Equities

We have shown in recent research 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. 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 contracted profits and more importantly revenues. The chart 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. Bottom Line: We are in the tail end of the equity market correction and as election and fiscal policy uncertainties recede they will pave the way for a robust SPX rally. ​​​​​​​

Highlights Portfolio Strategy Buybacks are down but not out. While financials have been weighing heavily on the S&P buybacks index, we would not write off the artificial engineering of higher EPS via equity retirement, especially in a world of ZIRP likely for the next five-to-seven years. COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities sunk late last week, as diminishing chances of fiscal easing coupled with news that the POTUS and the First Lady tested positive for COVID-19 more than offset buyers taking advantage of oversold conditions. Our sense is that the SPX will bounce around key moving averages during October (Chart 1), until the election outcome breaks the stalemate. In the back half of the month, banks also kick-start Q3 earnings season, which is important because banks’ wellbeing rests on a fresh stimulus bill. Peering over at the bond market is instructive in order to try to make sense of these crosscurrents. Two weeks ago, we first highlighted that the corporate bond market was waving a yellow flag. The selloff in the LQD ETF will continue to weigh on equities (top panel, Chart 2) and corroborates our view that the Fed is now a bystander, which puts added pressure on fiscal authorities to act. It is not a coincidence that the Fed’s balance sheet impulse peaked first and soon thereafter so did the LQD. Chart 1Trapped Between Moving Averages Worrisomely, the total return stock-to-bond ratio failed to break out to fresh all-time highs and has likely formed a head and shoulders pattern. The implication is that stocks are not out of the woods yet (bottom panel, Chart 2). Chart 2Bond Market… Junk spreads are also firing a warning shot. The high-yield option-adjusted spread (OAS) was in a tight range between 2017 and 2019. Then spreads exploded higher because of the pandemic. However, unlike the SPX making new all-time highs, junk spreads failed to make new all-time lows and more importantly have not settled back down to the 2017-2019 range (middle panel, Chart 3). The VIX index is following a similar pattern to the high-yield OAS, which is quite unnerving for equity bulls. Put differently, still elevated VIX futures in the 30s warn that in the near-term more turbulence lies ahead for the SPX (bottom panel, Chart 3). As a reminder, we first recommended buying the December VIX futures on July 27 in a joined Special Report with our sister Geopolitical Strategy service, and we continue to recommend such a hedge to long equity exposure. Chart 3…And VIX Signal Trouble For Stocks Bye-Bye Buybacks? According to the flow of funds data, a large dichotomy has taken shape between corporate debt issuance and net equity retirement. Up to very recently, the two moved in tandem. But now, the pandemic has caused a knee jerk reaction in non-financial corporate businesses that are tapping their credit lines and issuing debt at a breakneck pace. Worryingly, very little of these funds are used for equity retirement, which is a big break from recent past behavior (Chart 4). Not only does the Fed’s flow of funds data signal that buybacks have nearly ground to a halt, but also Standard and Poor’s data show that SPX buybacks collapsed to $88bn in Q2, from roughly $200bn in Q1. Crudely put, SPX buybacks have fallen by a whopping 67% quarter-over-quarter. Such a corporate buyer’s strike is negative for the near-term prospects of the S&P 500 (top panel, Chart 5). Chart 4Unsustainable Dichotomy Chart 5Buybacks Are Down… True, buybacks have come under intense scrutiny especially for bailed out sectors of the economy, nevertheless, the V-shaped economic recovery all but guarantees a rebound in depressed share buybacks sometime in 2021 (Chart 6). While our conservative $125/quarter buyback estimate proved overly optimistic in Q2, we maintain such an estimate for the next year (which it is the past decade’s average). On a cyclical 9-12 month horizon we have high conviction that SPX profits will return close to trend EPS of $162, and recovering CEO confidence should pave the way for a resumption of shareholder friendly activities, including equity retirement (middle panel, Chart 6). Drilling deeper beneath the surface is revealing. When we disaggregate the headline buybacks number into GICS1 sectors, we observe that once again the tech titans (comprising the S&P technology and the S&P communication services indexes) are doing all the heavy lifting accounting for 70% of the overall number (Chart 7). Q2 was the first time in recent memory where tech accounts for more buybacks that all the other sectors put together (bottom panel, Chart 5)! Chart 6But Not Out Chart 7GICS1 Sector Buyback Breakdown: Q1 & Q2 Chart 8 shows the ebbs and flows of sectoral SPX buybacks since late-2006. In order for our estimate to prove accurate in 2021, the Fed will have to allow financials to resume their buybacks, which collapsed from over $45bn in Q1 to just above $5bn in Q2 (Chart 7). Chart 8GICS1 Sector Buyback Breakdown: An Historical Perspective With regard to investable buyback indexes, financials dominate both the S&P 500 buyback index (Chart 9) and the NASDAQ US buyback achievers index. However, if the Fed does not relent and sustains a tight noose around banks’ shareholder friendly activities next year, then this index composition will change significantly in the 2021 rebalancing. While financials have been weighing heavily on the S&P 500 buyback index, its equal weighting methodology also partially explains why it has trailed the market cap weighted SPX by roughly 20% year-to-date (YTD). Nevertheless, in the long-haul buyback achievers come out on top. In fact, the S&P 500 buyback index has more than doubled the SPX’s return since the turn of the century (top panel, Chart 10) and such a portfolio tilt typically manages to shake off recession-related wobbles. Chart 9S&P 500 Buyback Index Sector Composition Bottom Line: We would not write off the artificial engineering of higher EPS via equity retirement, especially in a world where ZIRP is likely for the next five-to-seven years. Already buyback announcements have troughed (bottom panel, Chart 10) and factors are falling into place for a sizable resumption of buybacks in 2021 as the economy stands back on its own feet. Chart 10Buyback Comeback? Is CRE The Next Shoe To Drop? Last December in our 2020 Key Views report, the S&P real estate sector was one of our high-conviction underweight sectors for the year. However, frenetic trading in March compelled us to close out all our high-conviction trades and cement average relative gains of 3.4% in our eight high-conviction calls including 1.1% in the high-yielding S&P real estate sector. Nevertheless, we remained bearish on the prospects of this sector levered to commercial real estate (CRE) because the aftermath of the pandemic would leave this niche sector badly bruised. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25% (Chart 11). In other words, the resilience of these mega cap tech-related REITs masks the carnage ongoing beneath the surface. Chart 11Specialized REITs Masking True Picture Charts 12 & 13 break down the YTD relative performance of the real estate sector’s sub-groups and it is clear that most REITs categories are in distress with the exception of specialized and industrial REITs. Chart 12REITs Are Weak… Chart 13…Across The Board Not only will the long-term negative ramifications due to the pandemic scar office-, apartment- and mall-exposed REITs, but also uncertainty surrounding the fiscal stimulus bill risks a fresh down-leg in the S&P real estate sector. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel, Chart 14). A fresh stimulus bill could transfer funds directly to unemployed consumers and to cash-strapped business owners and extend the eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent this help, CRE will remain distressed. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels, Chart 14). Recent news that “Cerberus repackaged near junk rated CMBS paper into a AAA rated CDO” (effectively creating a AAA security out of thin air) is eerily reminiscent of the subprime crisis in 2008 and a stark warning that CRE excesses have yet to fully flush out.1 Chart 14More Pain Looms Chart 15Deflation Warning The downdraft in demand for CRE is already showing up in declining occupancy rates (Chart 15). We fear that there are more skeletons hiding in the closet. First the “amazonification” of the economy is still wreaking havoc on retail/shopping center REITs. Second the new “work from home” reality is putting strains on office landlords. Lastly, lodging will remain in distress at least until a vaccine is readily available. As a result, REITs cash flow growth will remain elusive, which will further dampen prospects of a recovery in the relative share price ratio (Chart 15). Finally, the relentless increase in supply is not showing any signs of abating. Non-residential construction is hovering near previous highs, and multi-family housing starts are perched close to prior cyclical peaks of 400K/annum (Chart 16). Undoubtedly, this excess supply backdrop will continue to weigh on CRE prices. Chart 16Mind The Supply Overhang Chart 17Valuations Have Yet To Fully Flush Out Despite all this dour news and near all-time lows in relative performance, valuations have only corrected down to the neutral zone, leaving ample room for an undershoot phase (middle panel, Chart 17). Encouragingly, persistent recent selling has pushed our relative Technical Indicator deep in oversold territory signaling that a near-term reflex rebound may be forthcoming. Netting it all out, COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Bottom Line: Stay underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://www.bloomberg.com/news/articles/2020-10-01/cerberus-is-repackaging-near-junk-cmbs-into-top-rated-securities   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations 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

Rotation out of the tech titans is a high probability scenario given that the easy money has already been made as AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization near the peak on September 2. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out. Using a concrete rebalancing example to illustrate such a rotation is instructive.1 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift. Bottom Line: As the economy opens up, it pays to rotate out of fully priced tech titans and into the beaten down deep cyclicals.    Footnotes 1 Our example assumes benchmark allocation in all sectors for illustrative purposes.

Highlights Misunderstanding 1: The danger of Covid-19 is its short-term mortality rate. In fact, the danger of Covid-19 is its long-term mortality and morbidity rate. Misunderstanding 2: The government-imposed lockdown causes the pandemic recession. In fact, the pandemic causes the pandemic recession. Misunderstanding 3: The pandemic’s main economic casualty is output. In fact, the pandemic’s main economic casualty is employment. Misunderstanding 4: The pandemic is a temporary shock to the way we live, work, and interact. In fact, the pandemic is accelerating long-term shifts in the way we live, work, and interact. Misunderstanding 5: The pandemic is pulling Europe apart. In fact, the pandemic is pulling Europe together. Feature Chart of the WeekThe Pandemic Is Pulling Europe Together Covid-19 is a novel disease. And living through a pandemic is a novel experience for most of us. The result is that many things are not fully understood. In this report, we pull together five major misunderstandings about the Covid-19 pandemic. Or at least, five topics on which we disagree with the mainstream narratives. Misunderstanding 1: The danger of Covid-19 is its short-term mortality rate. Truth 1: The danger of Covid-19 is its long-term mortality and morbidity rate. Some people argue that the danger of Covid-19 is overstated. The mortality rate seems low, especially in the new waves of the pandemic. These people argue that we should just let the pandemic rip to achieve so-called ‘herd immunity’. Yet this focus on the low immediate mortality rate misunderstands the true danger (Chart I-2). Chart I-2Focussing On Covid-19’s Low Immediate Mortality Rate Misunderstands The Danger The true danger might come from the long-term impact on mortality and morbidity. A good analogy is a non-lethal dose of radiation. It won’t kill you straightaway, and you might not even feel any immediate ill effects, but the exposure does irreparable long-term harm. Unlike other diseases, Covid-19 appears to have long-term sequelae. Unlike other diseases, Covid-19 appears to have long-term sequelae. It can permanently damage your respiratory, vascular, and metabolic systems. As The Lancet points out:1 “Weeks and months after the onset of Covid-19, people continue to suffer. 78 of 100 patients in an observational cohort study who had recovered from Covid-19 had abnormal findings on cardiovascular MRI and 36 reported dyspnoea and unusual fatigue… these patients are not only those recovering from the severe form of the acute disease, but also those who had mild and moderate disease. Long-term sequelae of Covid-19 are unknown… Other concerns are rising: does it cause diabetes, or other metabolic disorders? Will patients develop interstitial lung disease? We owe good answers on the long-term consequences of the disease to our patients and healthcare providers.” Until we know these answers, letting the pandemic rip to achieve herd-immunity is a very dangerous misunderstanding. Misunderstanding 2: The government-imposed lockdown causes the pandemic recession. Truth 2: The pandemic causes the pandemic recession. A pandemic is a classic complex adaptive system, in which there is constant feedback from millions of individual human actions to the pandemic, and from the pandemic to millions of individual human actions. It is this complex adaptive behaviour that generates a pandemic’s classic waves of infection, as well as its recessions. In response to an escalating pandemic, our instinct for self-preservation makes us go into our shells. In response to an escalating pandemic, our instinct for self-preservation makes us go into our shells. We shun crowds and public places, with the result that so-called ‘social consumption’ collapses. The misunderstanding is that the government-imposed lockdown causes the collapse in social consumption. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is that the escalating pandemic is making millions of people go into their shells. But to the extent that an escalating pandemic also leads to an escalating lockdown, many people confuse the correlated lockdown with the underlying cause, the escalating pandemic. As we have previously pointed out, Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the government-imposed lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, based on the rise in unemployment rates, no-lockdown Sweden performed worse than lockdown Denmark (Chart I-3 and Chart I-4). Chart I-3No-Lockdown Sweden Performed No Better... Chart I-4...Than Lockdown Denmark Misunderstanding 3: The pandemic’s main economic casualty is output. Truth 3: The pandemic’s main economic casualty is employment. The widespread use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three highly labour-intensive sectors: hospitality, retail, and transport. Using the US as a template, hospitality, retail, and transport contribute 12 percent of economic output, but employ 25 percent of all workers (Table I-1). If the pandemic forces these sectors to operate one third below full capacity, the economy will lose a tolerable 4 percent of output. But it will lose a devastating 8.3 percent of jobs. And on less optimistic assumptions, the job destruction could rise to well over 10 percent. Table I-1Sectors Hurt By Social Distancing Employ 25% Of All Workers Conversely, sectors which are unaffected by physical distancing and face masks make a much bigger contribution to economic output relative to employment. Financial activities generate 19 percent of economic output, but just 6 percent of jobs. Information technology generates 5 percent of output, but just 2 percent of jobs. Sectors hurt by social distancing employ 25 percent of all workers. Hence, the main economic casualty of the pandemic is not output. The main casualty is employment (Chart I-5 and Chart I-6). Worse, as employment suffers much more than output, the pandemic is devastating low-paid jobs. Chart I-5The Main Economic Casualty Of The Pandemic Is Employment… Chart I-6…Not ##br##Output Misunderstanding 4: The pandemic is a temporary shock to the way we live, work, and interact. Truth 4: The pandemic is accelerating long-term shifts in the way we live, work, and interact. The pandemic appears to have crystallised many shifts in consumer and business behaviour: for example, de-urbanisation, the shift from offline to online retailing, the shift from office working to remote working, and the shift from business travel to virtual meetings. In fact, these shifts were already in motion well before the pandemic hit (Chart I-7 and Chart I-8). Chart I-7The Pandemic Is Accelerating The Structural Shifts To De-Urbanisation… Chart I-8…And Online ##br##Shopping If the pandemic suddenly ended tomorrow, would people flock back to full-time office work in city centres? Would they flock back to bricks and mortar retailers? Would they return to the same intensity of long-haul business travel? We think not, because the shifts from these activities are not temporary. They are structural. The pandemic is devastating low-paid jobs. The pandemic has accelerated the hollowing out of labour-intensive industries such as bricks and mortar retailing, city centre cafes, bars and restaurants, and commercial travel. Combined with the ongoing threat to jobs from AI, this hollowing out process is blighting the job prospects of a generation, creating large numbers of underemployed and unemployed workers. Misunderstanding 5: The pandemic is pulling Europe apart. Truth 5: The pandemic is pulling Europe together. Let’s end on a positive note. The pandemic has allowed Europe to smash two major taboos: explicit fiscal transfers across countries, and the large-scale issuance of common EU bonds. The EU recovery plan also starts discussions on how the EU can ‘increase its own resources’. Which is to say, raise its own taxes. 2020 might turn out to be the most important year for European integration. The EU’s €750 billion ‘Next Generation’ recovery plan comprises €390 billion of grants whose main beneficiaries will be Italy and Spain – and these grants will be funded by common EU issuance. In breaking the long-standing taboos of fiscal transfers and common issuance, Next Generation constitutes a giant step towards European integration. Specifically, Italy’s net grant entitlement is likely to outweigh its contributions to the EU’s 2021-27 budget cycle. Thereby, Italy will flip from a net contributor to a net recipient of EU funds. The willingness to flip the sign of Italy’s contribution marks a sea-change in the EU’s attitude on fiscal solidarity, whose long-term significance should not be underestimated. 2020 might turn out to be the most important year for European integration. The irony is that it took a global pandemic to achieve it. Investment Conclusions The huge and growing slack in labour markets means that zero and negative interest rate policy will become a permanent feature of our lives. Hence, the relatively higher yielding 30-year US T-bond remains an effective hedge against stock market dislocations, as it did in March. Equity sectors whose profits can thrive off the shifts in the way we live, work, and interact, will outperform – specifically, technology, biotechnology, healthcare, and communications. Thereby, stock markets with an overweighting to these sectors will also outperform. The devastation of low-paying jobs means that bank credit growth is set to remain structurally weak or even non-existent. As such, banks should be bought for tactical countertrend moves (as now), but not for the long term. The yield spreads on euro area ‘periphery’ bonds over Germany and France will continue to tighten, and ultimately reach zero (Chart of the Week and Chart I-9). Chart I-9The Pandemic Is Pulling Europe Together Fractal Trading System* Within the EM universe, the strong outperformance of India versus Czech Republic is vulnerable to a countertrend sell-off. Accordingly, this week’s recommended trade is short MSCI India versus MSCI Czech Republic. The profit target and symmetrical stop-loss is set at 8 percent. Chart I-10MSCI: India Vs. Czech Republic In other trades, long USD/PLN achieved its 4 percent profit target, and short AUD/CHF reached the end of its holding period in profit. The rolling 1-year win ratio now stands at 57 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 Please see The Lancet, Long-term consequences of Covid-19: research needs, September 1, 2020. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations