Health Care

The recently instituted S&P biotech rolling stop got triggered yesterday and we crystalized gains of 5% since the February 2019 inception. This index is now downgraded to neutral, but it does not affect the overall S&P health care positioning that remains modestly overweight. The recent selloff in the bond market along with the catch up phase in earnest of the more cyclically sensitive parts of the equity market explain the rolling stop trigger in the S&P biotech index. None of the upbeat demand drivers have changed since our last update, however we are obeying our stop in order to protect profits from a portfolio management perspective. Bottom Line: Trim the S&P biotech index to neutral for a gain of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. ​​​​​​​

Highlights Social distancing must persist to prevent dangerous super-spreading of COVID-19. The jobs recovery will be much weaker than the output recovery, because the sectors most hurt by social distancing have a very high labour intensity. This will force a prolonged period of ultra-accommodative monetary policy… …structurally favour T-bonds and Bonos over Bunds and OATs… …growth defensives such as tech and healthcare… …and the S&P 500 over the Euro Stoxx 50. Stay overweight Animal Care (PAWZ). Working from home has generated a puppy boom. Fractal trade: short gold, long lead. Feature As economies reopen, economists and strategists are quibbling about the shape of the output recovery: U, V, W, square root, or even ‘swoosh’. But for the furloughed or displaced worker, the more urgent question is, what will be the shape of the jobs recovery? Unfortunately, the jobs recovery will be much weaker than the output recovery – because the sectors most hurt by social distancing have a very high labour intensity (Chart Of The Week). Chart Of The Week 1ALeisure And Hospitality Makes A Large Contribution To Jobs Relative To Output Chart Of The Week 1BFinance Makes A Small Contribution To Jobs Relative To Output Output Might Snap Back, But Jobs Will Not The sectors most hurt by social distancing make a huge contribution to employment but a much smaller contribution to economic output. This is true for Europe and all advanced economies, though the following uses US data given its superior granularity and timeliness. The leisure and hospitality sector generates 11 percent of jobs, but just 4 percent of output. Retail trade generates 10 percent of jobs, but just 5 percent of output. It follows that if both sectors are operating at half their pre-coronavirus capacity, output will be down by 4.5 percent, but employment will collapse by 10.5 percent. Conversely, sectors which are relatively unaffected by social distancing make a small contribution to employment but a much bigger contribution to economic output. Financial activities generate just 6 percent of jobs, but 19 percent of economic output. Information technology generates just 2 percent of jobs, but 5 percent of output (Table I-1). Table I-1Sectors Hurt By Social Distancing Have A Very High Labour Intensity If economies are reopened but social distancing persists – either via government policy or personal choice – then output can rebound in a V-shape, but employment cannot (Chart I-2). Forcing a prolonged period of ultra-accommodative monetary policy, with all its ramifications for financial markets. Chart I-2UK Unemployment Is Set To Surge If The US Is Any Guide This raises a key question. Must social distancing persist? To answer, we need to pull together our latest understanding of COVID-19. COVID-19: What We Know So Far Many people argue that coronavirus fears are disproportionate. The mortality rate seems comfortingly low, at well below 0.5 percent (Chart 3). Yet this argument misses the point. Chart I-3The COVID-19 Mortality Rate Is Not High COVID-19 is dangerous not because it kills, but because it makes a lot of people seriously ill. It has a low mortality rate, but a high morbidity rate. According to the World Health Organisation, around one in six that gets infected “develops difficulty in breathing”. Moreover, The Lancet points out that many recovered COVID-19 patients suffer pulmonary fibrosis, a permanent scarring of the lungs that impairs their breathing for the rest of their lives. Hence, while COVID-19 is highly unlikely to kill you, it could damage your health forever1 (Figure I-1). Figure 1COVID-19 Is Unlikely To Kill You, But It Could Permanently Damage Your Lungs The most famous COVID-19 victim to date is British Prime Minister Boris Johnson who spent several days recovering in intensive care. By his own admission, Johnson’s only pre-existing conditions are that he is overweight and “drinks an awful lot”. But those pre-existing conditions could apply to a large swathe of the population. COVID-19 is virulent. But we now know that most infections are the result of so-called ‘super-spreaders’ – a small minority of virus carriers who infect tens or hundreds of other people. We also know that talking loudly, singing, or chanting tends to eject higher doses of the virus, and in an aerosol form that can linger in enclosed spaces. This creates the perfect conditions for one infected person to infect scores of others very quickly.  Based on this latest knowledge, the good news is that economies can reopen. The bad news is that, until an effective vaccine is developed, social distancing must persist. Specifically, people must avoid forming the crowds, congregations, and loud gatherings that can generate very dangerous super-spreading events. Hence, the sectors that are most hurt by social distancing – leisure and hospitality and retail trade – will continue to operate well below capacity for many months, at a minimum. And as these sectors have a very high labour intensity, there will be no V-shape recovery in jobs. Without Higher Bond Yields, European Equities Struggle To Outperform Social distancing is set to persist, which will create heaps of slack in advanced economy labour markets. This will force central banks to push the monetary easing ‘pedal to the metal’ – though in many cases, the pedal is already at the metal. In turn, this will force bond yields to stay ultra-low and, where they can, go even lower. One immediate takeaway is to stay overweight positively yielding US T-bonds and Spanish Bonos versus negatively yielding German Bunds and French OATs. Depressed bond yields must also compress the discount rate on competing long-duration investments that generate safely growing cashflows. Meaning, growth defensive equities such as technology and healthcare. Now comes the part that is conceptually difficult to grasp because it is novel to this unprecedented era of ultra-low bond yields. Take some time to absorb the following few paragraphs. For growth defensives, both components of the discount rate – the bond yield and the equity risk premium (ERP) – compress together. This is because the ERP is a tight function of the difference in equity and bond price ‘negative asymmetries’, defined as the potential price downside versus upside. When bond yields converge to their lower limit, bond prices converge to their upper limit, which increases the potential price downside versus upside. The result is that the difference in equity and bond negative asymmetries converges to zero, forcing the ERP to converge to zero. As the discount rate on growth defensives such as tech and healthcare collapses towards zero, the net present value must increase exponentially. This exponentially higher valuation of tech and healthcare is a mathematical consequence of the novel risk relationship between growth defensive equities and bonds at ultra-low bond yields. The unprecedented phenomenon has a major implication for European equity relative performance. The Euro Stoxx 50 is heavily underweight technology and healthcare, and this defining sector fingerprint is the key structural driver of European equity market relative performance (Chart I-4). Meanwhile, the relative performance of technology and healthcare is just an inverse exponential function of the bond yield (Chart I-5). The upshot is that European equities tend to outperform other regions only when bond yields are heading higher and the growth defensives are underperforming (Chart I-6). Chart I-4The Euro Stoxx 50's Underweight In Tech Drives Its Relative Performance Chart I-5Tech Outperforms When The Bond Yield Declines... Chart I-6...Hence, Without Higher Bond Yields The Euro Stoxx 50 Struggles To Outperform Some commentators are calling the higher valuations in tech and healthcare a new bubble. But it is a bubble only to the extent that bond yields are in a ‘negative bubble’, meaning that ultra-low yields are unsustainable. However, with social distancing set to leave heaps of slack in the advanced economy labour markets, ultra-low bond yields are here to stay and could go even lower. Moreover, as shown earlier, tech and healthcare demand and output are immune to social distancing. They may even benefit from social distancing. Hence, on a one-year horizon and beyond, stay overweight the growth defensive tech and healthcare sectors. And stay overweight the tech and healthcare heavy S&P 500 versus Euro Stoxx 50. A Puppy Boom We finish on a very positive note for animal lovers. The shift to working from home has generated a puppy boom. The Association of German Dogs claims that “the demand for puppies is endless” and the UK Kennel Club says that “there is unprecedented demand.” In the era of social distancing, the waiting list for puppies has quadrupled, and prices of easy to look after crossbreeds such as cockapoos have more than doubled. The demand for pet food and equipment is also very strong. Dogs make excellent companions for the socially isolated, which describes how many people are now feeling. Furthermore, with millions of people now working from home or on extended furlough, a growing number of households can fulfil the dream of owning a dog. We have recommended a structural overweight to the Animal Care sector based on the ‘humanisation’ of pets and the structural uptrend in spend per pet, especially on veterinary costs (Chart I-7). Animal Care has outperformed by 50 percent in the past two and a half years, but the shift to working from home will add impetus to the structural uptrend (Chart I-8). Chart I-7Animal Care Prices Are Rising... Chart I-8...And The Animal Care Sector Is Strongly Outperforming Stay overweight Animal Care. The ETF ticker, appropriately enough, is called PAWZ.  Fractal Trading System This week’s recommended trade is to short gold versus lead, given that the relative performance recently reached a fractal resistance point that has successfully identified four previous turning points. Set the profit target and symmetrical stop-loss at 13 percent. In our other open trades, five are in profit and one is in loss. The rolling 1-year win ratio now stands at 64 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1    https://www.thelancet.com/journals/lanres/article/PIIS2213-2600(20)30222-8/fulltext Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Special Report

The COVID-19 induced recession has accelerated several paradigm shifts that were already afoot. Populism, anti-immigrant sentiment, deglobalization, and fiscal profligacy were replete – particularly in the US – even before the pandemic. For the first time since WWII, the US budget deficit significantly expanded for three years running at a time when the unemployment rate was declining, late in the cycle. We fear that the Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus, as our geopolitical strategists have posited in the past. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. The most important long-term consequence of the Buenos Aires Consensus will be higher inflation. And we are not talking just the asset price kind – which investors have enjoyed over the past decade – but of the more traditional flavor: consumer price inflation (Chart 1). Chart 1Inflation Is Coming A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (Chart 2). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium (Chart 3). Chart 2Only A Whiff Of Inflation Is Good For Stocks Importantly, the magnitude of the economic damage, the likelihood that a “second wave” requires renewed lockdowns, and a new steady state of the apparent “square root” type of recovery remain unknown. This means that “deflationistas” may continue to have an upper hand on the “inflationistas”, as witnessed by the subdued inflation expectations (Chart 3). Chart 3In The Near-Term Disinflation Looms The Federal Reserve’s Function As The Lender Of Last Resort What is certain is the Fed’s resolve to keep things gelled together and allow businesses and the economy enough time to heal and overcome the coronavirus shock. Simply put, there are high odds that the Fed will remain accommodative and take inflation risk “sitting down” for quite some time, certainly for the next year, and likely longer (Chart 4). While early on, the Powell-led Fed had been ambivalent, the FOMC’s swift and immense response to the coronavirus calamity with unorthodox monetary policies has been appropriate and unprecedented (Chart 5). Clearly, the sloshing liquidity cannot cure the coronavirus, but providing the credit needed in parts of the financial markets and select business sectors that had completely dried up was the proper policy response. The Fed acted promptly as a lender of last resort. Unlike the difficulty in defeating deflation – look no further than Japan – ending inflation is easy. The great Paul Volcker has taught the Fed and the world how to break the back of inflation. The Fed, therefore, has the credible tools to deal with a possible inflationary impulse. Chart 4Do Not Fight The Mighty Fed Chart 5Joined At The Hip Until economic growth regains its footing and climbs to its post-GFC steady 2-2.5% real GDP growth profile, the probability is high that the Fed will take some inflation risk (Chart 6). Chart 6The Fed Can Afford To Take Inflation Risk This is especially the case given that political risk in the US is tilted to the downside. With income inequality at nose bleeds levels, US policymakers (both fiscal and monetary authorities) will hesitate to act on the inflation mandate with gusto and objectivity (Chart 7). Chart 7The Apex Of Globalization And Income Inequality The Fed will therefore not rush to abruptly tighten monetary policy, a view confirmed by the bond market: fed funds futures are penciling a negative fed funds rate in mid-2021 and ZIRP as far as the eye can see (Chart 8). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside, which would compel the Fed to aggressively raise the fed funds rate. But that is not on the immediate horizon especially given the recent coronavirus-related blow to unit labor costs (please see Appendix below). Even if there were an inflationary backup in longer term Treasury yields, yield curve control is a tool the Fed is considering, something it first tried on the Treasury’s orders during and following WWII for a nine year period. Chart 8ZIRP As Far As The Eye Can See Dollar And The Inflationary Valve Importantly, the US dollar’s direction will be critical in determining whether any lasting inflation acceleration occurs. The top panel of Chart 9 shows that inflation accelerates during U.S. dollar bear markets. A depreciating greenback greases the wheels of the global financial system and also serves as a global growth locomotive given that trade is largely conducted in US dollars (bottom panel, Chart 9). Thus, the Fed’s recent US dollar swap lines to other Central Banks, along with its FIMA facility, were instrumental in unclogging the global financial system. Sloshing US dollar liquidity restored a semblance of normality to asset prices (Chart 10). Chart 9Inversely Correlated Chart 10Ample Liquidity To Debase The Greenback As we highlighted in our December 16 Special Report titled “Top US Sector Investment Ideas For The Next Decade” ,1 there are rising odds that a US dollar bear market takes root this decade. Eventually, the steeper the greenback’s fall, the higher the chance of a longer lasting inflationary spurt as US import price inflation will rear its ugly head (Chart 11). Chart 11US Dollar Bear Markets Are Synonymous With Inflation So What? While, in the near-term, accelerating inflation is a negligible risk owing to excess economic slack, in the intermediate-term, it is a rising probability outcome. BCA’s long-held de-globalization theme,2 the US/Sino trade war that is here to stay irrespective of the next electoral outcome and excessive US government fiscal largesse will likely, in the next two-to-three years, swing the global deflation/inflation pendulum toward sustained inflation (Chart 12). For investors that are worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap, especially if inflationary pressures become more acute sooner than we anticipate. Chart 12Deglobalization Will Result In Inflation Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be the primary beneficiaries. Table 1 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. On the flip side, utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. Table 1S&P 500 Sector Performance During Inflationary Periods With the exception of real estate, our portfolio will benefit from an accelerating inflationary backdrop. However, our early- and late-cyclical preference to defensives is a consequence of the current stage of the cycle: when in recession it pays to have a cyclical portfolio bent (please see Charts 6 and 7 from our mid-April Weekly Report).3 Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to further shift our portfolio in order to benefit from accelerating inflation. What follows is a one page per sector analysis of the impact of inflation on pricing power and performance. Sectors are ranked by their average returns (largest to smallest) in the six inflationary cycles we studied as shown on Table 1.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Health Care Health care stocks have consistently outperformed during the six inflationary periods we examined. Over the long haul, it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is on a secular rise around the globe most recently further catalyzed by the COVID-19 pandemic: in the developed markets driven largely by the aging population and in the emerging markets by the accelerating adoption of health care safety nets and higher standards. Chart 13Health Care Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector’s pricing power prospects that suffered from a constant derating. Now that political uncertainty has lifted as Biden is a more moderate Democratic President candidate than either Sanders or Warren, a rerating looms. Finally, demand for health care goods and services will not only remain robust, but also get a boost from the recent coronavirus pandemic as governments around the globe beef up their health care response systems. Chart 14Health Care Energy The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 above). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge. Chart 15Energy Relative energy pricing power collapsed during the COVID-19 accelerated recession plumbing multi-decade lows. Saudi Arabia’s decision in early-2020 to refrain from balancing the oil market triggered a plunge in WTI crude oil prices to negative $40/bbl. While global demand remains deficient, this breakdown in oil prices has brought some much needed supply discipline in global oil producers including US shale. As the reopening of economies takes hold oil demand will recover and absorb excess oil inventories. While base effects will push crude oil inflation to the stratosphere in Q1/2021, eventually a more balanced global oil market will pave the way to a sustainable rebound in oil prices. Chart 16Energy Real Estate REITs have outperformed the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (Table 1 above). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation. Chart 17Real Estate Following the GFC trough, REITs pricing power has outpaced the overall CPI. CRE selling prices had been on a tear since the GFC, but the ongoing recession has short-circuited this hard asset’s near uninterrupted price appreciation; according to Green Street Advisors, average CRE prices contracted by roughly 10% in April. Worrisomely the persistent multi-family construction boom and the “amazonification” of the economy will act as a restraint to the apartment REIT and shopping center REIT segments, respectively. Tack on the longer-term knock-on effects of the work-from-home wave that has staying power and even office REITs may suffer a demand-related deflationary shock. Chart 18Real Estate Materials Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind. Chart 19Materials Our relative materials pricing power gauge is currently contracting, but encouragingly it is showing some signs of stabilization. The drubbing in Chinese GDP in Q1 has dealt a blow to commodities-related demand and thus prices as infrastructure projects ground to a halt. As the Chinese economy has restarted slightly ahead of developed markets a return to normalcy is a high probability outcome in the back half of the year. Keep in mind that the delayed effect of stimulus spending should also hit in Q3 and Q4 likely further tightening commodity markets. Chart 20Materials Consumer Discretionary While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power. Chart 21Consumer Discretionary Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, and are on a trajectory to hit double digit growth. Deflating energy prices, ultra-loose monetary conditions and the $3tn fiscal stimulus have kept the US consumer afloat. As Washington and the Fed are providing a lifeline to the economy during the recession, the reopening of the economy has the potential to turbo-charge consumer discretionary spending as pent up demand will get unleashed. Chart 22Consumer Discretionary Financials Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Chart 23Financials Financials sector pricing power has jumped by about 450bps since the 2019 trough and have exited deflation. Given the recent steepening of the yield curve that is typical at the depths of the recession, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop even temporary could also provide a fillip to margins and offset the large precautionary provisioning that banks are taking to combat the looming recession-related losses. Chart 24Financials Industrials The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges. Chart 25Industrials Following a three-year period in the deflation zone, industrials relative pricing power is steadily rising, likely as a consequence of decreasing supplies, CEO discipline and the ongoing US/Sino trade war. The previously expansionary mindset has given way to retrenchment, as the scars from the late-2015/early 2016 manufacturing recession remain fresh. However, infrastructure spending is slated to increase at some point in late-2020 as China revs its economic engine and bolster the demand prospects for this deep cyclical sector. Chart 26Industrials Consumer Staples Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector’s track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign. Chart 27Consumer Staples Relative consumer staples pricing power has slingshot higher and is flirting with the upper bound of the past three decade range near the 10% mark. The current recession has augmented the status of consumer staples. While the lockdowns has dealt a blow to select discretionary purchases, demand for staples has actually increased according to recent retail sales and inflation data releases. Tack on falling commodity input costs and the implication is that consumer staples manufacturers will likely continue to enjoy widening profit margins. Chart 28Consumer Staples Tech Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than is typically perceived, generating enormous amounts of free cash flow. Cash flow growth is also steadier than in the past and has served as a catalyst to embark on shareholder friendly activities. Chart 29Tech Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2016, it has recently soared as tech companies preserved their pricing power, but overall wholesale inflation has suffered a sizable setback. Importantly, demand for tech goods and services has remained resilient during the current recession, further adding to the allure of the tech sector. Chart 30Tech Utilities Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis (Table 1 above). In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry’s lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times. Chart 31Utilities Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry’s marginal price setter, have risen 18% since the early-April trough, signaling that recent utility pricing power gains have more upside. Nevertheless, as the economy is gradually reopening, soft data will stage a V-shaped recovery bolstering the odds of a selloff in the bond market. Such a backdrop will dampen the demand for high-yielding defensive equities, including pricey utilities. Chart 32Utilities Telecom Services Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 above. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa. Chart 33Telecom Services Telecom services pricing power has been on a recovery mode since February 2017 when Verizon surprised investors and embarked on a price war by reinstating its unlimited plans in order to defend its market share. Importantly, earlier in the year telecom carriers relative selling prices exited deflation coinciding with the completion of the T-Mobile/Sprint deal. Intra-industry M&A is over as now only three major wireless providers are left raising the threat of monopolistic power. Nevertheless, the ongoing 5G deployment is of the utmost importance for telecom carriers and a foray further into cable/media/content services is inevitable so that the telecom incumbents move beyond being “dumb pipelines”. Chart 34Telecom Services Appendix Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6     Footnotes 1     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com 2     Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization - All Downhill From Here” dated November 12, 2014, available at gps.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.

Overweight (Downgrade Alert) We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits since February 2019. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs in absolute terms, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (see chart), but also to the more speculative NASDAQ biotech index that comprises 209 stocks. However, we do not want to overstate our welcome and are putting the index on downgrade alert and instituting a 5% rolling stop in order to protect profits. Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. Please refer to this Tuesday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX.  

Highlights Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Chart 3US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Chart 5Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Chart 7UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Chart 9Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy The Fed’s extremely easy monetary backdrop along with easy fiscal policy remain the dominant macro themes, and they will continue to underpin the equity market. We remain constructive on the equity market’s prospects on a cyclical 9-12 month time horizon. While the path of least resistance remains higher for the S&P biotech index, we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. Relative supply/demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.   Recent Changes Initiate a long S&P homebuilders/short S&P real estate trade, today. Table 1 Feature The SPX had a bumper week last week, but failed to pierce through the 200-day moving average. A flare up in the US/China trade war, a barrage of positive coronavirus vaccine news and Jay Powell’s 60 minutes interview brought back some volatility in trading, however, the VIX remains in a steady downturn. Importantly, investors are nowhere near as complacent as during the 2018/19 or early 2020 SPX peaks, judging by VIX futures positioning (net speculative positions shown inverted, Chart 1). Chart 1Positioning Is Far... In other words, there is still room for equities to rise before sentiment reaches greedy levels. A number of other indicators we track confirm that recent SPX trading is associated more with panic than with euphoria. Namely, Chart 2 shows that our Complacency-Anxiety, Capitulation and Equity Sentiment Indicators, all corroborate that investor confidence is far from previous exuberant peaks, and signal that there is scope for additional equity gains on a cyclical 9-12 month time horizon.  Delving deeper into investor psyche, our sense is that there are three distinct camps of investors at the current juncture, two of which are fiercely battling it out in the stock market. Chart 2…From Complacent First there are the pessimists that we call “second wavers” that are more often than not also “Fed non-believers” or “Fed fighters”. They argue that stocks are extremely expensive and if a second wave of the corona virus hits, then stocks are going to plunge anew given the lack of a valuation cushion, as all the money in the world (Fed QE5) cannot cure the virus (top panel, Chart 3). Second, there are the optimists that are hopeful that a vaccine/drug cocktail discovery is looming to effectively eradicate the coronavirus. These investors also believe in the smooth reopening of the economy. But, even if there were a second wave, their thinking goes that our societies/governments/health care systems are all going to be more prepared and effective to deal with a second viral outbreak in the fall. In addition, they are in the “do not fight the Fed” camp. Finally, there are the more moderate investors that lie somewhere in between these two camps. They sat tight and held on to their stock positions during the 36% peak-to-trough SPX drawdown and have likely been on the sidelines lately (bottom panel, Chart 3) awaiting a catalyst to either deploy fresh capital or raise some cash. We are in the more optimistic camp and while a vaccine may be months away, we will have to figure out a way as a society to more effectively protect the elderly that are most at risk from the virus and continue to live on, as we first posited in the March 23rd Weekly Report when we outlined 20 reasons to buy stocks and reprint here: "20. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a breakthrough in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus."1 Chart 3Cash Hoarding Is Associated With Market Troughs Chart 4Loose Monetary Policy… Moreover, we definitely refrain from fighting the Fed as we outlined in our recent “Fight Central Banks At Your Own Peril” Weekly Report2 and reiterate that view today (Chart 4). While some investors were surprised by Jay Powell’s 60 Minutes interview remarks on the way the Fed digitally creates money, Ben Bernanke in another 60 Minutes interview in March 20093 made a similar comment that we cited in our March 23 Weekly Report (please refer to reason number 6 to buy equities).4 Importantly, we felt that Jay Powell’s demeanor was more like “please test our resolve Mr. Market if you reckon the FOMC is out of ammunition”. As a reminder, the Fed is in a position of strength: devaluing a currency is easy, revaluing/defending a currency is difficult and at times impossible as FX (and gold) reserves eventually run dry. In sum, the Fed’s extremely easy monetary backdrop along with easy fiscal policy (Chart 5) remain the dominant macro themes, and they will continue to underpin the equity market. Eventually, a liquidity handoff to growth will take root, and the SPX will no longer require the immense fiscal and monetary supports. As a result we continue to believe that stocks will be higher in the coming 9-12 months. Chart 5…And Easy Fiscal Policy Are Underpinning Stocks Biotech Delivers We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits, however we do not want to overstate our welcome and are putting it on downgrade alert and instituting a 5% rolling stop in order to protect profits. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (Chart 6). The broader-based NASDAQ biotech index comprising 209 stocks has also quietly sprang to uncharted territory. True, relative share prices have yet to make the all-time high leap, but have bested the market roughly by 30% year-to-date irrespective of the biotech index or ETF tracked (Chart 6). Importantly, growth stocks in general and biotech stocks in particular perform exceptionally well in a disinflationary growth environment. Therefore biotech stocks are the primary beneficiaries of the Fed’s QE5 and NIRP policies at a time when inflation is missing in action (top panel, Chart 7). Chart 6Earnings-Led Advance This goldilocks backdrop is also evident in the US bank credit impulse that has gone parabolic. When there is flushing liquidity and growth is scarce and declining, investors flock to any growth they can get their hands on (bottom panel, Chart 7). Chart 7Goldilocks Backdrop US dollar based liquidity, also underpins biotech stocks. In recent research, we have been highlighting that the Fed is indirectly targeting the debasing of the greenback. All this excess US dollar liquidity will eventually boost global growth, and reflate corporate earnings via the export relief valve. Biotech stocks will also get a fillip from a depreciating US dollar (Chart 8). Our overweight thesis in biotech was predicated – among other things – upon Big Pharma taking out biotech players and acquiring their coveted drug pipelines. We continue to side with the potential M&A targets, rather than the acquirers. The number of industry M&A deals has reached fever pitch and deal premia are still averaging over 60% (Chart 9). Chart 8Dollar Flooding Is A Boon For Biotech Equities Currently, the global race to find a coronavirus vaccine has further propelled biotech stocks. Indeed, investors are voting with their feet and are betting on a vaccine breakthrough. Thus, the allure of biotech stocks has also increased a notch as the possibility of a vaccine makes their earnings streams even more valuable and desirable to Big Pharma. A mega M&A deal in the space would not take us by surprise. Chart 9M&A Activity Will Remain Robust A few words are in order on the earnings, valuation and technical fronts. While relative share price momentum is galloping higher, it is moving in lockstep with rising earnings estimates (second panel, Chart 10). We would be extremely concerned if this were a multiple expansion driven relative share price advance. In fact, the biotech forward P/E trades both below the historical mean and at a 39% discount to the broad market hovering near an all-time low (Chart 10). Even on a dividend yield basis, biotech stocks are cheap sporting a higher (and safer) dividend yield than the SPX (bottom panel, Chart 10). Chart 10Biotech Stocks Are As Cheap As They Have Ever Been Chart 11Earnings Hurdle Remains Low Finally, relative long-term profit growth euphoria reaching astronomical levels, preceded previous S&P biotech index peaks: three times in the past two decades biotech stocks were projected to surpass SPX profit growth by roughly 10%. The current reading has plunged to negative 1.2% (Chart 11). Netting it all out, the global race for a coronavirus vaccine, robust earnings growth, ample US dollar liquidity and generationally low interest rates suggest that the path of least resistance remains higher for the S&P biotech index.   Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. Intra-Real Estate Trade Idea There is an exploitable trade opportunity in the real estate market, preferring residential real estate to commercial real estate (CRE). The cleanest way to play this is via a long S&P homebuilders/short S&P REITs pair trade, and we recommend initiating such a market-neutral trade today. Relative performance remains below the upward sloping time trend and at least a mini overshoot phase is in the cards in the coming quarters (Chart 12). One of the key drivers for this pair trade is the ebb and flow of owning versus renting and the current message is positive for homebuilders at the expense of REITs (Chart 13). Chart 12Looming Overshoot Phase Chart 13Own Versus Rent Upswing Is Bullish For The Pair Trade Home ownership has suffered a setback and never reclaimed its pre GFC highs. However, there is pent up demand for single family homes, especially given the recent drubbing of interest rates which should bring first time home buyers back into the market. Millennials up to now have been more of a renter generation, but as household formation increases for the largest cohort in the US, homeownership will make a comeback. One can argue that both real estate segments are interest rate sensitive and that they should benefit from lower rates. However, banks are more willing to lend to consumers in order to buy a home rather than to investors for CRE properties/projects by a factor of 2:1 according to the latest Federal Reserve Senior Loan Officer survey.5 Similarly, whereas demand for CRE loans has collapsed according to the same survey in April, demand for residential real estate loans spiked (top panel, Chart 14). In times of coronavirus-induced social distancing there is a lot more risk associated with CRE versus residential properties. Apartment REITs for example have an element of density-related risk versus the allure of a single family home in the suburbs. Likely social distancing will place a premium on single family homes in coming quarters at the expense of living in high rises in the city. This backdrop bodes well for home prices, but ill for CRE prices which according to Green Street Advisors contracted by 9% in April.6 Keep in mind that residential real estate price only very recently surpassed their 2006 zenith whereas CRE price are still hovering at one standard deviation above the previous peak (Chart 14). Debt deflation is a real threat for CRE prices and given that REITs are at the bottom of this levered asset’s capital structure it is last to collect.  Also the long-term ramifications to demand on CRE are grave compared with residential real estate. On the office REIT segment as an example, we deem that corporations will rethink their often expensive downtown office space requirements and likely downsize, as working from home has become mainstream. The unintended consequence of this realization is that demand for (larger) single family homes will also increase as workers opt to set up more comfortable working spaces at suburban homes. Chart 14Homebuilders Have The Upper Hand Shopping mall REITs are under relentless attack from the Amazonification of the economy and now have to contend with social distancing. The retail shopping experience will never be the same again sustaining the threat of extinction for shopping centers. On the construction front, single family housing starts are breaking ground at the historical mean and way below the 2006 peak run-rate, however, multi-family supply has gone parabolic (Chart 15). These diverging supply conditions are a harbinger of rising relative share prices. Finally, with regard to technicals and valuations homebuilders have the upper hand. Our Technical Indicator is in the neutral zone and relative valuations have collapsed near all-time lows offering a compelling entry point to the pair trade (Chart 16). Chart 15Supply Dynamics Favor Homebuilders Chart 16Relative Pessimism Is Contrarily Positive Netting it all out, relative supply and demand dynamics, social distancing, the pendulum swinging from renting to owing and enticing relative technicals and valuations, all signal that a long S&P homebuilders/short S&P REITs pair trade is primed to generate alpha.  Bottom Line: Initiate a long S&P homebuilders/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. 3    https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    https://www.federalreserve.gov/data/sloos/sloos-202004.htm 6    https://www.greenstreetadvisors.com/insights/CPPI             Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights German bunds and Swiss bonds are no longer haven assets. The haven assets are the Swiss franc, Japanese yen, and US T-bonds. Gold is less effective as a haven asset. During this year’s coronavirus crash, the gold price fell by -7 percent. As such, our haven asset of choice for a further demand shock would be the 30-year T-bond, whose price rose by 10 percent during the crash. Technology and healthcare are the two sectors most likely to contain haven equities. Fractal trade: long Polish zloty versus euro. German Bunds And Swiss Bonds Are No Longer Haven Assets Chart of the WeekGold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset European investors have been left defenceless. German bunds and Swiss bonds used to be the safest of haven assets. You used to be able to bet your bottom dollar – or euro or Swiss franc for that matter – that the bond prices would rally during a demand shock. Not in 2020. When the global economy and stock markets collapsed from mid-February through mid-March, the DAX slumped by -39 percent. Yet the German 10-year bund price, rather than rallying, fell by -2 percent, while the Swiss 10-year bond price fell by -4 percent.1  The lower limit to bond yields is around -1 percent. The reason is that German and Swiss bond yields are close to the practical lower limit to yields, which we believe is around -1 percent (Chart I-2). This means that German and Swiss bond prices cannot rise much, though they can theoretically fall a lot. Chart I-2German And Swiss Bond Yields Are Near Their Practical Lower Bound The behaviour of German bunds and Swiss bonds during the current crisis contrasts with previous episodes of market stress when their yields were unconstrained by the -1 percent lower limit. During the heat of the euro debt crisis in 2011, the 10-year bund price rallied by 12 percent. Likewise, during the frenzy of the global financial crisis in 2008, the 10-year bund price rallied by 7 percent (Chart I-3 - Chart I-5). Chart I-3German And Swiss Bonds Protected Investors During The 2008 Crash Chart I-4German And Swiss Bonds Protected Investors During The 2011 Crash Chart I-5German And Swiss Bonds Did Not Protect Investors During The 2020 Crash The defencelessness of European investors can also be illustrated via a ‘balanced’ 25:75 portfolio containing the DAX and 10-year German bund. The balanced portfolio theory is that a large weighting to bonds should counterbalance a sharp sell-off in equities, thereby protecting the overall portfolio. The theory worked well… until now. In this year’s coronavirus crisis, the 25:75 DAX/bund portfolio suffered a loss of -13 percent. This is substantially worse than the loss of -2 percent during the euro debt crisis in 2011, and the loss of -7 percent during the global financial crisis in 2008 (Chart I-6 - Chart I-8). Chart I-6A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash Chart I-7A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash Chart I-8A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash What Are The Haven Assets? The lower limit to the policy interest rate – and therefore bond yields – is around -1 percent, because -1 percent counterbalances the storage costs of holding physical cash or other stores of value. If banks passed a deeply negative policy rate to their depositors, the depositors would flee into other stores of value. But if banks did not pass a deeply negative policy rate to their depositors, it would wipe out the banks’ net interest (profit) margin. Either way, a deeply negative policy rate would destroy the banking system. German and Swiss bond prices cannot rise much. German and Swiss bond yields are close to the -1 percent lower limit, meaning that the bond prices are close to their upper limit. Begging the question: what are the haven assets whose prices will rise and protect long-only investors when economic demand slumps? We can think of three. The Swiss franc. The Japanese yen (Chart I-9). US T-bonds. Chart I-9The Swiss Franc And Japanese Yen Are Haven Assets During the coronavirus crash, the 10-year T-bond price rallied by 4 percent while the 30-year T-bond price rallied by 10 percent (Chart I-10). Compared with German bund and Swiss bond yields, US T-bond yields were – and still are – further from the -1 percent lower limit. The good news is that long-dated T-bonds can still protect investors during a demand shock, although be warned that the extent of protection diminishes as yields get closer to the lower limit. Chart I-10Long-Dated US T-Bonds Are Haven Assets What about gold? As gold has a zero yield, it becomes relatively more attractive to own as the yield on other haven assets declines and turns negative. In fact, through the last three years, the gold price has been nothing more than a proxy for the US 30-year T-bond price (Chart of the Week). But gold is an inferior haven asset. During the coronavirus crash, the gold price fell by -7 percent, meaning it did not offer the protection that T-bonds offered. As such, our haven asset of choice for a further demand shock would not be gold. It would be the 30-year T-bond. What Are The Haven Equities? Many investors still use (root mean squared) volatility as a metric of investment risk. There’s a big problem with this. Volatility treats price upside the same as price downside. This is unrealistic. Nobody minds the price upside, they only care about the downside! Hence, a truer metric of risk is the potential for short-term losses versus gains. This truer measure of risk is known as negative asymmetry, or negative skew. In the twilight zone of ultra-low bond yields, bond prices take on this unattractive negative skew. As German bunds and Swiss bonds have taught us this year, bond prices can suffer losses, but they cannot offer gains. This means that bonds become riskier investments relative to other long-duration investments such as equities whose own negative skew remains relatively stable. The upshot is that the prospective return offered by equities must collapse. This is because both components of the equity return – the bond yield plus the equity risk premium – shrink simultaneously.  Equity valuations rise as an exponential function of inverted bond yields. Given that valuation is just the inverse of prospective return, the effect is that equity valuations rise as an exponential function of inverted bond yields. Chart I-11 illustrates this exponentiality by showing that technology equity multiples have tightly tracked the inverted bond yield plotted on a logarithmic scale. Chart I-11Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Unfortunately, not all equities will benefit from this powerful dynamic. Equities must meet two crucial conditions to justify this exponential re-rating. One condition is that their sales and profits must be relatively resilient in the face of the current coronavirus induced demand shock. And they should not be at risk of a structural discontinuity, as is likely for say airlines, leisure and many other old-fashioned cyclicals. A second condition is that their cashflows must be weighted further into the future, so that their ‘net present values’ are much more geared to the decline in bond yields. Equities that meet these two conditions are likely to benefit the most from the ongoing era of ultra-low bond yields. And the two equity sectors that appear the biggest beneficiaries are technology and healthcare. In the coronavirus world, these two sectors will likely contain the haven equities. Stay structurally overweight technology and healthcare. Fractal Trading System* This week’s recommended trade is to go long the Polish zloty versus the euro. The profit-target and symmetrical stop-loss are set at 2 percent. Most of the other open trades are flat, though long Australian 30-year bonds versus US 30-year T-bonds and Euro area personal products versus healthcare are comfortably in profit.  The rolling 1-year win ratio now stands at 61 percent. Chart I-12PLN/EUR When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 From February 19 through March 18, 2020. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Neutral On Monday’s Weekly Report we put the S&P managed health care index on downgrade alert and instituted a 5% rolling stop on the position in order to protect gains for our portfolio. This downgrade alert reflected the following rising risks: First, that rising unemployment will weigh on health care enrollment as now over 30mn Americans have filed for unemployment insurance claims over the past six weeks. Second, falling interest rates will also weigh on industry profitability given that these insurers invest their premia in the risk-free asset. And finally, relative valuations were perky and technicals overbought. On Wednesday this rolling stop was triggered. We are compelled to obey this risk management portfolio tool we recently implemented, and crystalize handsome gains since the April 2019 inception (see chart). Bottom Line: Trim the S&P managed health care index to neutral and book profits of 26% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH-UNH, ANTM, HUM, CNC.

Overweight (Downgrade Alert)   In this Monday’s Weekly Report we put the S&P managed health care index on downgrade alert to reflect, at the margin, recent negative news. Over the past five weeks unemployment insurance claims have soared to 26.5mn, erasing all the employment gains of the previous decade, thus private insurance enrollment will likely take a sizable hit (top panel). On the income side, the premia that HMOs take in are typically invested in the risk free asset, and given the two month fall from 1.5% to around 0.6% in the 10-year Treasury yield, managed health care earnings will also suffer a setback (bottom panel). Bottom Line: Stay overweight the S&P managed health care index, but it is now on our downgrade watch list. We also instituted a rolling 5% stop as a portfolio management tool in order to protect profits. The position is currently up 31% since the April 2019 inception. Please refer to yesterday’s Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG: S5MANH-UNH, ANTM, HUM, CNC.