Consumer Discretionary

Dear Client, As is custom every year, next Monday November 30 instead of our regular Strategy Report you will receive BCA’s flagship publication “The Bank Credit Analyst” detailing the house views and themes for next year. Our regular publishing schedule resumes on December 7 with our 2021 High-Conviction Calls Strategy Report. On December 14 we will host a Webcast to discuss our calls in more detail and answer questions. Happy Thanksgiving. Kind Regards, Anastasios Highlights Portfolio Strategy A firming demand backdrop for lodging services courtesy of the positive vaccine news, enticing industry operating metrics along with compelling valuations encourage us to take a punt on the niche S&P hotels, resorts & cruise line index. In marked contrast, we recommend investors avoid the high-flying S&P homebuilding index. Home-related survey data paint a rosy picture for homebuilding demand in the coming months underpinned by low mortgage rates and low housing supply. Nevertheless, most of the good news is baked in resurgent homebuilder stock prices and the prospects of rising interest rates, a looming profit margin squeeze and extremely high earnings expectations warn that the time is ripe to shed S&P homebuilding exposure.  Recent Changes Upgrade the S&P hotels, resorts & cruise lines index to overweight, today. Downgrade the S&P homebuilding index to underweight, today. Feature Similar to two Mondays ago, the SPX opened weekly trading with gusto courtesy of MRNA’s 94% efficacy vaccine news, but failed to breach previous all-time highs. The market has rallied roughly 10% this month, and while we remain cyclically and structurally bullish, a short-term consolidation period is likely in the cards. Extremely easy financial conditions along with a near halving in implied volatility – which have been key rally drivers since the March lows as we pointed out numerous times in our research – are nearly perfectly priced in the SPX. The implication is that were a meaningful rally to resume, further easing is required which is a tall order (top panel, Chart 1). Another factor underpinning the market’s recent advance is the drop in the CBOE’s implied correlation index (pair wise correlation of S&P500 constituents, shown inverted, bottom panel, Chart 1). However, correlations have collapsed and are near levels that have marked prior temporary peaks in the SPX. Beyond near-term jitters, output is poised to recover smartly next year and most importantly so are SPX EPS. In a recent Special Report we lifted our EPS target to $168 for calendar 2021 and introduced an end-2021 SPX target of 4,000. The GS Current Activity Indicator corroborates our macro four-factor profit growth estimate and heralds a slingshot EPS recovery next year (Chart 2). Chart 1Good News Is Priced In Good News Is Priced In Good News Is Priced In Chart 2One More V-Shape Is Coming One More V-Shape Is Coming One More V-Shape Is Coming Turning over to capital spending, the latest GDP report was revealing. On the surface private sector capex made a splash with non-residential investment contributing 2.88% to real GDP growth, the highest since Q4/1983 when the economy was recovering from that severe double-dip recession. In absolute terms, the Q/Q annualized growth clocked in at over 20%, a growth rate last seen in the late-1990s (Chart 3). Drilling deeper into capex is instructive. Technology investment was on fire. Surprisingly, software took the back seat and investment in tech goods roared. In other words, this data confirms that businesses and consumers alike prepared to work from home and bought up tech gadgets en masse, and stole demand from the future (Chart 3). Looking ahead we expect a reversal of this trend with software retaking the reigns and the rest of the tech sector fading. As a reminder, while base effects really augmented this capex rebound, recovering animal spirits signal that a capex upcycle is in the offing. We have shown in the past that as profits grow, CEOs become more confident in the longevity of the cycle and choose to deploy long-term oriented capital, albeit with a one-year lag. Eventually, this creates a virtuous upcycle where rising profits lead to rising capital outlays that further boost sales and profits and sustain the positive feedback loop (Chart 4). Chart 3Exploring Investment Data Exploring Investment Data Exploring Investment Data Chart 4Lagging Capex Will Also Recover Lagging Capex Will Also Recover Lagging Capex Will Also Recover This week we make two sub-surface consumer discretionary sector changes further adding exposure to our back-to-work reopening laggards and shedding exposure to work-from-home winners. Open For Business While admittedly we were early in locking in gains in the S&P hotels, resorts & cruises index last spring by lifting exposure to neutral from underweight, today we are compelled to augment this niche leisure index to an overweight stance. Relative share prices have bounced at a level last seen during the GFC and not far off the level hit post the 9/11 accelerated recession that dealt a big blow to everything travel related (top panel, Chart 5). The recent positive vaccine news is a key reason we are warming up to this consumer discretionary sub group. While neither lodging nor cruise line vacationing will return to their previous peaks any time soon, both industries will survive and thus should no longer be priced for bankruptcy. Industry pricing power has plunged, but it is trying to trough at an extremely depressed level (middle panel, Chart 5). As a result, profit margins have gone haywire (bottom panel, Chart 5), but again most of the negative news is likely priced into this negative profits backdrop. Chart 5Fell Off A Cliff… Fell Off A Cliff… Fell Off A Cliff… One key industry demand determinant is confidence. Consumer sentiment has staged a W-shaped recovery and while still flimsy the brightening vaccine efficacy news should catapult it higher in the coming quarters. The implication is that the wide gulf between consumer confidence and relative share prices will narrow via a catch up phase in the latter (top panel, Chart 6). Closely linked to the budding recovery in confidence are discretionary versus non-discretionary retail sales. Thus, the latter have been tightly correlated with the oscillations in relative share prices, and the current message is positive (top panel, Chart 7). Chart 6...But There Are Signs Of Life ...But There Are Signs Of Life ...But There Are Signs Of Life Moreover, the ISM non-manufacturing survey is on a sling shot recovery following the depths of the spring readings. This rebound also suggests that the path of least resistance is higher for lodging stocks (middle panel, Chart 6). Chart 7Enticing Signals Enticing Signals Enticing Signals On the business side, capex intentions are slated to increase in the coming year – as we highlighted above on the back of recovering animal spirits – and by extension so will business-related travel (bottom panel, Chart 7). Our hotel demand indicator does an excellent job at encapsulating all these different forces and forecasts an enticing lodging services demand backdrop into 2021 (bottom panel, Chart 6). Already, consumer outlays on hotels are staging a comeback albeit from an extremely depressed level. The upshot is that an earnings-led rebound is in the cards (middle panel, Chart 7). With regards to industry operating metrics, industry executives have reined in expansion plans: construction spending on hotels has been contracting all year long. At the margin, such a supply restraint on the heels of a seven-year expansion phase is quite encouraging (middle panel, Chart 8) as it will aid in the industry’s efforts to lift beaten down occupancy rates. Another reassuring industry operating metric is the confirmation that hotel workers are returning to work. Not only has leisure and hospitality employment absorbed more than half the losses suffered since the spring carnage, but also industry hours worked have ticked higher of late (bottom panel, Chart 8). Finally, washed out technicals and extremely alluring valuations provide an attractive reward/risk tradeoff at the current juncture (Chart 9). Chart 8Receding Supply Is Good Receding Supply Is Good Receding Supply Is Good Chart 9Plenty Of Upside Plenty Of Upside Plenty Of Upside Netting it all out, a firming demand backdrop for lodging services courtesy of the positive vaccine news, enticing industry operating metrics along with compelling valuations encourage us to take a punt on the niche S&P hotels, resorts & cruise line index. Bottom Line: Upgrade the S&P hotels, resorts & cruise lines index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH. Contrarian Housing Call Today we recommend a downgrade in the S&P homebuilding index to underweight. Since the March 23 SPX lows, consumer discretionary stocks are up 74%, besting the S&P 500 by 1500 basis points (bps). While single stock GICS4 sub-groups like household appliances (i.e. Whirlpool) have reached escape velocity rising over 200% over the same time frame, the S&P homebuilding index is also up a whopping 140%. While we were quick enough to close our underweight recommendation in March and cement impressive relative gains for the portfolio to the tune of 50%, we refrained from lifting exposure all the way to overweight and remained at benchmark. As a reminder, we opted instead to play a housing rebound via the sister home improvement retail index in mid-April that also added significant alpha to our portfolio. Residential real estate optimism abounds. The media’s bombardment is non-stop reminding consumers of runaway home prices, all-time lows in fixed mortgage rates (third panel, Chart 10) and nearly non-existent housing inventory (supply of homes shown inverted, middle panel, Chart 11), painting an urgency to stampede into home buying (top panel, Chart 11). Chart 10Positives Reflected In Prices Positives Reflected In Prices Positives Reflected In Prices Chart 11The Good… The Good… The Good… True, the COVID-19 recession has acted as an accelerant to the suburban housing boom and there is an element of at least a semi-permanent shift away from city centers and toward the suburbs as the work-from-home flexibility is not a fad. Tack on all-time highs on the overall NAHB housing sentiment survey and a number of sub-components like sales expectations (second panel, Chart 10) and no wonder mortgage applications to purchase a new home are also flirting with multi-year highs (bottom panel, Chart 10). Another survey, part of the Conference Board’s consumer confidence monthly survey, revealed that consumers’ plans to buy a new home are also probing all-time highs (second panel, Chart 10). Even the Fed’s October Senior Loan Officer survey highlighted that demand for residential mortgage loans is on the mend (bottom panel, Chart 11). However, we deem that most, if not all, of the good news is already priced in galloping homebuilders stock prices and exuberant expectations. While being contrarian is fraught with danger, as more often than not the herd is right, there is a key macro driver that gives us confidence to our going against the grain housing trade: interest rates. If our economic reopening thesis proves accurate next year, then the COVID-19 winners – homebuilders included – will take the back seat. Importantly, as the economy rebounds and is ready to stand on its own two feet, then the selloff in the bond market should gain significant steam. Using our 100-125bps rule of thumb to gauge how much monetary tightening the economy can withstand in a year’s time, then the 10-year US Treasury yield can hit 1.5% by next March. Historically, interest rates and relative share prices have been inversely correlated and a steep selloff in the bond market is bad news for homebuilding stocks (top panel, Chart 12). Chart 12...The Bad... ...The Bad... ...The Bad... Chart 13...And The Ugly ...And The Ugly ...And The Ugly Meanwhile on the operating housing front, some cracks are forming. New home sales, while brisk in absolute terms, are losing out to existing housing sales and homebuilders have resorted to price concessions in order to drive volumes (second, third & bottom panels, Chart 12). Profit margins are at the highest mark since the subprime crisis and are vulnerable to a squeeze not only from lower selling prices, but also from rising input costs. Framing lumber comprises roughly 15% of a new home’s commodity related costs and lumber prices have been expanding all year long (Chart 13). Finally, unfettered sell-side optimism reigns supreme. Net earnings revisions cannot go any higher as they hit a wall at the 100% ceiling. One year forward relative profit growth expectations are literally through the roof, and even five-year relative EPS growth estimates are up 1500bps since the 2019 nadir (Chart 14). All these metrics represent a high bar for homebuilders to surpass and we would lean against such extreme enthusiasm toward this niche early-cyclical group. However, there is a key risk to our bearish homebuilders call we are monitoring: cheap valuations. On relative forward P/E, trailing P/S and EV / EBITDA bases, home construction stocks offer compelling value (bottom panel, Chart 14). Whether this is a value opportunity or a trap, the jury is still out. For the time being we side with the latter. Chart 14Peak Sell-Side Euphoria Peak Sell-Side Euphoria Peak Sell-Side Euphoria In sum, home-related survey data paint a rosy picture for homebuilding demand in the coming months underpinned by low mortgage rates and low housing supply. Nevertheless, most of the good news is baked in resurgent homebuilder stock prices and the prospects of rising interest rates, a looming profit margin squeeze and extremely high earnings expectations warn that the time is ripe to shed S&P homebuilding exposure. Bottom Line: Trim the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Priced For Perfection Priced For Perfection Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Too Much Homebuilding Euphoria Too Much Homebuilding Euphoria Neutral – Downgrade Alert It no longer pays to chase the S&P homebuilding index higher; it is now on our downgrade alert watch-list. The recent pandemic-induced drubbing in interest rates boosted housing affordability and caused a knee jerk reaction in the mortgage application purchase index, which in turn served as a catalyst for the recent rally (top & middle panels). However, as the economy continues to open up, interest rates will reverse course and flip from a tailwind into a headwind. Sell-side analysts are also upgrading their earnings forecasts at the highest pace since the GFC, and we would lean against this extreme bullishness (bottom panel). Bottom Line: We are neutral the S&P homebuilders index, but it is now on our downgrade watch-list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. For more details, please refer to the recent Weekly Report.  

Dear client, Next Monday, October 19, we will be hosting our quarterly webcast, “From Alpha To Omega With Anastasios”, at 10am EST; Matt Gertken, BCA’s Geopolitical Strategist will be our guest on the eve of the US Presidential Election. Our regular weekly publication will resume on Monday October 26, 2020. Kind Regards, Anastasios Highlights Portfolio Strategy Homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. While the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index.  Recent Changes There are no changes to our portfolio this week. Table 1 COVID Fatigue, Fiscal Fatigue, Election Fatigue COVID Fatigue, Fiscal Fatigue, Election Fatigue Feature Equities seesawed last week as President Trump returned to the White House (WH) and injected fresh volatility in markets signaling that there will be no fiscal deal prior to the elections. The SPX immediately gapped down and we cannot stress enough the importance of our newly configured Fiscal Policy Loop: fiscal hawkishness causes skittishness in markets culminating to a classic BCA riot point and then policymakers relent and fiscal dovishness restores the equity bull market (Figure 1). While we cannot rule out a slimmed-down stimulus package deal by later this month, fiscal policy- and election-related uncertainties remain elevated. The daily back-and-forth on where Congress and the WH stand with passing a new stimulus bill coupled with the prospects of a contested election that would drag on the presidential race likely into December, have caused investor fatigue. The sooner both of these uncertainties recede, the quicker the SPX will climb to fresh all-time highs (Chart 1). Figure 1The Fiscal Policy Loop COVID Fatigue, Fiscal Fatigue, Election Fatigue COVID Fatigue, Fiscal Fatigue, Election Fatigue Chart 1Receding Uncertainty Will Boost Stocks Receding Uncertainty Will Boost Stocks Receding Uncertainty Will Boost Stocks   We have shown in recent research, and update today, that the fourth year of presidential cycles finds the SPX ending the year on average in the green with a calendar return in the high single digits (Chart 2). Peering back in 2016 is instructive as that presidential election cycle year was in some ways similar to the current one. The economy, in particular, was fighting off a manufacturing recession that spread and infected the services sectors as the vast majority of S&P GICS1 sectors saw profit contraction and more importantly revenue declines. Chart 3 shows a number of asset classes and compares 2016 with 2020. The 10-year US Treasury yield appears poised to rebound significantly, especially if Congress passes a fresh fiscal package that aides the parts of the economy that need the stimulus checks most. Fiscal easing uncertainty remains a thorny issue across different markets and if history is an accurate guide, the SPX could glide lower into the November election before rallying into year-end. Chart 2Back Up Near The Average Profile Back Up Near The Average Profile Back Up Near The Average Profile Meanwhile, a number of investors we talk to also experience COVID-19 fatigue (Chart 4). For the better part of the last 10 months media has constantly bombarded the world with pandemic news, and rightly so. However, all this seems dystopian by now, and we cannot wait for a semblance of normality to make a comeback, which a vaccine will definitively bring about. The equity market has been indurated to this news-flow and has shaken-off the recession. When the vaccine does arrive likely next year, profits will also return back to trend, as we have been arguing for some time, because the global economy will fully reopen. Chart 32016 Versus 2020 2016 Versus 2020 2016 Versus 2020 Already, if we juxtapose leading soft economic data surprises with lagging hard economic data surprises, it is clear that a stellar profit recovery looms (second panel, Chart 5). Similarly, within soft the data universe, the ISM new orders-to-inventories ratio paints a rosy picture for an earnings recovery in 2021 (third panel, Chart 5). Even within hard economic data, a simple liquidity indicator we have used in the past comparing industrial production (IP) with M2 money stock signals that S&P profits have troughed (IP vs. M2 shown advanced, bottom panel, Chart 5) Chart 4COVID Fatigue COVID Fatigue COVID Fatigue Finally, the US Equity Strategy’s four-factor macro profit growth model has slingshot higher recently and signals that a return to $162 level of EPS in calendar 2021 is a high probability outcome (Chart 6). Netting it all out, we are in the tail end of the equity market correction and as election and fiscal policy uncertainties ebb, they will pave the way for a robust SPX rally. Chart 5Profit Recovery On Track Profit Recovery On Track Profit Recovery On Track   Chart 6EPS Model Concurs EPS Model Concurs EPS Model Concurs This week, we continue with our strategy of preferring beaten-down cyclicals to defensives and steer the portfolio away from another safe haven staples industry via downgrading a consumer goods subgroup to underweight. We also delve deeper into the banking industry highlighting some cracks in small commercial banks. Put Homebuilders On Downgrade Alert Homebuilders have had a monster run since the depths of the recession back in March and the question a lot of our clients are now asking is: does it make sense to chase them higher at the current juncture? The short answer is no. Before we get into the details of our analysis a brief recap of our recent residential real estate-related moves is in order. Going into the March carnage we were cyclically underweight the niche homebuilding index. Moreover, last December we had identified homebuilders as a high-conviction underweight in our annual Key Views report. We monetized relative gains of 41% and 43%, respectively from both positions and lifted exposure to a benchmark allocation. While in retrospect we should have upgraded all the way to overweight, we did manage to participate in the V-shaped housing-related returns by opting to go overweight the mega cap home improvement retail index instead. In addition, this summer we eked out another 10% return from a long homebuilders/short REITs pair trade. Homebuilders are enjoying the single family home renaissance as the pandemic has turbo-charged the work from home movement and employees are rushing to move into comfortable spaces in the suburbs as the traditional office is literally declared dead. Indeed, housing starts and permits have renormalized, the drubbing in interest rates has boosted affordability and caused a knee jerk reaction in the mortgage application purchase index, and sell-side analysts are fighting hand-over-fist to upgrade profit projections for the homebuilding group (Chart 7). The end result has been a boom in new home sales that are trouncing existing home sales, and the NAHB’s survey of prospective homebuyers continues to paint a rosy picture for additional demand for new single family homes especially given the low inventory of homes (top & third panels, Chart 8). Chart 7Housing Tailwinds Housing Tailwinds Housing Tailwinds Chart 8Price Concessions Generate Volume Price Concessions Generate Volume Price Concessions Generate Volume This is where all the good news ends. With respect to selling prices, homebuilders are making price concessions compared with existing homes and also in absolute terms new home prices are deflating (second & bottom panels, Chart 8). Therefore, at close to 15%, homebuilding profit margins are near all-time highs and under threat especially from a firming industry wage bill (second & third panels, Chart 9). Tack on surging lumber inflation and a profit margin squeeze is a high probability outcome (bottom panel, Chart 9). As a reminder framing lumber, on average, comprises 15% of a new single family home’s total input costs. While the NAHB survey points to brisk demand for new homes, the sister Conference Board survey shows that consumers’ appetite for a new home has crested (second & third panels, Chart 10). With consumers rushing to move to the suburbs due to the pandemic, there is an element of bringing housing demand forward. Chart 9Beware Margin Squeeze Beware Margin Squeeze Beware Margin Squeeze Chart 10Good News Fully Priced Good News Fully Priced Good News Fully Priced Worrisomely, if the economy continues to open up then interest rates should continue to back up. From all the major asset classes the 10-year Treasury yield is the one that has yet to discount a V-shaped economic recovery. The implication is that rising interest rate would dent affordability and at the margin weigh on housing demand (10-year Treasury yield shown inverted, top panel, Chart 10). Moving on to the credit backdrop, while demand for residential real estate loans has recovered, bankers refuse to extend mortgage credit (second & third panels, Chart 11). According to the latest Fed H8 weekly credit release, residential real estate loans are on the verge of contraction (bottom panel, Chart 11). Finally, the tug-of-war on the fiscal package front is also threatening to sustain the unemployment rate near double digits, which could jeopardize the housing recovery. Historically, housing starts have been near perfectly inversely correlated with the unemployment rate and the current message is for a leveling off in residential construction activity (middle panel, Chart 12). The recent homebuilding run has pushed relative valuations from undervalued to overvalued. The relative P/S ratio trades roughly 30% above the historical mean (a three-year high), and leaves no cushion for any mishaps (bottom panel, Chart 12). Chart 11Bankers Refusing To Dole Out Loans Bankers Refusing To Dole Out Loans Bankers Refusing To Dole Out Loans Chart 12In Desperate Need Of Fiscal Help In Desperate Need Of Fiscal Help In Desperate Need Of Fiscal Help Netting it all out, homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. Bottom Line: Stay neutral the S&P homebuilders index, but it is now on our downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. A Few Words On Banks Pundits around the globe focus on Eurozone and pan-European banks and argue that these outfits have been value destroyers since the history of the data series in late-1986 (bottom panel, Chart 13). Similarly, US banks relative share prices peaked in the mid-1970s and have never looked back, and very recently have tumbled to fresh all-time lows whether one uses monthly, weekly or daily data (top panel, Chart 13). Meanwhile, the recent drubbing in relative share prices suggests that loan loss provisioning is not over. In fact, Q3 loan loss reserves will surpass the level hit in the GFC, and likely close in on the $300bn mark (provisions shown inverted, Chart 14). Chart 13Banks, The World Over, Are Value Destroyers Banks, The World Over, Are Value Destroyers Banks, The World Over, Are Value Destroyers Chart 14More Loan Losses Loom… More Loan Losses Loom… More Loan Losses Loom… Historically, loan loss provisions are the mirror image of bank net operating income and most importantly bank profits decline as provisioning increases (Chart 15). Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket (bottom panel, Chart 16). Chart 15…Which Will Weigh On Profits …Which Will Weigh On Profits …Which Will Weigh On Profits Chart 16Fiscal Policy Easing To The Rescue? Fiscal Policy Easing To The Rescue? Fiscal Policy Easing To The Rescue? Tack on the year-to-date more than halving in the 10-year US Treasury yield and the earnings outlook remains grim for banks (top & middle panels, Chart 17). The transmission mechanism is through net interest margins (NIMs). The fourth panel of Chart 17 highlights that the pair have been joined at the hip and all-time lows in the 10-year US Treasury yield have sank bank NIMs below 3%, which is another all-time low since the history of the FDIC data. Credit growth has crested and our loans and leases model suggests that loan growth will continue to decelerate into 2021 (second panel, Chart 17). Not only is there lack of appetite for new overall loan uptake, but bankers are stringent with extending credit to businesses and consumer alike, according to the most recent Fed Senior Loan Officer survey (Chart 18). Chart 17Credit Growth Blues Credit Growth Blues Credit Growth Blues Chart 18Lack Of Loan Demand And Tightening Credit Supply Lack Of Loan Demand And Tightening Credit Supply Lack Of Loan Demand And Tightening Credit Supply However, there are three significant offsets to all these stiff headwinds that prevent us from downgrading banks to an underweight stance. First, the 10-year US Treasury yield is one of the few assets that has yet to discount any economic recovery. Thus, as uncertainty lifts post the November election, the economy continues to open up and Congress and the new President manage to pass a fresh fiscal stimulus bill, all this could catalyze a catch up phase in the long bond yield. Second, valuations offer a deep enough discount to absorb a little bit of more negative news as analysts and investors alike have thrown in the towel in banks (bottom panel, Chart 19). Finally, the credible Fed’s stress test loom by year-end and assuming banks pass them with flying colors a resumption of shareholder friendly activities will boost the allure of owing banks and unwind extremely oversold conditions (middle panel, Chart 19). In sum, while the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index. Chart 19Unloved And Under-owned Unloved And Under-owned Unloved And Under-owned Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Cement Gains In The Internet Retail Index And In The Consumer Discretionary Sector Cement Gains In The Internet Retail Index And In The Consumer Discretionary Sector Neutral In mid-April we moved the S&P consumer discretionary sector to the overweight column via upgrading the internet and home improvement retail sub-sectors. While the home improvement retailers hit our stop earlier this month resulting into 15% relative gains, last Friday internet retailers followed suit. We are obeying our previously instituted stop in the S&P internet retail index and crystalizing gains at the 20% relative return mark and downgrade to neutral. This move also pushes the overall S&P consumer discretionary sector to a benchmark allocation, locking in profits of 15% in excess of the broad market over the past five months. Bottom Line: Downgrade the S&P internet retail index to neutral which also pushes our S&P consumer discretionary sector allocation to benchmark for 20% and 15% relative gains, respectively, since the mid-April inception.  

Highlights Portfolio Strategy We opt to stay patient and refrain from deploying fresh capital especially in the tech sector in the near-term; a better entry point will likely materialize between now and the end of the year. The softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and the risk of a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. A balanced outlook keeps us on the sidelines in the S&P home improvement retail (HIR) index. Recent Changes There are no changes to the portfolio this week. Table 1 Churning Churning Feature Equities tried to regain their footing last week, but risks still lingering on the (geo)political front should sustain the tug of war between bulls and bears and rekindle volatility. While monetary and fiscal policies will remain loose, the intensity of easing is waning as both the Fed’s impulse (i.e. second derivative) of asset purchases has ground to a halt and Congress has hit a stalemate over the next round of stimulus. Crudely put, the thrust of monetary and fiscal policies is at heightened risk of shifting from stimulative to contractive (Chart 1). As a result, we remain patient with fresh capital and will wait to deploy it when the dust settles hopefully by the end of the year. Turning to equity market internals and other high frequency financial market data is instructive in order to get a clearer picture of the direction of the broad equity market. The value line arithmetic and geometric indexes and small cap stocks that led the March 23 SPX trough are emitting a distress signal (Chart 2). Chart 1Running Out Of Thrust Running Out Of Thrust Running Out Of Thrust Chart 2Market Internals... Market Internals... Market Internals... Drilling deeper on a sector basis, hypersensitive chip stocks, energy shares, and discretionary versus staples equities will likely weigh on the prospects of the broad equity market (Chart 3). The VIX index, the vol curve and the yield curve, all excellent leading indicators of the S&P 500, have crested and warn that the shakeout phase has yet to run its course (VIX shown inverted ,Chart 4). Chart 3...Say It Is Prudent... ...Say It Is Prudent... ...Say It Is Prudent... Chart 4...To Remain On The Sidelines ...To Remain On The Sidelines ...To Remain On The Sidelines Trying to quantify the SPX drawdown, we turn to CBOE’s equity put/call (EPC) ratio. The EPC ratio is nowhere near recent extreme readings. SPX pullbacks since the early-2018 “Volmageddon” have corresponded to significantly higher EPC ratio readings. In the past 10 such iterations, the median EPC ratio has been 0.86, the mean 0.93, with a range of 0.77 to 1.28 (Table 2). Currently, the EPC ratio is hovering near 0.58 suggesting that downside risks persist (EPC ratio shown inverted, Chart 5). Chart 5Downside Risks Persist Downside Risks Persist Downside Risks Persist Table 2Equity Put/Call (EPC) Ratio During Pullbacks Since 2018 Churning Churning Finally, the commodity complex is also firing warnings shots. Lumber has collapsed nearly $300/tbf from the recent peak, oil is trailing gold bullion and silver is also cresting versus the yellow metal, iron ore is petering out and the Baltic dry index is wobbling. True, copper and materials stocks are holding their own, but overwhelmingly commodity market internals are waving a yellow flag (Chart 6). Chart 6Commodity Yellow Flags Commodity Yellow Flags Commodity Yellow Flags Netting it all out, we opt to stay patient and refrain from deploying fresh capital especially in the tech space in the near-term; a better entry point will likely materialize between now and the end of the year. This week we reiterate our underweight stance in a niche technology index and shed more light on our recent downgrade to neutral of a key consumer discretionary subgroup. Chip Equipment Update: Tangled Up In The Trade War We remain committed to our intra-tech strategy of preferring defensive software and services tech names to aggressive hardware and equipment tech stocks. In that light, we reiterate our underweight stance in the niche S&P semi equipment index. Recent news of the Trump administration’s potential tightening of the noose on Chinese chip company SMIC (the country’s largest foundry) was a net negative for US semi cap names, similar to export restrictions of American technology to Huawei was a net negative for US semi cap names. As a reminder, these manufacturers count China as one of their largest export market alongside Taiwan and South Korea. Thus, this flare up in the US/Sino trade war bodes ill for semi cap companies’ future sales and profit growth projections (Chart 7). There are high odds that relative share prices have plateaued earlier this month and a fresh down cycle has commenced. Under such a backdrop, this hyper-sensitive manufacturing group will likely overshoot to the down side as is evident in the historical tight correlation with the ISM manufacturing survey: these violent oscillations are warning that a cooling off in the ISM will be severely felt in this niche manufacturing intense index (Chart 8). Chart 7Lofty Expectations Lofty Expectations Lofty Expectations Chart 8Violent Oscillations Violent Oscillations Violent Oscillations On the global demand front, there is an element that COVID-19 is stealing sales from the future and bringing demand forward. Already global semi sales are rolling over, and a couple of industry pricing power proxies are deflating at an accelerating pace: Asian DRAM prices are topping out in the contraction zone and Taiwanese export prices are sinking like a stone, warning that a deficient demand down cycle will squeeze semi cap profit margins (Chart 9). Importantly, Taiwanese tech capex, which TSMC dominates, has crested, warning that all the euphoria behind 5G deployment and uptake is likely baked in the relative share price ratio. The implication is that semi cap names remain vulnerable to any global 5G-related hiccups (top panel, Chart 10). Chart 9Waning Selling Price Backdrop Waning Selling Price Backdrop Waning Selling Price Backdrop Chart 10Cresting Cresting Cresting Finally, the tight positive correlation between Bitcoin prices and the relative share price ratio remains intact. Were a knee-jerk rebound in the US dollar to knock down Bitcoin, at least temporarily, it would serve as a catalyst to shed chip equipment stocks (bottom panel, Chart 10). Moreover, 90% of the industry’s sales originate abroad, thus a rise in the greenback would eat into their P&L via FX translation losses. Adding it all up, a softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. Bottom Line: Stay underweight the S&P semiconductor equipment index. The ticker symbols for the stocks in this index are: BLBG S5SEEQ – AMAT, KLAC, LRCX. Home Improvement Retailers: Stay On The Sidelines Two weeks ago our trailing stop was triggered in the S&P home improvement retail index (HIR) and we monetized gains of 15% since the mid-April inception and moved to the sidelines. Today we reiterate our benchmark allocation in this consumer discretionary sub group. Clearly, HIR was a major beneficiary of the lockdown as the US and Canadian governments deemed these retailers “essential” and allowed them to stay open during the peak of the pandemic. These Big Box retailers saw their sales soar as the fiscal easing package replenished consumers’ wallets, and coupled with the lockdown, caused a surge in DIY remodeling activity. Our portfolio also greatly benefited from the stellar performance of the S&P HIR index, as existing home sales staged a significant comeback and inventories of homes for sale receded substantially thus further tightening the residential real estate market (top & middle panels, Chart 11). As reminder, historically a vibrant housing market is synonymous with handsome returns in relative share prices and vice versa. But now a number of stiff headwinds, which our HIR model encapsulates, signal that a lateral digestive move is in store in the coming months (Chart 12). Chart 11Unsustainable Front Running Unsustainable Front Running Unsustainable Front Running Chart 12Stiff Headwinds Stiff Headwinds Stiff Headwinds First, a repeat of the spike in demand for home improvement projects is highly unlikely, especially given that demand was brought forward. Also during the autumn and winter months there is a natural slowdown in the take-up of remodeling projects until the spring home selling season arrives. Second, the industry’s sales-to-inventories (S/I) ratio is literally off the charts (bottom panel, Chart 11). An inventory build-up and easing in demand will bring back the S/I ratio back to a more reasonable level. Lastly, lumber prices have taken a beating of late collapsing from over $900/tbf to below $600/tbf. This drubbing of this economically hypersensitive commodity directly cuts into HIR earnings. These Big Box retailers make a set margin on lumber sales so as prices fall they take a big bite out of profits (bottom panel, Chart 13). Nevertheless, a few offsets prevent us from turning outright bearish in this early cyclical retailers. Namely, the industry’s profit growth bar is on a par with the broad market and thus does not pose a large hurdle to overcome. Importantly, given that HIR earnings have kept pace with the massive run-up in stock prices (second panel, Chart 14), they have kept relative valuations at bay. While, the S&P HIR 12-month forward P/E trades at a market multiple, the relative forward P/E changes hands at a 20% discount to the historical mean. Thus, HIR enjoy a significant valuation cushion (bottom panel, Chart 14). Chart 13Timber! Timber! Timber! Chart 14But There Are Powerful Offsets But There Are Powerful Offsets But There Are Powerful Offsets Finally, the Fed just explicitly committed to stay on the zero interest rate line until 2023! This easy monetary policy as far as the eye can see is a powerful tonic to early cyclical and interest rate-sensitive home improvement retailers (fed funds rate shown inverted, top panel, Chart 14). Netting it all out, a balanced outlook keeps us on the sidelines in the S&P HIR index.  Bottom Line: Stick with a benchmark allocation in the S&P home improvement retail index. The ticker symbols for the stocks in this index are: BLBG S5HOMI – HD, LOW.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Neutral In mid-April we went overweight the S&P home improvement retail (HIR) index on the back of demand-stimulating zero interest rate monetary policy, loose fiscal policy as well as rising lumber prices. As a reminder, HIR companies make a set margin on lumber sales, hence higher lumber prices are a tonic to the industry’s top and bottom lines. Book Gains In Home Improvement Retailers Book Gains In Home Improvement Retailers However, in mid-June we highlighted weakness in our HIR macro model, a hook down in existing home sales and tick up in inventories. Together, those factors compelled us to institute a stop at the 10% relative return mark, which we subsequently increased further to 15%. Last week our stop was triggered, and we booked 15% in relative gains and moved to the sidelines in home improvement retailers. Bottom Line: Downgrade the S&P HIR index to neutral and book 15% in relative gains since the mid-April inception. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.  

Retailers Are On Fire Retailers Are On Fire Overweight Our S&P home improvement retail overweight continues posting healthy gains: the position is up 23%, in relative terms, since the mid-April inception. Such handsome returns compel us to move our trailing stop from 10% to the 15% relative return mark in order to protect gains. Nevertheless, we still expect to harvest more gains – a view that HD’s earnings release reiterated yesterday. Remote working has created an opportunity for homeowners to undertake remodeling projects that drove extra traffic to home improvement retail stores. Specifically, HD comparable-store sales grew by 25% year-over-year, which translated into a sizable EPS beat. The bottom panel of the chart corroborates that HIR sales are on fire. Bottom Line: We remain overweight the S&P home improvement retail index, but today we move our trailing stop from 10% to 15%. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.  

Highlights COVID-19 shutdowns have intensified the pressure on the original “everything stores,” … : A combination of factors has been weighing on department stores since at least the early 2000s. Pandemic store closures have turned up the heat. … and turned an unwelcome spotlight on the future of shopping malls: Bankruptcy filings by anchor tenants pose an existential threat to already struggling malls. Shelter-at-home orders and universal telecommuting have debilitated the fashion industry, further testing malls’ resilience: Apparel retailers account for an estimated 60% of leased mall space, and their struggles are ramping up the pressure on mall operators. City-to-suburb migration may act to accelerate incumbent malls’ decline: Chester County, Pennsylvania has steadily gained wealth and population since the 1970s, but all the legacy malls within a 15-mile radius of the county seat are dead or dying. Feature Dear Client, US Investment Strategy will take its second summer break next week, so there will be no publication on August 24th. We will return on the 31st with Part 2 of the Mallpocalypse series. Best regards, Doug Peta Come On. How Can It Be That Bad? The July 31st episode of BCA’s Friday Conversations webcast series featured a construction executive who expressed the view that a considerable share of America’s enclosed shopping malls has very little value.1 Many malls, he argued, are no longer viable as originally intended and a daunting mix of financial and zoning obstacles stand in the way of repurposing them for other uses. A client in attendance thought we were laying it on a little thick. “Aren’t you being extreme?” he asked. “Why won’t things go back to normal [for enclosed shopping malls] once there’s a vaccine?” Like casinos, malls created a self-contained environment where customers would spend more the longer they stayed, ...  We confess to a weakness for invented mash-up catchphrases that refer to the patently ridiculous (Sharknado) or relentlessly overhyped (the Snowmageddon build up to potential winter storms). It was with tongue in cheek that we titled the webcast “Mallpocalypse,” but this multi-part Special Report is testament to the dire prognosis for much of the stock of US malls. Malls were under pressure well before COVID-19 emerged and they would remain under pressure even if it were already in full retreat. The pandemic has dramatically accelerated weaker malls’ demise, and few of them appear to have a path back to viability. A Brief History Of The Shopping Mall The fully enclosed, temperature controlled Southdale Center in the Twin Cities suburb of Edina, Minnesota was the world’s first shopping mall. Its 1956 opening was front-page news across the national media, which greeted it with rapturous praise. It was designed by Austrian émigré Victor Gruen, who had made his name by reconfiguring New York City’s retail entryways in a way that lured prospective consumers into stores and helped to keep them there. His mall design achieved the same effect on a much greater scale. Southdale positioned 72 stores across two levels joined by escalators and bookended by two branch department store “anchors.” The open floor plan in the body connecting the anchors allowed for unimpeded views of nearly every storefront. “A ‘garden court’ under a skylight, with a fishpond, enormous sculpted trees, a twenty-one-foot cage filled with bright-colored birds, balconies with hanging plants and a café,”2 meant to evoke the feeling of a town square, was set in the center of the mall, inviting visitors to linger. Vast parking lots stood ready to accommodate thousands of their cars (Box 1). Malls revolved around the department store anchors that promised to deliver foot traffic that their rank-and-file tenants wouldn’t find on the high street or in supermarket-anchored shopping centers. Developers couldn’t get bank funding without contractually committed anchors and most mall leases today contain a provision that automatically resets rent lower, or allows tenants to exit their lease without penalty, if multiple anchors close. Per the 2019 10-K for Simon Property Group, the country’s largest mall owner, the rounded average base minimum rent for anchor tenants with leases expiring between 2020 and 2029 ranges from $4 to $8, while the average base minimum rent for inline tenants ranges from $50 to $65. Anchors are the belle of the ball and malls that lose them risk entering a death spiral. Box 1: The ‘70s: If It Ain’t Broke, Don’t Fix It Other developers faithfully followed Gruen’s initial template during the mall building boom from the mid-fifties to 1990. The three malls within a 15-mile radius of my hometown – Concord Mall (Wilmington, DE, opened 1968), Exton Square Mall (Exton, PA, 1973) and Granite Run Mall (Media, PA, 1974) – had every element but swapped out the bright-colored birds for outsized fountains. Concord Mall meant ICEEs in blue and red cups with a cartoon polar bear, Exton Square was Baskin-Robbins’ mandarin chocolate sherbet and Granite Run was large square floor tiles with a beguiling pattern of cross-sectioned stones, but this elementary schooler’s dominant mall impression was the Niagara-like roar of the fountains, which seemed to fill every cubic foot of the area outside the stores. The Long-Running Department Store Crisis The minimum base rent comparison is not quite apples-to-apples, as anchor tenants often own their own spaces, but anchors are malls’ drawing card. As Simon’s 10-K puts it, “our [properties] rely upon anchor tenants to attract customers.” Ideally, an anchor will comfortably fill the two-level bookend spaces and bring a steady stream of consumers who may spend at the stores they pass on the way. Fit is essential: dollar store customers aren’t likely to pony up for luxury brands or the merchandise on offer at high-end boutiques. Gyms and movie theaters can absorb the space, but shopping may not be on their clientele’s agenda. ... and they counted on department stores to lure them inside it. Before the advent of category-killers in the ‘90s, department stores were an ideal anchor. They were trusted well-known brands that shoppers in their area were conditioned to seek out for a broad range of purchases (Box 2). Despite their struggles, department stores remain the go-to anchors at most malls. High-end brands like Neiman Marcus, Nordstrom or Saks might anchor a mall with luxury tenants, while Dillard’s, JCPenney, Lord & Taylor or the ubiquitous Macy’s might anchor a mall seeking a more general clientele. Box 2: The ‘80s: Best. Purchase. Ever. At 19, I ventured to the massive King of Prussia Mall for a post-Christmas department store sale where I wrote my first check with a comma to purchase a floor model Sony rack system (turntable, amplifier, receiver and dual tape deck) and a CD player. The nearly three-foot-high speakers and cabinet were an early concession to marital comity (reciprocated by the gift of higher-end bookshelf speakers) but the amplifier would keep spreading joy until 2012, when it succumbed just three blocks from BCA’s Montreal office to time and the steady thump of Crazy Horse. Unfortunately for mall operators, department stores have been losing ground for at least 25 years and openly reeling for the last ten. The big-box, category-killer stores, like Home Depot, the late Circuit City, Best Buy, Barnes & Noble, Sports Authority and the late Toys ‘R’ Us, reshaped the retail landscape in the ‘90s, ushering in power centers and stealing business from department stores’ more expensive, less specialized and comparatively thinly stocked individual departments. The steady buildup of e-commerce (Chart 1), the shift in popular appeal from suburbia to urban centers and millennials’ celebrated preference for experiences over things contributed to further erosion. Private equity’s foray into the field exacerbated the other pressures. Its modus operandi of levering its portfolio companies up to the gills left the store chains it acquired dangerously unprepared to contend with falling revenues. Chart 1Perpetual Motion Machine Perpetual Motion Machine Perpetual Motion Machine A Rotten Time For A Pandemic Many department stores and other retail chains were staggering before a sick bat straggled into a live animal market in Hubei province. The subsequent pandemic has forced a long list of them, including Neiman Marcus, JCPenney and Lord & Taylor, into Chapter 11 to shrink their debt and their cost bases under the protection of the bankruptcy code (Table 1). Several national chains not in bankruptcy are trimming their footprints as well. Nordstrom has announced plans to close a sixth of its locations, and mall stalwart Macy’s (which also owns Bloomingdale’s) wants to shutter 125 of its 850 locations (Table 2). The pandemic has cut a wide swath through apparel retailers, department stores, gyms and restaurants and the toll continues to mount. Table 1Selected Pandemic Retail Bankruptcies Mallpocalypse, Part 1: An Overnight Collapse Decades In The Making Mallpocalypse, Part 1: An Overnight Collapse Decades In The Making Table 2Selected Store Closures Outside Of Bankruptcy Mallpocalypse, Part 1: An Overnight Collapse Decades In The Making Mallpocalypse, Part 1: An Overnight Collapse Decades In The Making Chapter 11 bankruptcy offers struggling businesses a second chance while protecting the interests of senior lenders and secured creditors, but it is cold comfort for unsecured creditors. From a landlord’s perspective at the back of the priority line, the time out that bankruptcy grants an ailing debtor is an excruciating limbo when it is enjoined from initiating eviction proceedings. The landlord collects little, if any, rent and is unable to market the space or spruce it up while the tenant is shielded by the court. The Fashion Industry Was Already A Mess The outlook for department stores is undoubtedly bleak, but the fashion industry, which has relied on department stores’ retail distribution channel, may have it worse. According to a wide-ranging New York Times Magazine cover story,3 the entire fashion ecosystem has been busily devouring itself ever since the financial crisis. Although turmoil in the fashion industry would not typically register with most non-specialist investors, apparel retailers account for around 60% of leased mall space and have become another flash point for mall distress. According to the apparel component of the consumer price index, clothing prices peaked in 1998, rebounded somewhat in 2011 and 2012, and had resumed drifting lower before plunging to 1998 levels in May. The decline in women’s clothing prices has been even more severe, falling 27% from their 1993 peak to slip all the way to 1981 levels (Chart 2). One culprit has been fast fashion. Enabled by social media’s instantaneous dissemination of runway designs, nimble non-luxury retailers like Zara and H&M are able to rush their own versions into production, front-running high-end collections and compelling department stores to discount their own inventory as soon as they receive it. Chart 2Salmon Have It Easier Salmon Have It Easier Salmon Have It Easier Discounting has been ruinous for the department stores’ apparel margins, as producers’ prices have failed to follow consumer prices lower (Chart 3). Department stores struck back by presenting designers with ridiculously one-sided vendor agreements. Designers reluctantly acquiesced, lest they lose access to the stores’ once-mighty distribution channel and fail to meet their lofty growth targets. Those targets are courtesy of a new breed of investor, eager to discover the next fashion star and ramp his/her operation up to scale immediately. The accelerated timetable pushes fledgling designers to expand well beyond the capacity of their bare-bones organizations and makes an inherently fickle business even more tenuous. Chart 3Rising Production Costs + Falling Prices = A Lot Of Red Ink Rising Production Costs + Falling Prices = A Lot Of Red Ink Rising Production Costs + Falling Prices = A Lot Of Red Ink E-commerce further eroded department stores’ and other brick-and-mortar retailers’ positions, a story with which investors are already familiar. The bottom line is that department stores (Chart 4) and apparel retailers (Chart 5) have been badly lagging the broader market for an extended period. Their relative market performance is consistent with their constituents’ cycling in and out of Chapter 11. Even though they shrink their debt loads and store footprints with every trip to the courthouse, they haven’t been able to do so fast enough to overcome revenue and margin headwinds that show no signs of letting up. Chart 4Gradually, Then Suddenly Gradually, Then Suddenly Gradually, Then Suddenly Chart 5Ex-The Discount Stores, Apparel Retailers Have Gotten Crushed Ex-The Discount Stores, Apparel Retailers Have Gotten Crushed Ex-The Discount Stores, Apparel Retailers Have Gotten Crushed Then the pandemic arrived and nearly the entire white-collar workforce, ex-health care professionals, ceased going to the office or traveling to meet clients in person. For five months and counting, the primary consumers of professional attire have had no reason to wear it, much less buy more. It’s no surprise that Brooks Brothers, Ann Taylor, JoS. A. Bank and Men’s Wearhouse have been among the casualties. Overall sales of clothing fell off a cliff in March, April and May (Chart 6, top panel) but clothing stores fared even worse (Chart 6, bottom panel). Chart 6Apparelocalypse Apparelocalypse Apparelocalypse With department store anchors, who occupy approximately 30% of malls’ leasable area, and apparel retailers under siege, mall operators have few places to turn to fill their space. The new breed of anchor stand-ins – fitness centers, movie theaters and entertainment spaces – are not able to open in every state and haven’t been paying rent. Gold’s Gym, 24 Hour Fitness and Chuck E. Cheese have already filed for bankruptcy and the big movie theater chains’ future is deeply uncertain. There’s Gold In Them Thar Hills, But Someone Else Has Already Staked A Claim Green Street Advisors, the leading commercial real estate research and advisory firm, estimates that half of all mall-based department stores will close by the end of 2021. Estimates of the share of malls that will close in the aftermath range from a quarter to a third. If the US has around 1,200 malls, 300 or 400 may soon disappear. Their owners and the entities that have lent to them will recoup only a fraction of their initial investments. If their losses lead to a reduction in the availability of credit, or trigger a self-reinforcing wave of defaults and bankruptcies, they could have a broader macro impact. We will explore the potential macro effects in the next installment of the series. We close this one by noting the sad fate of the ‘70s-era malls within a 15-mile radius of West Chester, Pennsylvania. Granite Run Mall was razed in 2016 and replaced with an open-air mixed-use facility that retained the original mall’s anchor spaces. Concord Mall was sold to a buyer of distressed malls in January, which has yet to disclose its plans for the site. Exton Square Mall, which underwent an ill-fated 2000 expansion that more than doubled its leasable area, is now owned by the ailing publicly traded Pennsylvania Real Estate Trust (PEI). PEI classifies the property as a non-core asset, along with the other two weakest malls in its portfolio. The Chester County mall experience bears on a client question from the July 31st webcast: “People are fleeing cities for the countryside. Isn’t that the opportunity?” Chester County, which has the highest mean household income in Pennsylvania and the 27th highest in the United States, bucks the state’s broader demographic decline. West Chester, the county seat, added a third public high school in 2006; its university has steadily grown enrollment, increasing its share of students in the 14-school State System of Higher Education consortium from 12.1% in 2010-11 to 18.5% in 2019-20; and new highway arteries and commuter rail stations have made it much more feasible for residents to work in Philadelphia, 25 miles to the east, than it was in the ‘70s and ‘80s. Chester County has been a prime suburban development opportunity for 20 or 30 years and commercial and residential developers have been making the most of it, converting acreage formerly devoted to feed corn into high-end housing, office parks, luxury auto dealerships and other commercial uses. It’s not that the market can’t support retail, it’s that it no longer wants 50-year-old spaces that were built to serve a humbler, less affluent constituency. A range of newer open-air options featuring more upscale retailers and restaurants have supplanted Concord, Exton Square and Granite Run. The area has improved; it’s the old nags that couldn’t keep up.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see BCA Research Webcast "Mallpocalypse", from July 31, 2020, available at bcaresearch.com. 2 Gladwell, Malcolm, "The Terrazzo Jungle," The New Yorker, March 15, 2004. 3 Aleksander, Irina. "Sweatpants Forever," The New York Times Magazine, August 9, 2020, pp. 28-33 and 42-43.

Highlights Even after the COVID-19 pandemic is over, likely within 18 months, many behavioral changes that were forced on society by social distancing will remain. Individuals who have gotten used to working from home, shopping online, and using the internet for socializing and entertainment will continue to do so. Amid any large structural shift, it is easier to spot losers than winners. The biggest losers are likely to be: (1) Parts of the real estate industry, as companies shed expensive city-center office space and office workers move away from big cities; and (2) the travel industry, since business travel will decline. The winners will include: Health care (as governments spend to strengthen medical services); capital-goods producers (with US manufacturers increasingly reshoring production but automating more); and the broadly-defined IT sector which, while expensively valued, is nowhere near its 2000 level and has several years of strong growth ahead.   “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” –  Bill Gates “There are decades where nothing happens, and there are weeks where decades happen.” –  Lenin Introduction The world has been turned upside down since February by the coronavirus pandemic. Households all around the globe have been forced to stay indoors; companies have been forced to drastically change working practices; some industries, such as online shopping or videoconferencing software, have seen a surge in demand. But once the pandemic is over, how many of these changes will stick? What will be the long-term impact on society, the workplace, consumer attitudes, and companies’ strategic planning? How should investors position themselves to take advantage of secular changes in the sectors that will be most affected, ranging from health care and technology, to real estate, retailing, and travel? In this Special Report (which should be read in conjunction with two other recent BCA Research Special Reports on the macro-economic and geopolitical consequences, respectively, of COVID-191), we look at the social and industry implications of the coronavirus pandemic. We assume that, within the next 12-to-18 months, the pandemic will be a thing of the past, either because a vaccine has been developed, or because enough people have caught it for herd immunity to develop. This does not mean that people will be unconcerned about a reoccurrence, or about a new virus triggering another epidemic. Pandemics are not rare, even in modern history (Table 1). And COVID-19 may return as an annual mild seasonal flu (as the 1968 Asian flu did), but which is not serious enough to alter behavior. But the assumption in this report is that, within a couple of years, people will feel comfortable again about being in crowded spaces and traveling, without a need for social distancing or periodic lockdowns. Table 1Estimated Mortality And Infection Rates Of Pandemics During The Past Century The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But that doesn’t mean that everything will return to the status quo ante. At least some individuals who have gotten used to working from home, video conferencing, and shopping online will continue these practices. Companies will, therefore, need to rethink their employment policies, as well as how they manage their office space, global supply chains, and just-in-time inventories. Government policies towards health care and education will need to be rethought. None of these changes are new. Indeed, the result of an exogenous shock is often simply to accelerate trends that were already in place. E-commerce, telecommuting, and “reshoring” have already been growing steadily for years. COVID-19 is, however, likely to accelerate these shifts. Not every individual or company will change their behavior, but even small changes at the margin can have a significant impact. Ultimately, what these changes amount to is a liberalization of space and time. Employees do not need to be in the same physical space to work together. Students can choose when to listen to a lecture. Music lovers based in a small city can have the same access to a live (streamed) concert as those in London or New York. This Special Report is divided into two sections. In the first section, we examine the meta-changes in consumer and corporate behavior that could result from the pandemic. How widely will the shift from office-based work to “working from home” stick? How much will shopping, entertainment, and education stay online? Will companies really bring back a large chunk of manufacturing from overseas? In the second section, we analyze the impact on specific industries, such as real estate, health care, technology, and retailing, and make some suggestions as to how investors should tilt their portfolios over the longer term to take advantage of these trends. In summary, we identify the winners as health care, technology, and capital-goods producers. The clear losers are in real estate and travel. Retailing and consumer goods will see a significant shakeout, with both winners and losers, but the overall impact on these industries will be neutral. Social Impacts Working From Home Teleworking, or working from home, is hardly new. Craftsmen before the industrial revolution did so as a matter of course. But the development of computers and telecommunications in the 1980s made it feasible for white-collar workers to work from home too. As Peter Drucker wrote as long ago as 1993: "...commuting to office work is obsolete. It is now infinitely easier, cheaper and faster to do what the nineteenth century could not do: move information, and with it office work, to where the people are."2  Until now, however, teleworking has been rare. But the requirements imposed by the pandemic could cause that to change. Technically, it is possible for workers in many job categories to telework effectively. A recent study by Jonathan Dingel and Brent Neiman3 estimated, based on job characteristics, that it is feasible for 37% of all jobs in the US to be done entirely from home (46% if weighted by wages). The vast majority of jobs in sectors such as education, professional services, and company management could be done from home (Table 2). Extending the analysis to other countries, they find that more than 35% of jobs in most developing countries can be done from home, but less than 25% in manufacturing-heavy emerging economies such as Turkey and Mexico (Chart 1). Table 2Share Of Jobs That Can Be Done At Home, By Industry The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 1Share Of Jobs That Can Be Done At Home, By Country The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But, in practice, before the coronavirus pandemic, many fewer people than this worked from home. Partly this was simply because many companies did not allow it. A survey by OWL Labs in 2018 found that 44% of companies around the world required employees to work from an office, with no option to work remotely.4 The percentage was even higher, 53%, in both Asia and Latin America. By contrast, OWL did find that 52% of employees globally worked from home at least occasionally, and that as many as 18% of respondents reported working from home always. The pandemic forced many white-collar workers to telework for the first time. The Pew Research Center found that 40% of US adults – and as many as 62% of those with at least a bachelor’s degree – worked from home during the crisis.5  How white-collar workers found the experience, and whether they plan to continue to work from home some of the time even if not required to do so, vary widely. Employers are generally positive about the idea. A survey of hiring managers by Upwork found that 56% believed that remote working functioned better than expected during the crisis (Chart 2). They cited reduced meetings, fewer distractions, increased productivity, and greater autonomy as reasons for this. The major drawbacks were technological issues, reduced team cohesion, and communication difficulties. Another survey, by realtor Redfin, found that 76% of US office workers had worked from home during the crisis (compared to only 36% who worked from home at least some of the time beforehand) and that 33% of respondents who had not worked remotely pre-shutdown expect to work remotely after shutdowns end (with another 39% unsure) (Chart 3). Chart 2Employers Found That Teleworking Worked Well The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 3Many Employees Expect To Continue Working Remotely After The Pandemic Ends The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But there are problems too. Research published in the Journal of Applied Psychology found that, while teleworking has some clear advantages, such as improved work-family interface, greater job satisfaction, and enhanced autonomy, it also has drawbacks. Most notably, if workers aren’t in the office at least half the week, relationships with fellow workers suffer, as does collaboration.6 There are also developed countries where backward technology has made the experience of working from home difficult. This is particularly the case in Japan. A survey by the Japan Productivity Center found that 66% of office workers said their productivity fell when working from home; 43% were dissatisfied with the experience. The reasons cited for the dissatisfaction were “lack of access to documents when not in the office” (49%), “a poor telecommunications environment” (44%), and a difficult working environment, such as lack of desk space (44%). Japanese companies remain rather paper-based, and household living space tends to be small. Research carried out on employees at Chinese online travel company Ctrip before the pandemic concluded that home working led to a 13% performance increase but, crucially, there were four requirements for working from home to succeed: Children must be in school or daycare; employees must have a home office that is not a bedroom; complete privacy in that room is essential; and employees must have a choice of whether to work from home.7  After the pandemic, a significant shift in the pattern of office work is likely. Many workers will work remotely part or most of the time. But they will also benefit from coming to an office a certain number of days a month to work together, bond with co-workers, exchange ideas, etc. Online Shopping E-commerce has been growing steadily for years. In the US, it increased by 15% year-on-year in 2019, to reach $602 bn, or 16% of total retail sales (Charts 4 and 5). The share is even higher in some other countries: For example, 25% in China and 22% in the UK. The pandemic caused a big acceleration in e-commerce the first few months of this year, as consumers in most countries around the world were either not allowed to go outside, or felt unsafe doing so. Chart 4The Share Of E-commerce Has Been Steadily Expanding For Years… The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Data from Mastercard show that, in the worst period of lockdowns in April, e-commerce grew by 63% in the US, and 64% in the UK year-on-year, compared to a decline of 15% and 8%, respectively, in overall retail sales (Chart 6). The growth was particularly apparent in products such as home improvement, footwear, and apparel (Chart 7). Chart 5…With Growth Of Around 15% A Year The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 6In April, Online Sales Soared… The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not?   Chart 7…Especially In Certain Categories The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Moreover, many consumers in advanced economies bought goods such as clothing, medicine, and books online for the first time, and used services such as online grocery delivery, and apps to order food from restaurants (Chart 8). Note, however, that few consumers bought financial services, magazines, music, and videos online for the first time. Presumably these are products that the vast majority of households had already been consuming online. Chart 8Consumers Shifted Purchases Of Many Items Online The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? It is hard to know how sticky these trends will be. Once shops permanently reopen without restrictions, will consumers simply return to their old habits of going to supermarkets, restaurants, and clothing stores? Perhaps many enjoy the experience of browsing. It seems likely, however, that the newly acquired habit of shopping online will at least accelerate the trend towards e-commerce. Many of those who ordered, for example, supermarket deliveries online for the first time will continue to do so at least occasionally in the future. Other changes are likely too: Many smaller retailers were forced to close their physical stores during the pandemic and so had no choice but to set up an online delivery service. Some struggled with this, but others were aided by companies such as Shopify, which simplify the process of setting up a website, processing payments, and arranging delivery. Shopify now works with over a million merchants. These smaller retailers are now better able to compete with giants such as Amazon. During the lockdown, US consumers notably diversified their online product searches away from Amazon and Google to smaller retailers (Chart 9). Chart 9Search Diversified Away From Amazon And Google The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? We might see a trend towards smaller-scale, local shops benefiting as consumers stick to shopping in smaller stores closer to their homes. Many stores during the pandemic refused to accept cash; this might accelerate the shift towards contactless payments. Consumers may be less focused in future on conspicuous consumption. The trend towards wellness, home-cooking, gardening, crafts, and self-investment might continue. Other Uses Of Technology It is not only work and shopping habits that changed during lockdowns. Individuals also got used to a range of technologies for socializing, entertainment, education, and medical consultation. Consumer surveys by the Pew Research Center show that a third of American adults have socialized online using services such as Zoom, and a quarter have used online systems for work or conferences (Chart 10). But these percentages are much higher for certain demographics. For example, 48% of 18-to-29 year-olds have socialized online, and 30% of this age group have taken online fitness classes. The percentage using video systems for work is as high as 48% for people with a college degree. And, unsurprisingly, with many university courses moving online since the spring, 38% of 18-to-29 year-olds say they have taken an online class. Chart 10Individuals Have Been Socializing And Communicating More Online The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? How sticky these trends will be once the pandemic is over is not easy to forecast. But further research by Pew showed that 27% of US adults believed that online and telephone contacts are “just as good as in-person contact,” and only 8% thought of them as not much help at all, although a rather larger 64% answered that online socializing is “useful but will not be a replacement for in-person contact.” The responses differed little between gender, race, and political views, although fewer people under the age of 30 thought online contacts were as good as in-person ones (Table 3). Table 3How Do Online Interactions Compare To In-Person Ones? The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Another survey in Japan by Ipsos suggests that people’s values have changed as a result of the pandemic and quarantines, with a greater focus on wellbeing, home-based activities such as cooking, and self-improvement. When questioned, a large percentage of people believe they will persist with these habits even when lockdowns end. For example, 51% of Japanese respondents believe they will continue to enjoy themselves as much as possible at home in their spare time, compared to only 20% who favored entertainment at home before the pandemic (Chart 11).  Chart 11Pandemic Brought A Greater Focus On Wellbeing And Home-Based Activities The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Other areas that have moved online en masse include education, health care, the judiciary, concerts, and sports (e-sports, and popular sports such as soccer and baseball that are now being played in empty venues). Education at the tertiary level in advanced economies was already partly online before the pandemic. In the US, out of 19.7 million tertiary students in 2017, 2.2 million (13.3%) were enrolled in exclusively online/distance learning courses, and another 3.2 million (19.5%) took at least one course online.8 Of course, everything changed during the pandemic, with 98% of US institutions moving the majority of in-person courses online, and many planning to continue this through the Fall 2020 semester. At the elementary and secondary school level, online education was much more limited pre-pandemic. According to the National Center for Educational Statistics, 21% of US schools offered some courses entirely online in 2016 but, of this 21%, only 6% offered all their courses online and only another 6% the majority of courses. Many of these schools were forced to shift entirely online during lockdowns: According to UNESCO data, at the peak of the pandemic 1.6 billion children (90% of the total in school) in 191 countries attended schools that had closed physically. It seems likely that, while in-person teaching will remain the central method of education, distance and online learning solutions, even at the high school level, will become more prevalent in the future. The health care sector has lagged in technology, in terms of using AI for diagnosis, digitalizing patient records, and offering online doctor-patient consultation. But the use of digital tools had started to increase in recent years, particularly in the number of practices using telemedicine and virtual visits (Chart 12). At the peak of the pandemic in April, the number of telehealth visits in the US rose by 14% year-on-year, compared to a 69% decline in in-person visits to a doctor.9 It seems likely that this trend will continue, as medical practitioners find viritual consultations more efficient and effective for many simple initial diagnoses, and as sick or elderly patients prefer to avoid a physical visit to a surgery.10 Chart 12The Transition To A Digital-Driven Health Care Model The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Travel Travelers have been very reluctant to get back on airplanes and stay in hotels again, even in countries and regions where the pandemic has eased over the past couple of months (Chart 13). Based on our assumption that the pandemic will be completely over within 18 months, it seems likely that people will eventually resume travelling, at least for leisure and to see family and friends. After previous disruptions to global travel, such as 9/11 and SARS, it took only two-to-three years for air travel to resumed its pre-crisis trend (Chart 14). Chart 13Travelers Remained Reluctant Even When Pandemic Eased The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 14 Business travel might be very different, however. Salespeople who have become used to making sales calls over Zoom may not feel the need to travel to see clients so much. Conferences, exhibitions, and other events will be increasingly (at least partly) online. Travel budgets are a large expense for many companies. According to estimates by Certify, a travel software provider, spending on business trips in 2019 totalled $1.5 trillion (including $315 billion by US businesses). The availability of a technological alternative to at least some business trips will provide a good excuse for many companies to meaningfully reduce the number of trips and their travel budget. In the future, business travel may become more of a privilege than a necessity. It is easy to imagine a significant decline in overall business travel. Manufacturing Supply Chains Corporate behavior could also change as a result of the disruptions caused by the coronavirus. Companies in the US and Europe realized how vulnerable their complex supply chains are. Popular and political pressure is pushing firms to reshore at least some of their overseas production. Firms will need to build in more “operational resilience,” with higher levels of inventory, less debt, and greater redundancy in their systems. Developed economies such as the US have been deindustrializing for 40 years – since reforms in China in the late 1970s, followed by Mexico and central Europe in the 1990s,  made these countries appealing locations for cheap manufacturing. US manufacturing employment has almost halved since 1980, falling to only 27% of the workforce (Chart 15). Manufacturing output, especially outside of the computer sector, has substantially lagged that of the overall private sector (Chart 16). The US has also fallen behind in automation, with a much lower number of robots per manufacturing worker than in countries such as Germany and Japan (Chart 17). Chart 15US Manufacturing Employment Has Halved Since 1980 US Manufacturing Employment Has Halved Since 1980 US Manufacturing Employment Has Halved Since 1980   Chart 16Manufacturing Output Outside The Computer Sector Has Lagged The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 17The US Has Relatively Few Robots The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? The pandemic highlighted how vulnerable widely distributed supply chains are. This was clearest in the health care sector. The US is far away the biggest spender on health care research and development (Chart 18). And yet it was unable to provide critical medical equipment such as face masks, testing kits, and ventilators to its population at an adequate rate, mainly because almost 70% of the facilities which manufacture essential medicines are based abroad (Chart 19). During the pandemic, countries such as China and India prioritized their own citizens, forcing the US government to strike emergency deals to avoid drug shortages. Chart 18The US Spends A Lot On R&D In Health Care… The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 19…But Drug Production Is Mostly Done Overseas The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Once the crisis subsides, CEOs of American companies (as well as the US government) will have to decide if they are comfortable with the fact that, while they possess a vast store of intellectual capital, the manufacturing of their products happens halfway around the world. What happens if there is another pandemic? What about a global disaster caused by climate change? Finally, and perhaps more worryingly, what happens if tensions between the US and China escalate seriously? This shift will not happen overnight: China still has much cheaper labor, an enormous manufacturing base of factories and parts suppliers, and formidable transportation infrastructure. Many aspects of supply chains are too deep-rooted and the economics too compelling for them to be unwound quickly. Some production will shift from China to other emerging economies. A Biden administration might be less confrontational with China, and could lower some of the Trump tariffs. But, at the margin, companies will choose to build new factories in the US (and in western Europe and Japan), with highly automated systems. Government policy (via both subsidies and tariffs) will encourage these trends. Manufacturers which have lived “on the edge” in recent years, with dispersed supply chains, just-in-time processes, minimal inventories, the fewest possible workers, and the maximum amount of debt compatible with their targeted credit rating (often BBB) now understand the need to build redundancy into their systems. Corporate debt levels are high by historical standards in many countries (Chart 20). Companies may want to build up a buffer of net cash in the future, as Japanese companies did for decades after the bubble there burst in 1990. Inventories have risen a little relative to sales since the Global Financial Crisis but will probably rise further (Chart 21). These trends are likely to be negative for profit margins. Chart 20In The Future, Will Companies Be Happy With This Much Debt... In The Future, Will Companies Be Happy With This Much Debt... In The Future, Will Companies Be Happy With This Much Debt... Chart 21...And Such Low Level Of Inventories? ...And Such Low Level Of Inventories? ...And Such Low Level Of Inventories? Implications For Industries In light of the social changes described above, how will various industries be reshaped over the coming years? Which sectors should investors tilt towards because they are likely to emerge as winners from post-COVID structural shifts? And which are the sectors that investors should avoid since they will suffer from the creative destruction? In the midst of major social and technological change, it is often easier to spot losers than winners. Think of the arrival of the internet in the 1990s. How many investors would have correctly picked Google, Amazon, Apple, and only a handful of others as the winners? It would have been easier to correctly identify industries that were likely to lose out to disruption, such as book retailers, travel agents, newspaper publishers, and TV broadcasters. We start, therefore, with the industries likely to lose out from post-COVID changes. The Losers Real Estate Over the next few years, prime real estate seems the most likely loser. It is not clear how many white-collar workers will choose to work from home in the future, or how many days a month they will want to come into an office to meet with fellow workers. But it seems likely there will be a strong continued trend in the direction of remote working. As a result, demand for prime central-business-district property will fall, given that it is very expensive. In Manhattan, for example, the average workspace for each of the 1.5 million office workers is around 310 square feet. At pre-COVID rental costs, that amounts to an average of $20,000 per employee – and more than $30,000 for A+ grade buildings. And rent is only part of what a company pays: There are also costs for cleaning, utilities, technology, security, coffee machines, and cafeterias on top of that. Employees working at home pay for their own space, utilities, food (and often even computer equipment). The size, location, and layout of offices will need to be rethought. Maybe companies will choose to build a campus in the suburbs, with a range of different working spaces (for meetings, quiet work, or collaboration). They may prefer to rent shared co-working spaces by the day or week. Some real estate developers and builders would be beneficiaries of this. Companies would save money in real estate costs. But they may need to pay a stipend to employees who work at home to cover the extra space they will require, and to upgrade their technology (computer equipment, internet speed, and so on). On the other hand, companies may pay lower salaries for workers who move out of high-cost locations such as Manhattan or London to places where it is cheaper to live. Many office spaces are leased on a long-term basis, so some companies will not be able to move out of big cities immediately. But residential property is more liquid. The trends in work practices might accelerate a shift to the suburbs which has already been emerging over the past few years (Chart 22). Workers will not need to live so close to the company’s office if they will visit it for only a few days a month. Small towns with a lively community and pleasant environment (and decent transportation links to a big city) could grow in popularity. This would be bad news for developers which are specialized in developing residential property in cities such as London, Sydney, Toronto, and Vancouver, and for the owners of those properties. But it might be positive for builders who will develop the new houses and out-of-town office campuses. Chart 22The Shift To The Suburbs Was Already Taking Place The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? This does not mean that cities will wither away. After previous epidemics and crises in history (think the Great Plague of London in the 17th century, or 9/11), they have always bounced back. “Casual collisions” – chance meetings with interesting people which lead to collaborative relationships – are crucial in creative industries, and happen online only with difficulty. Buildings will be repurposed: Retail space will be turned into warehouses or apartments, for example. A fall in rents would allow cities to “degentrify” and attract back young people, making the city more dynamic again. But the period of transition could be painful for some segments of the real estate industry. Travel A permanent decline in business travel would be a significant blow to airlines and hotel chains. Business travelers account for only about 12% of the number of air tickets purchased, but they generate 70%-75% of airlines’ profits. Even discount leisure airlines such as Southwest have in recent years started to target business travelers. And it will not just be airlines that are affected. Data from the US Travel Association show that 26% of the $2.5 trillion in travel-related revenues in the US in 2018 came from business travelers. Of that, 17% goes to air travel, 13% to accommodation, and 5% to car rental. An even larger portion goes to food (21%). Around 40% of hotel rooms are occupied by business travelers. Conference organizers and venues could also suffer: 62% of US business trips are to attend conferences. “Sharing economy” companies would be affected too. In 2018, 700,000 business travelers booked accommodation through AirBnB, and 78% of business travelers use Uber and other ride-sharing services. Furthermore, a slowdown in business travel would have knock-on effects on the leisure travel sector. Surveys suggest that almost 40% of business trips in the US are extended to include leisure activities (“bleisure” in the travel industry parlance). The Winners Health Care A recent report by BCA Research’s Global Asset Allocation service argued in detail that the macro environment for global health care equities will remain very positive in the coming years.11 An aging population in the world, and a growing middle class in emerging countries will steadily raise demand for health care services (Charts 23 and 24). China, in particular, has underinvested in health care: It spends only 5% of GDP, barely higher than it did 20 years ago, and well behind other emerging economies such as Brazil and South Africa (Chart 25). Chart 23Positives For Health Care Include An Aging Population… Positives For Health Care Include An Ageing Population... Positives For Health Care Include An Ageing Population... Chart 24…And A Growing Emerging Market Middle Class ...And A Growing Emerging Market Middle Class ...And A Growing Emerging Market Middle Class As a result of the COVID-19 pandemic, governments everywhere will need to spend more money on health care (or, in the case of the US, perhaps spend it more effectively). In the US, before the pandemic, intensive-care beds were sufficient to cope only with the peak of a normal seasonal influenza breakout. The World Health Organization warns that, while pandemics are rare, highly disruptive regional and local outbreaks of infectious diseases are becoming more common (Chart 26). More money will need to be spent, in particular, on developing health care technology (online consultations, digitalized patient records, track-and-trace systems), on improving senior care homes (80% of COVID-19 deaths in the Canadian province of Quebec were in such facilities), and on biotech (such as gene-related therapies). Chart 25Expenditures On Health Care Will Have To Grow Expenditures On Health Care Will Have To Grow Expenditures On Health Care Will Have To Grow Chart 26Number Of Countries Experiencing Serious Outbreak Of Infectious Disease The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not?   The health care equity sector is not expensive, trading in line with its long-run average valuation (Chart 27). Within the sector, biotech and health care technology look more attractive than pharmaceuticals, which are expensive and vulnerable to the price caps proposed by Joe Biden if he is elected US president this November. Chart 27Health Care Stocks Are Not Expensive Health Care Stocks Are Not Expensive Health Care Stocks Are Not Expensive Technology In a plethora of ways, the pandemic has propelled the use of technology: For working at home, communication, online shopping, entertainment, etc. Companies such as Zoom have moved from niche players to mainstream business providers: Zoom’s peak daily users rose from 10 million in December 2019 to 300 million in April. Chart 28Tech Stocks Are Nowhere Close To Previous Peaks Tech Stocks Are Nowhere Close To Previous Peaks Tech Stocks Are Nowhere Close To Previous Peaks Assuming that at least some of these developments remain in place once the pandemic is over, it is easy to see how technology stocks (broadly defined to include any company that uses information technology as a central part of its business) will continue to prosper. These stocks will not be just in the IT sector, but also in communications and consumer discretionary. Picking the individual winners will be hard: Will Microsoft overtake Amazon in cloud computing? Will Zoom’s much-discussed privacy issues undermine it? Will competitors emerge to Shopify in merchant services? Can Spotify compete with Apple in online music streaming? But the broadly-defined sector seems likely to have improving fundamentals for some years to come. The only question is whether the good news is already priced in, after the huge run-up in stock prices over the past few years. We do not believe it is fully. The valuations of these sectors are still nowhere close to the level they reached at the peak of the TMT Bubble in 1999-2000 (Chart 28), they have strong balance-sheets, and considerable earnings power. For their outperformance to end, it will take one of two things. The first trigger could be a significant shift down in growth. Over the past three years, Amazon has grown EPS at a compound rate of 47%, and Netflix at 76% (Chart 29). Over the next three years (2020-2023), analysts forecast compound EPS growth of 32% for Netflix, 30% for Amazon, 15% for Facebook (compared to 24% in 2016-2019), and 12% for Microsoft (compared to 16%). Those are still impressive growth numbers, and should be achievable as long as these companies can continue to grow market share. Chart 29Can The Big Tech Stocks Keep Growing Earnings At This Rate? The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? The second set of risks would be regulatory: A move to break up companies such as Google and Amazon, the US introducing data privacy legislation similar to that in the European Union, or a move to a digital tax or minimum global taxation. None of these seems likely in the immediate future. Automation/Robotics/Capital Goods The return, at the margin, of some manufacturing to the United States (and other developed economies) will bring about economic changes. Unable to tap into the pool of cheap international labor as easily as before, companies will have to invest significantly in this sector. This will result in the following: A resurgence of manufacturing productivity, thanks to increased investment. An intensification of automation. The US will need to boost the number of robots per capita to compete with Korea, Germany, and Japan. This will further improve productivity. The development of a high-tech manufacturing sector. Analogous to the FAANG stocks during the 2010s, a new group of innovative manufacturing companies could emerge. New infrastructure, roads, factories, and machinery will be needed to replace what is now an outdated capital stock in the US (Chart 30). These trends should all be positive for the capital-goods sector. Such a project would also need large amounts of raw materials. This might push up the prices of commodities such as industrial metals, and benefit materials producers. As mentioned above, it could boost the price of real estate outside of the major cities, where the new manufacturers would be likely to set up. Chart 30The US Capital Stock Is Becoming Outdated The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Mixed Retailing / Consumer Goods Retailing is likely to see a significant shakeout over the next few years. The cracks have been apparent for some years: Decreasing footfall, and empty units on many high streets and shopping malls, amid the shift to online shopping. A shift to the suburbs and further growth in online shopping will change retailing further. Rents in the highest end Manhattan shopping districts have already fallen noticeably since the start of the year, especially Lower Fifth Avenue (between 42nd and 49th Streets) which is dominated by large chain stores (Chart 31). Shopping malls, particularly undistinguished ones in poorer areas, will continue to suffer. Overall, the US in particular has an excess of retailing space, almost five times as much per capita as the major European economies (Chart 32). Chart 31Manhattan Retail Store Rents Already Falling Sharply The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 32The US Has Far Too Much Retail Space The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But it is hard to predict the winners from this shake-out. Overall spending by consumers is unlikely to be significantly affected, so it is a matter of forecasting which companies and formats will emerge victorious. Will Walmart and Target and other large retail chains improve their online offering to fight back against Amazon? Facebook, Shopify, and others have set up new services to compete with Amazon on price – will they be successful? Will small stores start to win back market share? Will supermarkets figure out how to make profits from their order-online-and-deliver services (which are now very costly because most often a human has to run around the store picking out the items ordered), or will new, fully automated competitors emerge? Will new technologies materialize to make it easier to buy clothes online (for example, digitized body measuring systems)? These changes will also affect producers of consumer products. They will have to understand the new channels, and adapt their offerings and positioning strategies accordingly. These changes will make the sector a tricky one. A skilled fund manager might be able to predict which companies’ strategies will be successful. But it could be a problematic area for investors owning individual stocks within the sector who do not have detailed expertise. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "Beyond The Virus," dated May 22, 2020 and Geopolitical Strategy, "Nationalism And Globalization After COVID-19," dated June 26, 2020. 2 Peter E. Drucker, "The Ecological Vision: Reflections on the American Condition," 1993, p.340. 3 Jonathan I. Dingel and Brent Neiman, "How Many Jobs Can Be Done At Home?" NBER Working Paper No. 26948, April 2020. 4 OWL Labs, “The State of Remote Work Report,” available at www.owllabs.com. 5 Pew Research Center survey conducted March 19-24 2020. Please see https://www.pewsocialtrends.org/2020/03/30/most-americans-say-coronavirus-outbreak-has-impacted-their-lives/psdt_03-30-20_covid-impact-00-4/ 6 Gajendran, R.S., & Harrison, D.A., “The Good, the Bad, and the Unknown about Telecommuting”,  Journal of Applied Psychology 92(6), 2007. 7 Nicholas Bloom, James Liang, John Roberts & Zhichun Jenny Ying, “Does Working from Home Work? Evidence From a Chinese Experiment,” The Quarterly Journal of Economics (2015), 165-218. 8 Please see educationdata.org. 9 Ateev Mehrotra, Michael Chernew, David Linetsky, Hilary Hatch, and David Cutler, "The Impact of the COVID-19 Pandemic on Outpatient Visits: A Rebound Emerges," The Commonwealth Fund, dated May 19, 2020.  10For more on the long-term outlook for the health care sector, Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight," dated July 24, 2020, available at gaa.bcaresearch.com. 11Please see Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight,"dated July 24, 2020, available at gaa.bcaresearch.com.

Highlights While difficult to forecast, the trajectory of global auto sales likely will follow that of GDP growth (Chart of the Week). As a result, palladium’s supply constraints will re-emerge, but its “epic rally” likely unfolds at a slower pace as global economic conditions normalize at an uneven rate.1   We expect the COVID-19 pandemic will be contained – likely via a vaccine later this year or early next year, if public-health officials are correct in their assessments, and populations become habituated to observing social-distancing and face-mask measures.2   There is evidence to suggest that in the post-pandemic world consumers will avoid public transportation in favor of their own vehicles.  This would lift palladium demand at the margin – assuming environmental regulations are not relaxed dramatically. South Africa’s derelict power grid will continue to limit palladium supply growth, despite new investment in Russia.  We expect palladium prices to remain close to current levels at ~ $2,300/oz to year-end. Chart of The WeekGlobal Auto Production Will Follow GDP’s Trajectory Global Auto Production Will Follow GDP's Trajectory Global Auto Production Will Follow GDP's Trajectory Feature COVID-19 clobbered palladium, just as it has commodities generally – taking prices from close to $2,900/oz in February to just under $1,600/oz in mid-March (Chart 2). Since then, prices rallied to more than $2,350/oz and are now languishing just above $2,200/oz. As dramatic as the metal’s price action has been, the pandemic's demand destruction only provided a respite from what remains a fraught supply backdrop. Chart 2Palladium’s Rollercoaster Ride Will Not Encourage New Output Expect Backwardation To Persist Palladium's Rollercoaster Ride ill Not Encourage New Output Expect Backwardation To Persist Palladium's Rollercoaster Ride ill Not Encourage New Output South African palladium output, which represents 36% of global supply, is once again threatened by rolling electricity blackouts, which have plagued the economy for years.3 Russia accounts for 42% of global palladium supply, and its top producer, Nornickel is maintaining production guidance of ~2.7mm ounces of palladium output this year. Even so, Nornickel expects global palladium output will total ~ 6.3mm ounces this year, down 1.3 mm ounces from 2019 levels (Chart 3).4 Inventories remain tight, and, with any recovery, can be expected to contract further (Chart 4). Chart 3Palladium's Physical Deficit Will Persist Palladium's Physical Deficit Will Persist Palladium's Physical Deficit Will Persist Chart 4Any Increase In Automobile Demand Will Further Strain Inventories Any Increase In Automobile Demand Will Further Strain Inventories Any Increase In Automobile Demand Will Further Strain Inventories This will continue a decade-long contraction in supply relative to demand, which spurred prices from $407.3/oz in 2010 to current levels but failed to energize supply growth or capex, which, from 2015 to 2019, grew by 7% and 15.2%, respectively. Auto Production Drives Palladium Demand Forecasting a recovery in palladium demand is extremely difficult, so much so even the most in-the-know market participants have suspended their usual balances assessments.5 All the same, there is a strong relationship between GDP and automobile production, as the Chart of the Week shows.6 This production drives the demand for palladium, as it is critical to the functioning of anti-pollution technology in gasoline-powered cars, which predominate in the global automobile market. Monthly car production in our sample peaked in November 2017 at 5.6mm units. In our modeling, we expected production will come in at ~ 4.3mm units in December of this year, and 4.6mm units in December 2021. This translates into a downturn of close to 6% in auto production this year versus 2019, and a recovery of ~ 9% for next year. If realized, this year’s downturn in auto production would only amount to a brief respite from the chronic supply-side weakness that has plagued the palladium market for a decade. In its May 2020 assessment, Johnson Matthey (JM) projects South African platinum-group metals (PGM) mining output will fall “at least 20%” this year. This suggests to us the physical deficits in palladium will widen and continue to do so over the medium term, which, all else equal – i.e., the global economic recovery we anticipate remains on track – will force prices higher if for no other reason than to attract capex to the PGM space. Upside Price Risk For Palladium Palladium prices will be prone to upside risk if the massive fiscal and monetary stimulus deployed globally is effective in reviving consumer demand for automobiles as household budgets are restored (Chart 5). Chart 5Rising Incomes Will Boost Auto Demand Rising Incomes Will Boost Auto Demand Rising Incomes Will Boost Auto Demand We find GDP (income) growth is an important explanatory variable for price, and would expect rising incomes in DM and EM markets would restore global employment growth and consumer confidence, leading to higher demand for new autos (Chart 6). In addition, anti-pollution regulations continue to be enforced, although states could relax these to help auto manufacturers reduce unsold inventories and to reduce the overall contribution palladium makes to a vehicle’s cost (Chart 7). Chart 6Fiscal And Monetary Stimulus Will Revive Consumer Demand Fiscal And Monetary Stimulus Will Revive Consumer Demand Fiscal And Monetary Stimulus Will Revive Consumer Demand These regulations pushed palladium loadings in internal-combustion engines globally up 14% last year, led by stout increases in Europe and China, according to JM. At 9.6mm ounces of the total gross demand for palladium, autocatalysts accounted for ~ 84% of global consumption last year (Chart 8). Chart 7Environmental Regulations Drive Palladium Demand Environmental Regulations Drive Palladium Demand Environmental Regulations Drive Palladium Demand Chart 8Autocatalysts Dominate Palladium Demand Palladium’s Recovery To Follow Auto Sales Palladium’s Recovery To Follow Auto Sales Bottom Line: The COVID-19 pandemic provided a respite for the palladium market’s relentless drive to take prices high enough to encourage new capex to bring no new supply. However, with the massive stimulus now deployed globally, we expect global GDP growth to revive in line with the World Bank’s estimates, which drive our modeling of GDP growth. This will cause demand for automobiles to revive next year, pushing demand for palladium higher as supplies are contracting – assuming, of course, governments do not relax environmental regulations pushing demand for the metal higher.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight  Brent crude oil trade through $46/bbl, or ~ 3.7% in early trading Wednesday, on the back of sharp inventory drawdowns for the week ended reported by the US EIA Wednesday. We continue to forecast a physical deficit for the balance of the year and expect to see continued draws as a result. Our price forecast for the 2H20 remains at $44/bbl and $65/bbl next year for Brent, with WTI expected to trade ~ $3/bbl below that this year and next (Chart 9). Base Metals: Neutral Copper production in Peru, the second-largest producer in the world, fell 20.4% y/y in 1H20, according to mining.com. Production appears to have recovered by June, with output increasing almost 41% m/m to 180,792 MT. The government began relaxing its quarantine restrictions, imposed in March, in May. Precious Metals: Neutral We are moving our rolling stop on gold to $1,950/oz at tonight’s close, up from our previous stop of $1,850/oz. Gold was trading close to $2,050/oz early Wednesday. We also are moving our silver stop-loss to $26/oz at tonight’s close, up from $23.50/oz, and making this a strategic position. We remain bullish these precious metals, expecting central banks globally, led by the Fed, to continue to flood markets with liquidity, particularly USD liquidity. This will keep real rates low, and will, in our view, continue to support a weakening of the USD, both of which are bullish for gold and silver (Chart 10). The Fed has made it clear they are not considering any rate increases in the foreseeable future, which will lead markets to expect continued weakness in real rates. Ags/Softs:  Underweight The USDA reported 72% of the US corn crop was in good-to-excellent condition for the week ended August 2, compared to 57% for the same period last year in the 18 states accounting for 91% of the crop. 73% of the soybean crop was in good-to-excellent condition vs. 54% last year at this time. Chart 9 Oil Price Rally Remains Intact Oil Price Rally Remains Intact Chart 10 USD Weakening Bullish For Precious Metals USD Weakening Bullish For Precious Metals Footnotes 1 Please see Epic Palladium Rally Likely Continues, which we published February 27, 2020.  2 Please see Anthony Fauci Explains Why the US Still Hasn’t Beaten Covid published by wired.com July 29, 2020. 3 Eskom, the South African electricity monopoly supplying ~ 90% of the country’s power, resumed rolling blackouts last month as COVID-19-induced lockdowns were relaxed.  The lockdowns provided a brief respite to the overloaded grid.  Please see Eskom: SA on the brink of load shedding again, as six units ‘trip-out’ published by thesouthafrican.com news service July 27, 2020.  We discuss this in our earlier publication cited in fn 1. 4 Please see Pandemic helps Russia tighten its grip on a key strategic metal published by miningweekly.com July 2, 2020.   5 See, e.g., Johnson Matthey’s Pgm Market Report: May 2020 published May 18, 2020, which notes, “At the time of writing, it was not possible to quantify these changes to supply and demand and we have elected not to publish forecasts for 2020. Our autocatalyst pgm demand models incorporate external industry estimates of vehicle production; at the time of preparing our report, these industry forecasts for 2020 were undergoing regular downgrades as the pandemic progressed across Asia and then to Europe and North America. It is also unclear to what extent primary and secondary supplies will be disrupted.” 6 Automobile demand also could get a boost at the margin from more people choosing to use their own cars and light vehicles instead of public transportation in the post-COVID-19 world. The IBM Institute for Business Value surveyed 25k US consumers in April, and found COVID-19 prompted almost 20% of their sample to say they intended to use their personal vehicles more frequently. Please see https://newsroom.ibm.com/2020-05-01-IBM-Study-COVID-19-Is-Significantly-Altering-U-S-Consumer-Behavior-and-Plans-Post-Crisis. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Palladium’s Recovery To Follow Auto Sales Palladium’s Recovery To Follow Auto Sales Commodity Prices and Plays Reference Table Trades Closed In Summary of Trades Closed In Palladium’s Recovery To Follow Auto Sales Palladium’s Recovery To Follow Auto Sales