Consumer Discretionary

Foreword Today we are publishing a charts-only report focused on the S&P 500, and GICS 1 sectors.  Many of the charts are self-explanatory; to some, we have added a short commentary. The charts cover macro, valuations, fundamentals, technicals, and the uses of cash. Our goal is to equip you with all the data you need to make investment decisions along these sector dimensions. We also include performance, valuations and earnings growth expectation tables for all styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We alternate between Styles and Sector chart pack updates on a bi-monthly basis. Changes In Positioning Downgrade Growth to an equal weight and upgrade Value to an equal weight.  Upgrade Small to an overweight and downgrade Large to an underweight. Downgrade Technology to equal weight by reducing overweight in Software and Services.  We remain overweight Semiconductors and Equipment. We are on board with the ongoing market rotation: We were waiting for a decisive shift in rates and a dissipation of the Covid-19 scare as a signal to initiate this repositioning (Chart 1). Chart 1Performance Of S&P 500 Sectors And Styles US Equity Chart Pack US Equity Chart Pack Overarching Investment Themes: Rotation Has Begun! Taper Tantrum 2.0: With tapering imminent and monetary tightening around the corner, both real yields and nominal yields are up sharply over the past couple of weeks (Chart 2A).  Chart 2ARates Are Up Sharply Rates Are Up Sharply Rates Are Up Sharply Chart 2BProbability Of Two Rate Hikes In 2022 Has Been Climbing Probability Of Two Rate Hikes In 2022 Has Been Climbing Probability Of Two Rate Hikes In 2022 Has Been Climbing Market expects two rate hikes by the end of 2022: Although Chairman Powell has explicitly separated the decision to taper from the timing of the first rate hike, which he conditioned on full employment and which is “a long way off,” the market is still spooked by the timing and the speed of rate hikes. Currently, the probability of two rate hikes in 2022 stands at around 40%, rising sharply over the past two weeks (Chart 2B). The BCA house view is that the Fed will start hiking in December of 2022. Market rotation is on: Rising yields and a recent decline in Delta variant infections have triggered a fast and furious style and sector rotation. Higher rates put pressure on rate-sensitive sectors and styles, such as Growth, Technology, Communication Services, and Real Estate. While the “taper tantrum” pullback affects the entire US equity market, areas most geared to rising rates, such as Cyclicals, Financials, and Small Caps fare the best (Chart 3). An easing of the Delta scare has led to the “reopening” trade outperforming the ”work-from-home” trade.   Chart 3Rotation Away From Rate-sensitive Sectors And Styles US Equity Chart Pack US Equity Chart Pack Macro Economic slowdown is finally priced in: At long last, deteriorating economic data is fully digested by investors. The Citigroup Economic Surprise index is still in negative territory (Chart 4A) but has turned decisively. The markets move on the second derivative and a “less bad” economic surprise is a major positive for the markets. Chart 4ADeterioration Of Economic Data Is Finally Priced In Deterioration Of Economic Data Is Finally Priced In Deterioration Of Economic Data Is Finally Priced In Chart 4BSupply Bottleneck Are Not Easing Supply Bottleneck Are Not Easing Supply Bottleneck Are Not Easing Supply-chain disruptions are not abating: Shipping costs continue their ascent. The average delay of cargo ships traveling between the Far East and North America is 12 days – compare that to 1 day in January 2020.1 The ISM PMI Supplier Performance index increased from 69.5 in August to 73.4 indicating that supply bottlenecks are not easing (Chart 4B). There are also significant backlogs of goods (Chart 5A), and plenty of new orders. It will take time for supply chains to normalize, with most industry participants expecting the situation to improve only in 2022. Chart 5AManufacturers Are Overwhelmed Manufacturers Are Overwhelmed Manufacturers Are Overwhelmed Chart 5BA Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? Labor shortages: Companies are still struggling to fill job openings. According to the US Census Survey, “pandemic layoff” or “caring for children” were the top reasons for not working. The number of people not working because of Covid-19 infections or fear of Covid spiked at the end of August.2  This explains the August jobs report. The ugly “S” word: With the ubiquitous shortage of input materials and labor, along with transportation delays, suppliers are simply unable to meet demand for goods, pushing prices higher.  Stagflation may be rearing its ugly head: The Dallas Fed manufacturing index is showing a divergence, with prices moving higher while business activity is shifting lower. This is not the case with the ISM PMI index components, but investors need to be vigilant (Chart 5B). Americans are in a worse mood: Consumer confidence survey readings continue on a downward path. The combination of higher prices for everyday goods, the loss of purchasing power, the discontinuation of supplementary unemployment benefits, and paychecks not adjusted for inflation weigh on consumer sentiment. On the positive side, jobs are still plentiful.  Valuation And Profitability Despite recent turbulence and rotations across sectors and styles, consensus is still expecting 15% YoY earnings growth over the next 12 months. However, QoQ growth rates look very different as we remove the base effect: Growth is expected to dip this coming quarter (Q3, 2021), and stay modest for most of 2022. This is a low bar that should be easy for companies to clear, although supply disruptions may dent corporate earnings. In the meantime, valuations remain elevated at 20.7 forward earnings (Chart 6). Chart 6Earnings Growth Expectations Are Modest US Equity Chart Pack US Equity Chart Pack Sentiment There are still inflows into US equities, but they are easing. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines that many retail investors aim to park in US equities.  (Chart 7A). However, this is changing as rising rates render the TINA (“there is no alternative”) trade much less attractive. Chart 7AInflows Into US Equities Are Easing Inflows Into US Equities Are Easing Inflows Into US Equities Are Easing Chart 7BCapex Is On The Rise Capex Is On The Rise Capex Is On The Rise Uses Of Cash Capex: Capital goods orders are soaring, pointing to robust capex.  The latest S&P estimates suggest that capex will rise 13% this year.3 This points to economic normalization, and attests to corporate confidence in economic growth. It is also a likely byproduct of shortages that plague the US supply chain – companies are expanding their capacity. (Chart 7B). Investment Implications Low for longer is over: The Fed has committed to tapering within the next 2-3 months.  Unless this intention is derailed by another Covid scare or a significant deterioration in economic growth, we are now convinced that rates will move up to hit the BCA house view of 1.7%-1.9% by year-end. S&P 500:  There is plenty of rotation under the hood; yet we expect US equities to hold their own into the balance of the year as, for now, monetary and fiscal policy remain easy, and earnings growth is likely to surprise on the upside. Severe and prolonged supply disruptions are a key risk to this view, as they chip away from economic growth, and cut into companies sales growth and profitability. Growth vs. Value: With rates rising into year-end, interest-rate sensitive stocks, such as Growth and the Technology sector, are under pressure.  Since we opened overweight Growth and underweight Value position on June 14, Growth has outperformed S&P 500 by 4.1%, and Value underperformed by 4.5%.  We do not want to overstay our welcome, and are neutralizing both sides of the trade, bringing positioning to an equal weight.  Technology has beaten the S&P 500 by 2.2%, and we are shifting to an equal weight positioning by reducing overweight of the Software Industry Group. We remain overweight Semiconductors and Equipment. We are closing our overweight to Growth and underweight to Value allocation. We reduce overweight to Technology. Chart 7C US Equity Chart Pack US Equity Chart Pack Cyclicals vs. Defensives:  The onset of the Delta variant is dissipating, and we expect consumer cyclicals to rebound as more people are willing to travel and eat out. We also believe that the parts of the Industrials sector most exposed to restocking of inventories, infrastructure, and construction will perform strongly. Small vs. Large: We are upgrading Small from neutral to an overweight, and downgrade Large to an underweight. Small is highly geared to rising rates. It is also cheaper than Large, and most of the earnings downgrades are already in the price. We are now constructive on this asset class.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 8Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 9Profitability Profitability Profitability Chart 10Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 11Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 28Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 29Profitability Profitability Profitability Chart 30Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 31Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 32Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 33Profitability Profitability Profitability Chart 34Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 35Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 37Profitability Profitability Profitability Chart 38Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 39Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 41Profitability Profitability Profitability Chart 42Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 43Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 44Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 45Profitability Profitability Profitability Chart 46Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 47Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 49Profitability Profitability Profitability Chart 50Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 51Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 53Profitability Profitability Profitability Chart 54Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 55Uses Of Cash Uses Of Cash Uses Of Cash       Footnotes 1     Source: eeSea 2     US Census Household Pulse Survey, Employment Table 3. 3    S&P Global Market Intelligence, S&P Global Ratings; Universe is Global Capex 2000   Recommended Allocation

Chart 1Cyclicals Styels and Sectors Outperform In The Rising Rates Environment Treasury Rates Vs. Sector And Style Performance Treasury Rates Vs. Sector And Style Performance In a recent daily report, we analyzed performance of the S&P 500 sectors before and after the 2013 tapering announcement. Today we expand our analysis and map relative performance of the S&P 500 sectors and styles under the different US 10-year Treasury yields (UST10Y) regimes, i.e., rates rising vs rates falling.1  As expected, deep cyclicals, such as Energy, Financials, and Industrials fare best in a rising rates environment, while Communication Services and Health Care outperform when rates head south (Chart 1, top panel). Styles’ performance across regimes is broadly consistent with the sector performance. Specifically, Small Caps, thanks to their high exposure to deep cyclicals, post the best performance when UST10Y is rising. Meanwhile, defensives are a mirror image of Small Caps and outperform once global growth starts softening (Chart 1, bottom panel). Finally, we bring one more dimension to our analysis and calculate the performance of the long-duration Technology and Health Care sectors, under different rates and yield curve regimes (Chart 2).  To do so, we overlap rates and yield curve regimes and calculate median performance of each cell. Both Technology and Health Care underperform when rates are rising, and the yield curve is steepening: Long end of the curve is most important for discounting cash flows. Chart 2Performance of Technology and Health Care Sectors Is Also A Function Of Changes Of The Yield Curve Treasury Rates Vs. Sector And Style Performance Treasury Rates Vs. Sector And Style Performance The current environment of rising rates and flattening yield curve is empirically a goldilocks scenario for these sectors as a flattening yield curve signifies that the long-term rate, which is more important for discounting future cash flows, is falling and the P/E contraction phase will be limited.  It will also be offset by the growth in earnings as rising long rates indicate higher growth. Falling rates are also good for Tech stocks regardless of the direction of change in the yield curve.  The Health Care sector behaves somewhat differently: It tends to underperform when rates are falling but the yield curve is steepening as such scenario is not dire enough for Defensives to outperform. Bottom Line: Cyclical sectors and high beta styles tend to outperform in a rising rates environment. At the same time, the performance of Technology and Health Care stocks is more nuanced: rising Treasury rates are not necessarily bad for these sectors if the yield curve is flattening.   Footnotes 1 Methodology: We calculate three months change in UST10Y and calculate median of three months contemporaneous relative returns for each sector at each regime.  To remove historical performance biases, we subtract sector median relative return for the whole period.  

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 1 CHART 1 CHART 2 CHART 2 CHART 2 Appendix CHART 3 CHART 3 CHART 4 CHART 4  

Highlights This is the second part of the publication, in which we provide an in-depth overview of Hotels, Restaurants, and Airlines, or the “travel complex” as we dubbed it. In last week’s report, we provided an overview of the macroeconomic backdrop, the Delta variant trajectory, and a “deep dive” into the hotel industry. We concluded Hotels is a sound tactical and cyclical investment, and we recommended an overweight. Airlines Less profitable trip mix and excess capacity: Domestic travel has rebounded to 2019 levels, while international and corporate travel are still lagging due to government and corporate restrictions (Chart 1). Some of the excess capacity is being redirected to domestic leisure travel, which has higher volume but is far less profitable. Airline cargo growth is a saving grace. The cost side of the airline business has its own challenges. Airlines have high fixed costs as they own or lease aircraft fleets. This creates a heavy financial burden during downturns. The price of jet fuel has increased to pre-pandemic levels. Labor costs are high due to the unionized work force and rising wages. Profitability is elusive: With airline revenues down 27% YoY in August 2021, and costs on the rise, it is hard to envision profitability without a return of international and business travel. Too much debt: Airlines’ net debt has risen significantly since the pandemic. Without positive cash flow generation, it will become harder and harder for them to meet their debt obligations. We have a negative outlook for airlines and are underweight the S&P Airlines index. Restaurants Defensive: Although the S&P Restaurant Industry resides within the pro-cyclical S&P Consumer Discretionary Index, its composition is nothing but defensive as it is dominated by fast-food chains. Profitable and resilient: Despite the havoc wreaked by Covid, the restaurant industry has not stopped being profitable (Chart 2). With any new Covid variant scare, restaurants will just go back to their “drive-throughs” playbook. Over the course of 2021, restaurant spending has risen by more than 40%. We have a positive outlook for fast-food chains and are overweight the S&P Restaurant index. Feature This is the second part of the publication, in which we provide an in-depth overview of Hotels, Restaurants, and Airlines, or the “travel complex” as we dubbed it. These industries share many drivers of profitability as each provides in-person experiences. They are also highly dependent upon public sentiment regarding the potential dangers and likelihood of Covid infections. Further, consumer confidence and financial wellbeing are at the core of this group’s profitability, as the travel complex is a quintessential discretionary spending category. The recovery of the group was coming along quite well until the Delta variant derailed it in late summer, with reports pouring in about dining rooms closing, airline bookings flagging, and hotel occupancy dipping. What is next? In last week’s report, we provided an overview of the macroeconomic backdrop, the Delta variant trajectory, and a “deep dive” into the hotel industry. We concluded that the Hotels, Resorts, and Cruise Lines industry has significant potential to return to its former “glory”: Delta is cresting, financially healthy US consumers are choosing to spend their money on services and experiences, sell-side forecasts are pointing to surging sales, and hotels have substantial pricing power. The industry is a sound tactical and cyclical investment, and we recommend an overweight. This week we will continue with a deep dive into the Restaurant and Airline industries. Sneak Preview: We like restaurants (overweight) but airlines, not so much (underweight). Chart 1Airline Majors' Traffic Still Has Not Recovered To 2019 Level Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 2Profitability Is Resilient To Downturns Profitability Is Resilient To Downturns Profitability Is Resilient To Downturns Airlines “To suggest that the airlines should have better prepared for this environment seems akin to suggesting Pompeii should have invested more heavily in firefighting technology.” (JP Morgan, Mar. 22, 2020) Having avoided bankruptcy in 2020 thanks to federal payout support, US passenger airlines recorded $4.3 billion more in pre-tax losses in the first half of 2021. Clearly, this industry’s woes are far from over. Unsurprisingly, airlines have had the worst performance of any industry in the travel complex, underperforming the S&P 500 by 5% over the past year (Chart 3 & Table 1). Importantly, the performance of the industry slumped at the end of the summer, triggered by the Delta variant scare: After several months of steady increases, new ticket sales have dipped. As we noted last week, several major airlines have warned in regulatory filings that their third quarter may not look as rosy as was hoped. American Airlines, Southwest Airlines, and United all noted a deceleration in near-term customer bookings in August and elevated trip cancellations, even in leisure.1 All three have suggested that the Delta variant is having a dampening effect on business. We believe that the Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the travel complex is vulnerable to any new virus scare (Table 2), and this is a risk that investors need to keep in mind. However, unlike hotels, airlines face multiple other challenges. Chart 3The S&P Airline Industry Index Is Still Under the Pre-pandemic Level The S&P Airline Industry Index Is Still Under the Pre-pandemic Level The S&P Airline Industry Index Is Still Under the Pre-pandemic Level Table 1Performance Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Table 2Airline Industry Composition Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Competitive Landscape The US airline industry generated total operating revenues of $92.7 billion in 2020, down 48.3% from $179.4 billion in 2019. The industry is dominated by five majors, that are included in the S&P 500 index). Macroeconomic Backdrop For Airlines The airline industry is highly cyclical, and its wellbeing is tightly tied to economic growth. As economic activity improves, business travel tends to increase (except when Covid-related restrictions change the normal course of things). As economic growth translates into higher wages and stronger employment gains, leisure travel also takes off. So does the transportation of goods. As we discussed in Part 1 of the report, the economy is currently in a slowdown stage of the business cycle: Growth is slowing but off high levels. As such, even in the absence of Covid-19 or the Delta variant, Airline sales would continue to grow but at a slow pace. US consumers are financially healthy, and while most of the stimulus money has been spent, more and more people are returning to work. Recently, consumer confidence has soured on the back of a resurgence in Covid infections and rising prices (Chart 4, panel 2). However, domestic airline tickets are still cheap, and only fear of infection is keeping Americans grounded. With Delta cresting, people will go back to flying. Chart 4Airlines Are Highly Cyclical Airlines Are Highly Cyclical Airlines Are Highly Cyclical Key Drivers Of Profitability: Revenue Vs Expenses Revenue While many industries have been hit hard by the pandemic (brick-and-mortar retail, hotels, restaurants) most have turned the corner and are now profitable. Airlines, however, are still struggling (Chart 5). The good news is that losses have been declining, but the bad news is that the financial situation of most airlines is still precarious. Airlines rely on diverse sources of revenue, and thanks to that, business is starting to recover. The following are the key streams: Fares charged to customers In-flight entertainment, food, and beverages Sales of frequent-flyer credits to hotels, auto rental agencies, credit card issuers Auxiliary charges: Baggage checks, choice of seat, extra leg room Cargo and mail Chart 5Airlines' Revenue Remain Airlines' Revenue Remain Airlines' Revenue Remain Chart 6Airline Majors' Traffic Still Has Not Recovered To 2019 Level Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Traffic Recovery: Domestic Travel Has Rebounded, While International And Corporate Travel Are Still Lagging Budget airlines are pandemic winners: As of October 2021 compared to October 2019, scheduled available seat miles are down for all the airlines in the S&P 500 index (AAL, LUV, DAL, UAL, and ALK) (Chart 6). Only the budget airlines such as Allegiant, Spirit, and Frontier have a scheduled number of flights above the 2019 watermark. The underlying reason for such a dichotomy is easy to explain. The successful rollout of Covid-19 vaccines in the US has unleashed material pent-up demand for domestic leisure travel, benefiting domestic budget airlines. US domestic seat miles and load factors have recovered to pre-pandemic levels (Chart 7) as consumers have eagerly spent their stimulus checks on travel within the US. Chart 7Domestic Load Factor Has Fallen Below Pre-Pandemic Levels Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Major airlines are bleeding cash due to high exposure to international and business travel segments: In the meantime, many government and company-imposed restrictions on international and business flights are still in place. Companies are taking a very cautious approach to office re-openings and employee travel, and Zoom has become embedded as a viable corporate communications alternative and a cost-saving tool. As a result, the airline traffic of the majors with high exposure to international (Chart 8) and business travel (Chart 9), is still below the pre-pandemic level. Some of that capacity is being redirected to domestic leisure travel, which has higher volume but is far less profitable. Chart 8In August 2021, US-International Air Travel* Fell 54% Below 2019 Levels Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 9Since Mid-July, Growth Of Overall And Corporate Ticket Sales Has Slowed Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Corporate and international travel are the most lucrative revenue segments and are significant in size: Before the pandemic, business travel constituted 30% of all trips. The industry can hardly recover without these segments rebounding. Until that happens, companies will stay unprofitable, and cash burn will continue. Business travel is projected to recover in 2022 at best and 2024 at worst: The US Travel Association projects US business travel to return to the 2019 level in 2024. The Airlines for America Association (A4A) concurs. It projects that airline passenger volumes will return to the 2019 level in 2022 in the best-case scenario and in 2024 in the worst. Airline cargo is a saving grace: With passenger revenues still lagging 2019 levels, many airlines are focusing on the capacity of their cargo units. With global supply chains clogged and shipping costs increasing five-fold over the past few months, this is a profitable niche. Air cargo demand reached its all-time high in 2020 and continues to grow in 2021: US airlines posted a 20.5% increase in demand for international air cargo in July 2021 from the July 2019 actuals (Chart 10). Chart 10For US Airlines, Growth In Air Cargo Continues To Outpace Air Travel By A Large Margin Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Airlines Compete On Volume: Airfares Are Low Despite the inflationary environment, the price of airfares is still 18% below its 2019 level (-10% annualized), and that is after 7% YoY price increases in 2021 (Chart 11). These are price levels not seen since the 1990s. With all the spare capacity, former international and business travel is now competing to attract domestic leisure passengers. Making things worse, due to prior commitments, airlines continued to grow their fleets throughout the pandemic closures (Chart 12), further increasing capacity and exacerbating competition for passengers as business and international travel are likely to lag, making peak ticket prices and peak revenue elusive (Chart 13). There is also another matter to consider, which is hardly minor. Airline taxes and fees constitute about a quarter of the price of a ticket. According to an example put together by A4A, the base airline fare of $236 has $64 in multiple taxes and fees, making tickets less affordable. Chart 11Airfares Have Fallen by 10% A Year Since The Beginning Of The Pandemic Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 12Capacity Continues To Increase Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 13Airfares Are Down 18% From 2019 And 29% From 2014 Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Sales Growth Analysts expect airline sales growth to stabilize at 60% over the next 12 months. The base effect certainly plays a significant role, but this rate will help the industry to recover. Expenses Airlines have high fixed costs as they own or lease aircraft fleets. This creates a heavy financial burden during downturns, as costs can hardly be cut. Other expenses such as labor and fuel are also sticky. Price Of Jet Fuel Has Increased To Pre-pandemic Levels The cost of jet fuel is one of the most significant input costs for airlines, constituting anywhere between 10% and 30% of revenue (Chart 14). The price of fuel can make a significant difference for an airline’s razor-thin margins. Airlines therefore tend to hedge their fuel exposure. Jet-fuel prices have rebounded to their pre-pandemic level and are up 49% from January 2021 (Chart 14), no longer giving the airline any slack on the cost side. According to Zach Research, at United Airlines the average aircraft fuel price per gallon increased by 66.9% year-over-year to $1.97 in the June quarter. Owing to the uptick in air travel demand witnessed in the June quarter following increased vaccinations, fuel gallons consumed were up 206.4%. Chart 14Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Chart 15Labor Costs Increased Again Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Labor Costs Are Fixed Due To The Unionized Work Force Labor is another significant line item on the expense side of the airline’s income statement. Normally labor costs constitute 30-40% of sales. During the darkest days of the lockdowns, labor expense soared to 60% of sales (Chart 15). With a highly unionized labor force, layoffs and furloughs require significant payouts. There are also many other conditions in the labor contract that must be met. As a result, as sales tanked, labor costs did not change in the same proportion. Even so, airlines reduced their workforce from 458,000 people in 2019 to 363,000 in November 2020 (Chart 15). Now, with sales growing again, airlines have started rehiring. However, with recent wage rises, new employees are more expensive. Profitability With revenue challenged by a less profitable trip mix, excess capacity, and rising fuel and labor costs, airlines have been losing money for over a year now (Chart 16). While the increase in leisure travel and cargo units is helping, it is hard to envision profitability without a return of international and business travel. With airline revenue down 27% YoY in August 2021, and costs on the rise, profitability is still a long way off (Chart 17). Chart 16Airlines Are Unprofitable… Airlines Are Unprofitable… Airlines Are Unprofitable… Chart 17…And Are Burning Cash …And Are Burning Cash …And Are Burning Cash Net Debt Airlines’ net debt has risen significantly since the pandemic, driven by their need to support fixed costs (Chart 18). The increase in net debt was also stimulated by large government support and a low interest-rate environment. The problem is that since airlines are unprofitable, and are burning cash, it is becoming harder and harder for them to meet their debt obligations (Chart 19). While there have not been any high-profile bankruptcies in the US, some European and Asian carriers, such as Norwegian Air and AirAsia Japan Co., had to file for bankruptcy protection. As airlines are expected to continue to burn cash through 2022 their credit ratings have been downgraded (Table 3). We would not be surprised if more bankruptcies or industry consolidations take place in the near term. Chart 18Debt Levels Have Increased Significantly Debt Levels Have Increased Significantly Debt Levels Have Increased Significantly Chart 19Airlines Have Difficulty With Interest Payments Airlines Have Difficulty With Interest Payments Airlines Have Difficulty With Interest Payments Table 3All Airlines Credit Ratings Have Been Downgraded Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) When Will Airlines Thrive Again While revenue lags, the industry will remain vulnerable to shocks and cost headwinds. However, once international and business travel recovers, sales will pick up, and companies will generate positive cash flow. Cash generation is a necessary condition for financial recovery – once airlines arrest the cash burn, they can shift their efforts towards rebuilding profitability and, eventually, repairing their balance sheets. Valuations And Technicals Airlines are trading at 36x forward earnings, which is optically high. However, the Valuations Indicator suggests that airlines are not expensive relative to their own history (Chart 20). The industry is also modestly oversold (Chart 21). Chart 20Airline Are Not Expensive Relative To Own History… Airline Are Not Expensive Relative To Own History… Airline Are Not Expensive Relative To Own History… Chart 21…And Are Oversold …And Are Oversold …And Are Oversold  Investment Implications Airlines are slowly recovering from a malaise induced by the pandemic lockdowns. However, the road to recovery will be long. While domestic leisure and cargo traffic has picked up, it will be another couple of years before international and business travel rebounds to the pre-pandemic levels. With fuel and labor costs on the rise, profitability is elusive without those segments. And, even when airlines return to profitability, it will take them years to repair their indebted balance sheets. What is worse, with current levels of debt burden and negative interest coverage, bankruptcies may not be out of the question for some. While airlines may rally with rates rising and cyclicals outperforming, we are negative on the industry on both a cyclical and structural basis. However, if any of our clients wish to trade this industry, there are several liquid ETFs that represent this space (Table 4). If investors chose to be granular and pick individual stocks in this space, they need to be aware of the individual challenges of each airline and their levels of indebtedness vs cash burn. In short, we have a negative outlook for airlines and are underweighting the industry. Table 4Airline ETFs Are Readily Available Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Restaurants: Defensive Cyclicals Industry Composition Although the S&P Restaurant Industry resides within the pro-cyclical S&P Consumer Discretionary Index, its composition is nothing but defensive. In fact, a more appropriate name would have been the S&P Fast-Food Industry, with MCD and SBUX accounting for 70%+ of the industry market cap (Table 5). Table 5Industry Composition Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Performance Restaurant Industry performance has been tracking the performance of the S&P 500, lagging the benchmark by only 8% since January 2020 (Chart 22) Chart 22Restaurant Performed Almost In Line With The S&P 500 Restaurant Performed Almost In Line With The S&P 500 Restaurant Performed Almost In Line With The S&P 500 Restaurants Are “Defensive Cyclicals” Since fast-food prices are generally low, fast-food restaurants tend to be what economists call “inferior” goods, i.e., goods whose sales rise when the economy is in a downward spiral. Restaurants tend to outperform in the slowdown stage of the business cycle (Chart 23), are flat during contraction, and underperform during expansions. Consistent with these expectations, fast-food restaurants also came out as winners of Covid lockdowns: Although sales initially dipped, they quickly recovered as fast-food chains reoriented their business toward drive-throughs and other forms of take-out (Chart 24). Chart 23Fast-Food Restaurants Are Defensive Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 24Sales Growth Is Recovering Sales Growth Is Recovering Sales Growth Is Recovering Covid While the restaurant business was coming along quite well, concerns emerged at summer’s end that the Delta variant would further delay industry recovery. Chains like McDonald’s and Chick-fil-A announced that they are slowing their dining room re-openings. As data from restaurant analytics firm Black Box Intelligence demonstrates, sales that had grown steadily earlier this summer have fallen.2 We believe that the reaction to the Delta variant is transitory as new infections are cresting. And, in the worst-case scenario, fast-food restaurants in the index will just switch back to their Covid “drive-through playbook,” and will maintain their level of profitability. Restaurant Spending And Profitability Over the course of 2021, US retail sales releases reveal that restaurant spending rose by more than 40%, outpacing the headline number (13%) by a wide margin (Chart 25). While restaurant spending is likely to decelerate over the coming months as pent-up demand for services is satisfied, earnings will continue to improve. This is in line with analyst expectations (Chart 26). Chart 25Restaurant Sales Skyrocketed In 2021 Restaurant Sales Skyrocketed In 2021 Restaurant Sales Skyrocketed In 2021 Chart 26Earnings Will Continue to Grow But At A Slower Pace Earnings Will Continue to Grow But At A Slower Pace Earnings Will Continue to Grow But At A Slower Pace Despite the havoc wreaked by Covid, the restaurant industry has not stopped being profitable, and although margins dipped in the midst of the lockdown, they swiftly rebounded. The 83% YoY print in restaurants FCF is nearly an all-time high reading since the history of the data going back to the 1990s (Chart 27). Debt Is Low Net debt to total assets also echoes the upbeat message highlighting that US dining stocks remain in good financial health (Chart 28). Chart 27Free Cash Flow Is At All-Time High Free Cash Flow Is At All-Time High Free Cash Flow Is At All-Time High Chart 28Debt Is Low Debt Is Low Debt Is Low Valuations And Technicals Valuations are not demanding while technicals suggest that the industry is oversold (Chart 29). Chart 29Restaurants Are Oversold & Undervalued Restaurants Are Oversold & Undervalued Restaurants Are Oversold & Undervalued Investment Implications The current slowdown stage of the business cycle is favorable for the fast-food industry. This industry is profitable and resilient in downturns. It is also attractively valued. The industry is oversold, which represents a favorable entry point for an overweight position. In short, fast-food restaurants are a sound “cyclical defensive”: They are resilient to downturns, highly profitable, and have healthy balance sheets. We have a positive outlook on the industry and are overweight. A Quick Aside: Toast IPO Before we conclude, a brief note on the new Toast (TOST) IPO is in order. While the stock became public only last week and is not a part of the S&P 500, it is an important newcomer to the stock market. The company is a market leader in cloud-based restaurant management software. Toast’s performance is tied to the health of the overall US restaurant industry. Many of the popular restaurants and fast-food chains are among Toast’s clients. Bottom Line We have a negative outlook for Airlines: This highly cyclical industry is on a long-winding path towards recovery, profitability, and deleveraging. Airlines face multiple challenges and headwinds: Fuel and labor costs are rising, while their most profitable revenue segments, international and business travel, are missing in action. Cash burn is still acute, and profitability is elusive despite all the progress made. We are much more positive on the outlook for the Restaurant Index, which represents some of the largest fast-food chains in the nation. This industry thrives during economic slowdown, is resilient to shocks, and is highly profitable.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Travel Investors Need More Drive, WSJ, Sep 12, 2021 2     Restaurants Close Dining Rooms Again as Delta-Driven Infections Spread, WSJ, Sep 13, 2021.     Recommended Allocation

Today we take a close look at the historical GICS1 level performance following the taper event in 2013.  Chart 1 provides an overview of a price action of the 10-year US Treasury yield, the US dollar, and gold to provide context, while Charts 2 - 4 summarize performance of the S&P sectors.   Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Chart 3 CHART 3 CHART 3 Chart 4 CHART 4 CHART 4 The Fed’s decision to modestly reduce the pace of its asset purchases in December of 2013 was a risk-off event which triggered a decline in Treasury yields and put upward pressure on the dollar. S&P 500 sectors followed the script from a risk-off “playbook” with Technology outperforming on the back of falling Treasury rates, while Financials underperformed.  A spike in USD also led to underperformance of the Energy sector. The Consumer Discretionary sector was a notable outlier underperforming the S&P 500 by 6%.  However, empirical analysis is hardly helpful in this case as in 2013 Amazon constituted 7.05% of the sector weight compared to 40% today. Finally, the performance of the defensive sectors was mixed as while tapering was perceived by the market as a clear risk-off event, it was also a sign that the economy is strong, and the Fed is comfortable with withdrawing the liquidity crutch. Bottom Line: Investors should not worry about the Fed and tapering as in the US its effect was short-lived and many more years of the bull market have ensued after it.    

Highlights Covid-19 has wreaked havoc in the markets, but the Hotels, Restaurants & Leisure, and Airline industries have been most affected. These industries constitute what we call the “travel complex” as they share common drivers of profitability: First, they have been significantly affected by restrictions imposed on individuals and businesses in response to Covid-19 and, second, they rely on discretionary spending. Recovery of the group was proceeding swimmingly until the Delta variant derailed it in late summer, with reports pouring in about dining rooms closing, airline bookings flagging, and hotel occupancy dipping. What is next? The Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the travel complex is vulnerable to any new virus scare, and this is a risk investors need to keep in mind. Rising rates will be a mild tailwind for the group, as it tends to outperform in that regime. But this is not a key driver of its performance. Consumer confidence and financial wellbeing are at the core of this group’s profitability. So far, Americans still have money to spare and generally prefer to spend it on services. It is disconcerting that the Consumer Confidence Indicator has turned, but we are not too alarmed just yet: Jobs are still plentiful, and Americans are going back to work. August retail sales surprised on the upside. In Part 1 of the report this week, we take a deep dive into the Hotel, Resort, and Cruise Lines industry. We find the industry attractive for the following reasons: Hotel occupancy has increased, and the amount of money consumers are prepared to spend in hotel stays has surged. Sales are expected to increase by 75%, albeit from low levels, over the next 12 months. Hotels have also discovered many new sources of revenue. Earnings growth is impossible to estimate since last year the industry was losing money; however, margins have just turned positive. Companies also have significant pricing power to pass on expenses to their guests, and have the ability to mend their margins, eventually going back to the historical 20%. Lastly, the industry is cheap relative to its own history on a forward PE basis. According to our Technical Indicator, it is also oversold. The Hotels, Resorts, and Cruise Lines industry has a significant potential to return to its former “glory”, and we believe that it is a sound tactical and cyclical investment. We recommend overweighing this industry. NB: Please stay tuned for Part 2 of the report, on Restaurants and Airlines, next week. Feature Part 1: Hotels, Resorts And Cruise Lines In this two-part publication, we will provide an in-depth overview of Hotels, Restaurants, and Airlines. These industries constitute what we call the “travel complex” as they share many common drivers of profitability: First, they are the industries most exposed to Covid-related fears as well as corresponding government health directives, and, second, they rely on the discretionary spending of both consumers and businesses. In this publication, we will examine the macroeconomic backdrop for the entire travel complex, and then zoom into the Hotels, Resorts, and Cruise Lines industry (“Hotels”). Next week, we will provide an in-depth overview of Restaurants and Airlines. Sneak preview: We are bullish on Hotels and are overweight this industry in our portfolio. Hotels, Restaurant And Leisure, Along With Airlines, Were The Poster Child For Post-Covid Recovery… Covid-19 has wreaked havoc in the markets, but the travel complex was most affected. Airlines, hotels, and restaurants have suffered tremendous losses, and all have required government bailouts either directly, or indirectly through the Paycheck Protection Program (PPP). The travel complex rebounded mightily as the vaccine became widely available in February, and Americans suffering from cabin fever boarded planes, traveled, and ate out (Chart 1). Chart 1Hotels And Airlines Are Still Trading Below Their Pre-Covid Levels Hotels And Airlines Are Still Trading Below Their Pre-Covid Levels Hotels And Airlines Are Still Trading Below Their Pre-Covid Levels Table 1Travel Complex Is Lagging S&P 500 Travel: Extend Your Hotel Stay (Part 1) Travel: Extend Your Hotel Stay (Part 1) …Everything Changed This Summer All these positive developments began to reverse over the summer as Delta made its appearance in the US, and even the vaccinated succumbed to fears of infection. Airlines were one of the worst performers in the index. Hotels and restaurants were doing better, but their performance did not shoot the lights out either (Table 1). Restaurants: According to a National Restaurant Association survey of 1,000 adults, in recent weeks nearly one in five Americans say they are no longer going out to restaurants, 9% have canceled existing plans to eat out, and 37% of adults said they ordered delivery or takeout instead of dining in a restaurant. Chains like McDonald’s and Chick-fil-A are slowing their dining room reopenings. As data from restaurant analytics firm Black Box Intelligence demonstrate, sales that had grown steadily earlier this summer have fallen.1 Airlines: Several major airlines have warned in regulatory filings that their third quarter may not look as rosy as hoped. United Airlines has noted a deceleration in customer bookings, while Southwest Airlines reported a continued softness in bookings—even in leisure—and elevated trip cancelations. Similarly, American Airlines has said that, after a strong July, it saw a softness in near-term bookings in August and an increase in near-term cancelations. All three have suggested that the Delta variant is having a dampening effect on business.2 Hotels: Marriott International said that revenue per available room in August of 2021 was down 27% from the 2019 level – a drop from the 23% decline seen in July. However, the CEO of the company sounded sanguine: “The trends seem to be stabilizing as we get into the early days of September”. Most of the decline came from lockdowns in China. The most recent data shows revenue per available room was down 44 percent off 2019 levels — not ideal but an improvement from the 57 percent decline seen a week prior.3 With bad news abundant, the natural question is whether these industries are still a good tactical and cyclical investment. Delta Variant Clearly, a resurgence in infections has had an adverse effect on the travel complex. However, there are early signs that the Covid-19 Delta variant is cresting (Chart 2). Around 75% of the U.S. population has had at least one vaccine shot. Globally, 31.5 million doses/day are being administered. At this rate, it will take just eight months to vaccinate 75% of the global population. Herd immunity is not far off. Our base case is that Covid-19 and its multiple variants are unlikely to disappear, but consumers and businesses are learning how to live with it. We believe that the surge of Delta infections will subside over the fall, and the entire travel complex will continue to recuperate from the Covid-inflicted damage. Of course, the resurgence of Covid-19 cases and newer variants could undermine a recovery. This is a risk investors need to monitor. Chart 2The Covid-19 Delta Variant Is Cresting The Covid-19 Delta Variant Is Cresting The Covid-19 Delta Variant Is Cresting Macroeconomic Backdrop Rising Rates Are A Tailwind For The Travel Complex Direction and rate of change in yields dictate which US equity sectors and industries will do well. There are many crosscurrents in both economic data and Fed speak currently that obscure the answer to this question. Analysis of the performance of travel industries by rates regime suggests that all of them tend to do better when rates are rising, as higher rates indicate stronger economic growth (Chart 3). Airlines are most sensitive to an economic slowdown and will underperform most if rates stay “lower for longer”. Consumers Still Have Money To Spend On Services But Less Than Before Chart 3Travel Outperforms When Rates Are Rising Travel: Extend Your Hotel Stay (Part 1) Travel: Extend Your Hotel Stay (Part 1) Travel is a quintessential representation of discretionary spending on services. Consumers travel and eat out when they are confident about the future and have a healthy income and excess savings. Chart 4Disposable Income And Savings Are Returning To Trend Disposable Income And Savings Are Returning To Trend Disposable Income And Savings Are Returning To Trend The helicopter money drop has increased consumer income and padded their savings. However, income gains were not permanent and, recently, disposable income has returned to trend (Chart 4, Panel 1). Further, much of the excess savings has been spent (Chart 4, Panel 2). In another unpleasant twist, over the past few months, wage gains (4.8%) have lagged price increases (5.2%), reducing the purchasing power of American consumers. In response to these developments, the consumer mood has soured: The Consumer Confidence Indicator has slumped to a six-month low of 114 from 125 a month earlier. The next 12-month inflation expectations have surged to 6.5%. While it is disconcerting that consumer confidence has turned, we are not too alarmed just yet: Jobs are still plentiful, and Americans are likely to go back to work as the majority of children are now attending schools in person. In short, Americans are not destitute, but the pattern of spending is normalizing and returning to the pre-pandemic trend. The August retail sales print at 0.7% surprised on the upside and proves that US consumers have not tightened their belts. It is also a positive for the travel complex that demand for services exceeds demand for goods: Consumer expenditure on goods is above trend and has recently turned, while spending on services is below pre-pandemic levels, and the rebound is running its course (Chart 5). Inflation Is Not A Concern For The Travel Complex CPI readings for the travel complex this summer looked outright scary: In July, airfares were up 19% YoY and the price of hotel stays was up 24% YoY. These numbers have come down to 6.7% and 19.6% in August. Indeed, these readings make us wonder whether travel is still affordable to consumers. The answer is a resounding “yes” – reported surges in prices are a function of a base effect and, compared to the same time two years ago, the two-year CAGR of prices looks reasonable for all the industries (Chart 6). Chart 6Price Increases For The Travel Complex Are Moderate Travel: Extend Your Hotel Stay (Part 1) Travel: Extend Your Hotel Stay (Part 1) Chart 5Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Analysis By Industry: Hotels, Resorts, And Cruise Lines Hotels is a $55B industry4 which is forecast to produce 31.4% growth in 2021 (Table 2). Its market cap is $239Bn and it constitutes 0.6% of the S&P 500 index. The US Hotel industry suffered about $125 billion5 in aggregate lost revenues due to the pandemic in 2020. Hotel operators were in total cash-conservation mode – slashing capex budgets by 75%, suspending dividends, and raising capital. Some 670,000 workers lost their jobs or were furloughed – only half of these workers have returned so far (Chart 7). Table 2Hotels (GICS 4) Constituents Travel: Extend Your Hotel Stay (Part 1) Travel: Extend Your Hotel Stay (Part 1) After a tough year, Hotels have now mostly reopened. Demand is expected to surge by 31.4% YoY in 2021, and per room revenue has reached $94, higher than the pre-Covid-19 level. Many hotels have returned to profitability. However, hotel occupancy in the US is yet to return to the pre-pandemic level: It currently stands at around 50% compared to 70% plus pre-Covid (Chart 8). Chart 7Industry Was Decimated By Covid And Is Recovering Slowly Industry Was Decimated By Covid And Is Recovering Slowly Industry Was Decimated By Covid And Is Recovering Slowly Chart 8Occupancy Rates Are Returning Back To Normal Occupancy Rates Are Returning Back To Normal Occupancy Rates Are Returning Back To Normal Sources Of Revenue Hotels started to recover during the first half of 2021 and revenues are expected to continue to surge to well above the pre-pandemic level in 2022. Analysts expect hotel sales to rebound by 75% over the next 12 months (Chart 9). There are multiple sources of revenue, and a reduction in business travel and international tourism is likely to be replaced by other creative options. Leisure Travel: Significant pent-up demand has been driving a recovery in hotel stays, but it is mostly in leisure travel. According to AHLA, 56% of consumers say they expect to travel for leisure, roughly the same amount as in an average year. Consumer spending on hotels has rebounded and is close to the pre-pandemic normal (Chart 10). Chart 9Blockbuster Sales Growth Is Expected (Off Low Base) Blockbuster Sales Growth Is Expected (Off Low Base) Blockbuster Sales Growth Is Expected (Off Low Base) Chart 10Consumers Eagerly Spend On Hotels Consumers Eagerly Spend On Hotels Consumers Eagerly Spend On Hotels Business travel is still lagging. According to AHLA, business travel was down by 85% compared to 2019 through April 2021, and since then has only begun ticking up slightly. However, going forward, this trend may turn as companies start positioning their in-person visits as a competitive advantage. Bleisure travel: A new post-Covid trend has developed: Workers combine business travel with leisure, prolonging hotel stays. Another creative idea is “working from a hotel” packages to appeal to remote workers tired of being cooped up at home. International tourism: Covid-related restrictions in the rest of the world, and especially cessation of travel from China, is still denting hotel revenue. With global vaccination rates improving by the day, this segment won’t take long to rebound. Profitability While there is forecast to be a pronounced rebound in hotel sales growth over the next 12 months, it is less obvious whether and when the industry will return to its former levels of profitability (Chart 11). After all, not only was the travel complex damaged by the pandemic, but now hotel operators also incur additional Covid-related cleaning expenses. Currently, analysts expect the next 12 months EPS to rebound to about a quarter of January 2020 trailing EPS ($10 vs $34). While this looks measly, from an investment standpoint it presents an opportunity as eventually, albeit slowly, earnings will return to trend. Historical earnings growth is not calculable as the industry was losing money until very recently. Chart 11Earnings Are Expected To Grow Again Earnings Are Expected To Grow Again Earnings Are Expected To Grow Again Margins And Pricing Power Margins crossed the zero threshold in Q2-2021, but are still almost 20 percentage points below the long-term average (Chart 12). While hotel costs have increased with the pandemic, this industry has significant pricing power to pass on its costs to consumers (Chart 13). Chart 12The Hotel Industry Has Returned To Profitability The Hotel Industry Has Returned To Profitability The Hotel Industry Has Returned To Profitability Chart 13Hotels Have Significant Pricing Power And Can Pass Extra Costs To Guests Hotels Have Significant Pricing Power And Can Pass Extra Costs To Guests Hotels Have Significant Pricing Power And Can Pass Extra Costs To Guests Valuations And Technicals The Hotels industry is trading at 30x forward PE and on a 5-year normalized basis, it is trading with a discount to the S&P 500, which is unusual (Chart 14). In terms of our Technical Indicator, the industry is somewhat oversold, and now looks more attractive than it did earlier this year (Chart 15). Chart 14Hotels Are Trading With A Discount To S&P 500 Which Is Unusual Hotels Are Trading With A Discount To S&P 500 Which Is Unusual Hotels Are Trading With A Discount To S&P 500 Which Is Unusual Chart 15Hotels Are Slightly Oversold Hotels Are Slightly Oversold Hotels Are Slightly Oversold Cruise Lines Cruise Lines were the worst-hit and the slowest to recover among the sub-industries, but they are expected to make a comeback in 2022 with a significant surge in revenue growth. Most of the drivers for these companies are similar to Hotels and Resorts – but recovery is delayed due to restrictions that kept cruise ships anchored much longer than initially expected. Investment Implications We stay with our overweight in Hotels, Resorts, and Cruise Lines. We will summarize the reasons: The Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the industry is also vulnerable to any new virus scare, and this is a risk that investors need to keep in mind. Rising rates will be a mild tailwind for the industry, as it tends to outperform in that regime. But this is not a key driver of its performance. Consumer confidence and financial wellbeing are at the core of Hotel profitability. So far, Americans still have money to spare and prefer to spend it on services. It is disconcerting that the Consumer Confidence Indicator has turned, but we are not too alarmed just yet: Jobs are still plentiful, and Americans are going back to work. Hotel occupancy has increased, and the amount of money consumers are prepared to spend on hotel stays has surged. Sales are expected to increase by 75%, albeit from lower levels, over the next 12 months. Hotels have also discovered many new sources of revenue. Historical earnings growth is not available as until recently the industry was losing money; however, margins have just turned positive. Companies also have the significant pricing power to pass on expenses to their guests and have the ability to mend their margins, eventually going back to the historical 20%. Lastly, the industry is cheap relative to its own history on a forward PE basis. According to our Technical indicator, it is also oversold. The Hotels, Resorts, and Cruise Lines industry has significant potential to return to its former “glory”, and we believe that it is a sound tactical and cyclical investment. We recommend overweighing this industry. Bottom Line The Hotels, Resorts, and Cruise Lines industry has been severely damaged by the pandemic, and the road to recovery may be long. It is also vulnerable to any new virus scare. However, with Delta cresting, financially healthy US consumers choosing to spend their money on services and experiences, sell-side forecasts pointing to surging sales, and companies possessing substantial pricing power mean that we are bullish on the industry.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Restaurants Close Dining Rooms Again as Delta-Driven Infections Spread, WSJ, September 13, 2021.   2     Travel Investors Need More Drive, WSJ, September 12, 2021. 3    Hotel Industry News: Marriott CEO Sees Hotels Bouncing Back Quickly After Delta Variant Slump, Skift, September 9, 2021. 4    IBISWorld, August 23, 2021. 5    Oxford Economics. Recommended Allocation

Highlights Our willingness to spend money depends on which ‘mental account’ it occupies. Once windfall income enters our ‘savings mental account’, we will not spend it. Hence, the pandemic’s windfall income receipts will have no sustained impact on spending, or on inflation. This means that US monetary tightening will be later and shallower than the market is pricing. As we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples). Fractal analysis: The US dollar, and base metals versus precious metals. Feature Chart of the WeekNo Tsunami Of Spending Despite Excess Income No Tsunami Of Spending Despite Excess Income No Tsunami Of Spending Despite Excess Income Many people claimed that the war chest of savings that global households accumulated during the pandemic would unleash a tsunami of spending. Well, it didn’t. For example, US consumer spending remains precisely on its pre-pandemic trend (Chart I-1 and Chart I-2). This, despite stimulus checks and other so-called ‘transfer payments’ which boosted aggregate household incomes by trillions of dollars. Indeed, paste over 2020, and you would be forgiven for thinking that there was no pandemic! Chart I-2No Tsunami Of Spending Despite Excess Income No Tsunami Of Spending Despite Excess Income No Tsunami Of Spending Despite Excess Income Of course, households that lost their livelihoods during the pandemic, and thus became ‘liquidity constrained’, did spend the lifeline stimulus payments that they received. Yet in aggregate, households did not spend the excess income received during the pandemic. Moreover, the phenomenon is global – the savings rate in the UK has surged near identically to that in the US (Chart I-3). Chart I-3The Savings Rate Has Surged Everywhere The Savings Rate Has Surged Everywhere The Savings Rate Has Surged Everywhere The excess income built up during the pandemic did not unleash a tsunami of spending. Neither will it unleash a tsunami of future spending. We can say this with high conviction because we have seen the same movie many times before. Previous tranches of stimulus and transfer payments that boosted incomes in 2004, 2008, and 2012 (though admittedly by less than in 2020) had no lasting impact on spending. Whether We Spend Or Save Money Depends On Which ‘Mental Account’ It Occupies Why do windfall income receipts not trigger a tsunami in spending? (Chart I-4) Chart I-4Stimulus Checks Had No Meaningful Impact On Spending Stimulus Checks Had No Meaningful Impact On Spending Stimulus Checks Had No Meaningful Impact On Spending One putative answer comes from Milton Friedman’s Permanent Income Hypothesis. Contrary to the Keynesian belief that absolute income drives spending, Friedman postulated that income comprises a permanent (expected) component and a transitory (unexpected) component. And only the permanent income component drives spending. In the permanent income hypothesis, spending is the result of estimated permanent income rather than a transitory current component. Therefore, for households that are not liquidity constrained, a windfall receipt – like a stimulus payment – will not boost spending if it does not boost estimated permanent income. Nevertheless, this theory does require households to estimate their future permanent incomes, and it is debatable if households can do this. Stimulus and transfer payments that boosted incomes in 2004, 2008, 2012, and 2020 had no lasting impact on spending. We believe that a more real-world answer to how we deal with windfalls comes not from Economics but from the field of Psychology, and the theory known as Mental Accounting Bias. Mental accounting bias states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, so that a dollar in a current (checking) account is no different to a dollar in a savings account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings or investment accounts we will not spend. Hence, the moment we move the dollar from our current account into our savings or investment account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. More likely, it will be used to reduce household debt, and thereby constrain the broad money supply. In effect, part of the recent increase in public debt will just end up decreasing private debt, as happened in Japan during the 1990s (Chart I-5). Chart I-5In Japan, Public Debt Ended Up Paying Down Private Debt In Japan, Public Debt Ended Up Paying Down Private Debt In Japan, Public Debt Ended Up Paying Down Private Debt With no permanent boost to spending, the pandemic’s windfall income receipts will have no sustained impact on inflation. As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable While consumer spending remains precisely on its pre-pandemic trend, the sub-components of this spending do not. Specifically, spending on durable goods stands way above its pre-pandemic trend, while spending on services languishes below trend (Chart I-6). Chart I-6The Pandemic Distorted Spending Patterns The Pandemic Distorted Spending Patterns The Pandemic Distorted Spending Patterns This makes perfect sense. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. Therefore, consumers just shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods. But now that shift is reversing. In turn, these massive and unprecedented shifts in spending patterns explain the recent evolution of inflation. As booming demand for durable goods created supply bottlenecks, durables prices skyrocketed (Chart I-7). Chart I-7The Pandemic Distorted Prices The Pandemic Distorted Prices The Pandemic Distorted Prices Remarkably though, the 10 percent spike in US durable good price through 2020-21 was the first increase in an otherwise persistently deflationary trend through this millennium (Chart I-8). As such, it was a huge aberration and as Jay Powell pointed out last week in Jackson Hole: Chart I-8The Increase In Durables Prices Was A Huge Aberration The Increase In Durables Prices Was A Huge Aberration The Increase In Durables Prices Was A Huge Aberration “It seems unlikely that durables inflation will continue to contribute importantly over time to overall inflation.” Meanwhile, with services simply unavailable, their prices did not fall, given that the price of something that cannot be bought is a meaningless concept. Moreover, unlike for an unbought durable good, which adds to tomorrow’s supply, an unbought service such as a theatre ticket – whose consumption is time-sensitive – does not add to tomorrow’s supply. Hence, when unavailable services suddenly became available, the initial euphoric demand for limited supply caused these service prices also to surge. But excluding such short-lived euphoria in airfares, car hire, and lodging way from home, services prices remain well-contained. This reinforces our conclusion from the first section. The pandemic’s windfall income receipts will have no sustained impact on inflation. As Jay Powell went on to say: “We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2 percent inflation on a sustainable basis.” All of which means that US monetary tightening will be later and shallower than the market is pricing. Another important investment conclusion is that as we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. The abnormally high spending on durables has a long way to fall. Given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market, this will weigh on consumer discretionary sectors (Chart I-9). Chart I-9As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples) (Chart I-10). Chart I-10Underweight XLY Versus XLP Underweight XLY Versus XLP Underweight XLY Versus XLP Fractal Analysis Update Fractal analysis suggests that the dollar’s rally since late-Spring could meet near-term resistance, given the incipient fragility on its 65-day fractal structure (Chart I-11). Chart I-11The Dollar's Rally Could Meet Near-Term Resistance The Dollar's Rally Could Meet Near-Term Resistance The Dollar's Rally Could Meet Near-Term Resistance A bigger vulnerability is for the strong and sustained rally in base metals versus precious metals, which is now extremely fragile on its 260-day fractal structure (Chart I-12). We are already successfully playing this through short tin versus platinum, but are adding a new expression: short aluminium versus gold. The profit target and symmetrical stop-loss are set at 13.5 percent. Chart I-12The Massive Rally In Base Metals Versus Precious Metals Is Vulnerable The Massive Rally In Base Metals Versus Precious Metals Is Vulnerable The Massive Rally In Base Metals Versus Precious Metals Is Vulnerable   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations