?sc_lang=en and https://www.marketwatch.

com/story/heres-what-investors-need-to-know-about-mscis-inclusion-of-china-a-shares-in-itsindexes-2018-05-31

9

“How China Pressured MSCI to Add Its Market to Major Benchmark”, https://www.wsj.com/articles/

how-china-pressured-msci-to-add-its-market-to-major-benchmark-11549195201

10 Inclusion is different from weight. The former is the proportion of Chinese stocks that is included in

the index, while the latter is the proportion of the overall index that is based on Chinese securities.

11

See Panel A of Table 1 for the corresponding statistics for the FTSE Emerging Index and the S&P

Emerging BMI.

12 Policy bank refers to China Development Bank, the Agricultural Development Bank of China,

and the Export-Import Bank of China, see e.g. http://www.chinadaily.com.cn/a/201909/11/

WS5d788406a310cf3e3556afaa.html

13 Other bond types available through Bond Connect include Negotiable Certificate Deposit (NCD),

asset-backed security (ABS), etc., see https://www.chinabondconnect.com/en/Primary/PrimaryInformation/Onshore.html

14 For example, a $100 million fund that tracks an index that has an expected 5% weight at the end

of 2020 will have a projected exposure of $5 million. The expected year-end index weights used

in our estimates are either what the equity index providers have implemented, or the weights

announced by the relevant bond index providers (Bloomberg and JP Morgan) or market expectation

(FTSE Russell).

15 https://blogs.imf.org/2019/06/19/china-deepens-global-finance-links-as-it-joins-benchmark-indexes/

16 https://www.msci.com/documents/1296102/12275477/China_A_Further_Weight_Increase_

Feb_2019_Presentation.pdf and https://www.msci.com/documents/10199/822e3d18-16fb-4d239295-11bc9e07b8ba

17 https://www.tsp.gov/whatsnew/Content/index.html#ifundDefer

18 The ten largest state public pension funds that we examined are as follows (2018 AUM in parentheses): California Public Employees’ Retirement System ($376 billion), California State Teachers Retirement System ($230 billion), New York State Common Retirement Fund ($213 billion), Florida State

Board of Administration ($175 billion), Texas Teachers Retirement System ($153 billion), New York

State Teachers Retirement System ($122 billion), Wisconsin Investment Board ($114 billion), Washington State Board ($112 billion), North Carolina Retirement Systems ($111 billion) and Ohio Public

Employees Retirement System ($101 billion). Source of the pension funds’ AUM: https://www.thinkingaheadinstitute.org/en/Library/Public/Research-and-Ideas/2019/09/P_I_300_2019_research_

paper

19 About a quarter of PBGC’s International Public Stock fund, which accounts for 9.6% of its total AUM

of $119 billion, tracks MSCI EM, see https://www.pbgc.gov/sites/default/files/pbgc-fy-2019-annualreport.pdf

20 U.S. Teachers and Firefighters Are Funding Rise of China Tech Firms, https://www.bloomberg.com/

graphics/2019-china-tech-money-threatened-by-trade-war/

21 https://www.realclearpolitics.com/articles/2019/10/19/why_are_american_investors_funding_chinese_fraud_141540.html, https://www.wsj.com/articles/that-calm-chinese-stock-market-its-engineered-by-the-government-1527775089 and https://www.cnbc.com/2018/09/11/

chinas-stock-market-is-still-immature-so-volatility-is-to-be-expected-former-pboc-governorsays.html

22 https://www.internationalinvestment.net/opinion/4001647/china-debt

23 https://www.ft.com/content/068a83e0-27a7-11ea-9305-4234e74b0ef3 and https://www.reuters.

com/article/china-markets-default/chinas-private-firms-face-record-default-risk-to-stay-high-in2020-fitch-idUKL4N28K1YM

40 | U.S. SECURITIES AND EXCHANGE COMMISSION

24 In terms of size, the China equity market remains relatively small at only 46.5% of GDP, compared

with over 100% of GDP for most developed economies (https://cammackretirement.com/knowledge-center/insights/china-a-shares-the-implications-for-u-s-investors and https://www.ceicdata.

com/en/indicator/china/equity-market-index).

25 See, e.g., https://blog.alliancebernstein.com/library/will-china-export-volatility-as-equity-marketsopen, https://www.cnbc.com/2015/07/02/why-are-chinas-stock-markets-so-volatile.html, https://

www.cnbc.com/2018/09/11/chinas-stock-market-is-still-immature-so-volatility-is-to-be-expectedformerpboc-governor-says.html

26 DERA staff calculations show that the daily price volatility on the Chinese stock markets has been

higher than that for other Asian markets over the last 5, 10, 15 and 20 years. Moreover, using data

from the last nine years, the CBOE China ETF Volatility Index had a standard deviation of 6.7, while

the S&P 500-based CBOE VIX had a standard deviation of 5.3.

27 See https://www.ilo.org/dyn/natlex/docs/ELECTRONIC/92643/108008/F-186401967/CHN92643

Eng.pdf

28 “China’s Banking Sector Risks and Implications for the U.S.,” staff report by U.S.-China Economic

and Security Review Commission. (https://www.uscc.gov/research/chinas-banking-sector-risks-andimplications-united-states)

29 See https://www.wsj.com/articles/s-p-rating-is-landmark-for-chinese-bond-market-11562835842

30 https://www.bloomberg.com/opinion/articles/2019-12-01/msci-raises-bar-on-china-stocks-underincreased-u-s-criticism

31 “600 million Chinese earn 1,000 RMB a month — so are the Chinese rich or poor?”, https://www.

thinkchina.sg/600-million-chinese-earn-1000-rmb-month-so-are-chinese-rich-or-poor

32 https://www.imf.org/en/News/Articles/2017/08/09/NA081517-China-Economic-Outlook-inSix-Charts

33 https://www.iif.com/Portals/0/Files/content/1_IIF_Capital%20Flows%20Tracker_April.pdf

34 See, e.g. “The emergence of China, Inc.: behind and beyond the trade war” (https://www.researchgate.net/publication/341357034_The_emergence_of_China_Inc_behind_and_beyond_the_tra de_

war), “Congress Urged to Block Certain Chinese Investments in the U.S.” (https://www.pillsburylaw.

com/en/news-and-insights/congress-urged-to-block-certain-chinese-investments-in-the-us.html),

and “How China’s Economic Aggression Threatens the Technologies and Intellectual Property of the

United States and the World” (page 11, https://www.whitehouse.gov/wp-content/uploads/2018/06/

FINAL-ChinaTechnology-Report-6.18.18-PDF.pdf)

35 The China Securities Regulatory Commission requires listed companies to “set up Chinese Communist Party and carry out Party activities”. Furthermore, China’s 2017 National Intelligence Law states

that any organization shall support and cooperate with state intelligence and that the state protects

any organization that aids See, e.g., https://www.theepochtimes.com/china-requires-all-publiclylisted-companies-to-establish-communist-partybranches_2565214.html and https://www.reuters.

com/article/us-china-governance-party/chinas-listed-firms-need-tobeef-up-communist-party-building-activity-regulator-says-idUSKBN1JB16F.

36 The U.S. Department of Commerce’s Bureau of Industry and Security (BIS) first published the “Entity

List” in 1997 to inform the public of entities engaging in activities that could result in an increased

risk of the diversion of exported, re-exported, and transferred (in-country) items to weapons of mass

destruction programs. Since then, grounds for inclusion have expanded to activities sanctioned by

the U.S. State Department and activities contrary to U.S. national security and/or foreign policy interests. (https://www.bis.doc.gov/index.php/policy-guidance/lists-of-parties-of-concern)

37 https://www.whitehouse.gov/presidential-actions/memorandum-protecting-united-states-investorssignificant-risks-chinese-companies/

DERA ECONOMIC AND RISK OUTLOOK | 41

U. S . S E C U R I T I E S A N D E XC H A N G E CO M M I SS I O N