Equities

Highlights Chinese economic growth slowed in June & July, but at a more moderate pace than had been the case earlier this year. The housing market is a notable exception, which appeared in June to slow in a broad-based fashion. The near-term (0-3 month) outlook is bearish for China-related assets, and investors should bet on further weakness in the RMB. However, investors should remain cyclically bullish (i.e., over a 6-12 month time horizon) in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the intensifying drag from weak external demand. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident measures of economic activity suggest that China’s economy experienced “controlled weakness” in June and July: growth continued to slow, but at a more moderate pace than had been the case in late-2018 and early-2019. The housing market appeared to be the exception to this relative stability; all 10 of the core housing indicators that we track decelerated in June, suggesting that a moderation in housing-related activity was broad-based. This implies that a further slowdown in construction is likely over the coming months, barring a meaningful pickup in sales. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, all of the key developments have occurred over the past several trading days, in response to President Trump’s threat last week to further hike U.S. import tariffs at the beginning of September. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark, as have Hong Kong stocks in response to intensifying protests in the city. A sharp decline in the RMB and the U.S. designation of China as a currency manipulator have unnerved Chinese and global investors, and our bias is to expect even further weakness in the yuan. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Otherwise stated, we expect Chinese relative performance to trend lower in the near-term, but to be higher 12-months from today. Investors should also continue to hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks with a long USD-CNH position. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Our leading indicator for the Li Keqiang Index is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth. Chart 1Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Chart 2Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator The Li Keqiang index (LKI) rose moderately in June after a significant decline in May, but remains in a downtrend (Chart 1). The June increase was driven entirely by a pickup in electricity production (which had nearly contracted in May); bank loan growth and rail cargo volume both decelerated. The takeaway for investors is that while the Chinese economy did not slow meaningfully further in June, the pace of growth remained tepid, suggesting the economic activity remains vulnerable to a further increase in U.S. import tariffs. Our leading indicator for the LKI is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth (Chart 2). However, the magnitude of the rise in the indicator is being held back by growth in the money supply, which has only slightly accelerated over the past few months, as well as a “half strength” recovery in credit. Our view is that Chinese policymakers are likely to wait for further economic weakness before allowing money & credit growth to significantly overshoot, which increases the odds of a continued market riot in the short-term. Chart 3Decelerating House Price Appreciation Is Coming All 10 of the housing indicators shown in Table 1 decelerated in June, suggesting that a moderation in housing-related activity was broad-based. Our BCA 70-city diffusion index for (YoY) house prices has an excellent track record at leading inflection points in overall price growth (Chart 3), and is currently suggesting that house price appreciation is at risk of falling back to mid-2018 levels (which would imply a 5-6 percentage point deceleration). Continued weakness in floor space sold continues to suggest that the ongoing pace of housing construction is unsustainable; we expect a further moderation in floor space started over the coming several months barring a meaningful pickup in sales. Both the Caixin and official manufacturing PMI for China rose in July, including the official new export orders component (which we have been closely following). However, the survey was taken prior to President Trump’s renewed tariff threat last week, and we expect the July gains to reverse in August barring a major de-escalation in the conflict. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark over the past week due to President Trump’s threat to impose tariffs on all remaining imports from China. We noted in our May 29 weekly report that a financial market riot point remained likely over the coming few months,1 and we explicitly recommend an underweight position in Chinese stocks for the remainder of 2019 in last week’s report.2 Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Investors who are already positioned in favor of Chinese stocks should stay long, despite the likelihood of further near-term losses. ​​​​​​​Investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Chart 4Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance The MSCI Hong Kong index has also significantly underperformed the global benchmark since late-July, in response to intensifying protests in the city (Chart 4). The protests have been driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. However, Hong Kong has no real alternative to Beijing’s sovereignty, and the unrest should gradually die down as long as the imposition of martial law is avoided. Nonetheless, Hong Kong’s stock market is likely to remain under pressure in the interim; for now, we recommend that investors stay underweight versus China and Taiwan.​​​​​​​ The sector performance within China’s investable and domestically-listed equity markets over the past month has largely been along cyclical / defensive lines. In the investable market, consumer staples, health care, financials, information technology, communication services, and utilities have all outperformed, in contrast to energy, materials, industrials, consumer discretionary, and real estate stocks. The pattern has been similar in the domestic market, with two exceptions: modest staples underperformance, and material underperformance of comm services. Real estate stocks have been among the worst performers in both markets over the past month, possibly in response to the deteriorating housing market data that we highlighted above. China’s 3-month repo rate has fallen approximately 20 bps over the past month, and is now back close to its one-year low. We continue to believe that a cut to the benchmark lending rate is unlikely in the near-term, but could occur in Q4 if economic conditions in China weaken materially further.​​​​​​​ Chinese onshore corporate spreads increased modestly over the past month, but have not yet risen to a new high for the year. The uptrend in spreads that began in late-May does reflect renewed risks to the Chinese economy from a further increase in U.S. import tariffs, but annualizing the most recent pace of onshore corporate defaults suggests that onshore bond spreads are still much too high. Our long China onshore corporate bond trade continues to register gains in local currency terms (Chart 5), and we recommend that investors stick with a long/overweight currency-hedged stance. ​​​​​​​Our bias is to bet on further RMB weakness until policymakers aggressively ramp up their reflationary efforts. The yuan weakened sharply this week, with the U.S. dollar breaking above 7 versus both the onshore and offshore RMB (Chart 6). This is the weakest level for the currency since the global financial crisis, and the decline has clearly occurred in response to last week’s tariff threat. We noted in our May 15 report that a meaningful decline in the exchange rate would likely be required in order to stabilize the outlook for earnings & the economy,3 and we recommended at that time that investors should hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. It is difficult to forecast how much further the RMB is likely to fall, but our bias is to bet on further weakness until policymakers aggressively ramp up their reflationary efforts. Stay tuned. Chart 5Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Chart 6Weakest RMB In A Decade, And Further Declines Are Likely   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com 1      Please see China Investment Strategy Weekly Report, “Waiting For The Pain,” dated May 29, 2019. 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?” dated July 24, 2019. 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019.   Cyclical Investment Stance Equity Sector Recommendations

Feature The global manufacturing cycle looks dire at the moment. Around the world, manufacturing PMIs have fallen, profit growth has slowed, and capex has been reined back (Chart 1). This is clearly a risky moment for the economic expansion (and the equity bull market) which began in 2009. We hear that many clients are having vigorous debates on their investment committees about what to do – and indeed, at BCA, the views of our strategists are unusually divided.1 Recommendations Chart 1Heading Downhill Fast       Global Asset Allocation veers towards the optimistic camp. In brief, we expect the services and consumer sectors of major economies to remain robust, and that manufacturing will bottom out in the coming months, partly as a result of easier financial conditions, including the dovish turn by central banks and monetary stimulus in China. But we recognize the risks currently and have constructed our portfolio accordingly. We remain overweight equities versus bonds, but leaven that with an overweight on the most defensive equity market, the U.S. The global economy is a wonderful self-organizing system. The disparity between manufacturing and services is stark everywhere. Both the soft data, such as PMIs (Chart 2), and hard data, such as industrial production and retail sales (Chart 3), show that manufacturing almost everywhere is in recession (the U.S. is not yet, but is perhaps headed that way), but that services growth remains robust. Services have been held up by decent wage growth (even in the manufacturing-heavy eurozone) and generally easier fiscal policy (in the eurozone and China, in particular), which have allowed consumers to continue spending. (In the U.S., the risk of tighter fiscal policy next year has been alleviated by last month’s budget agreement which will produce a small positive fiscal thrust in 2020 – see Chart 4.) Chart 2Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data   Chart 5China Is The Root Cause   The manufacturing recession was clearly triggered by China – it is notable, for instance, that large exporting countries have seen no slowdown in sales to the U.S. but a big drop in those to China (Chart 5). In 2017-18, China slowed as a result of its tighter monetary policy and clamp-down on shadow banking. The countries that have been most affected by the slowdown over the past 18 months are, unsurprisingly then, those which have the largest manufacturing sectors, notably Korea, Germany and Japan (Chart 6). But the global economy is a wonderful self-organizing system. Historically, intra-expansion industrial cycles have typically lasted around 18 months from peak to trough, and 18 months from trough to peak (Chart 7). Lower commodity prices, easier financial conditions, and pent-up demand mean that, after a period of slowdown, demand and risk appetite build up. This self-equilibrating cycle breaks only if there is a major structural imbalance, usually excess debt or rising inflation. As we have argued previously, we do not see clear signs currently that either of these usual structural triggers of recession is present (Chart 8). Chart 7Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased The Fed cut rates on July 31 as a risk management measure, “a mid-cycle adjustment to policy,” as Chair Powell put it in his post-FOMC press conference. With the stock market close to a record high and unemployment at a 50-year low, there is no obvious need for the Fed to implement a full-out easing campaign. But with inflation well below its 2% target, and a risk that the manufacturing slowdown could spill over into consumption (perhaps if companies start to lay off workers – something there is little sign of yet), an “insurance” cut seemed prudent. Financial conditions have eased significantly in the U.S. this year, and somewhat in Europe (Chart 9), and this should soon start to positively affect growth. China’s stimulus remains key. So far it has been half-hearted (Chart 10). This is because Chinese growth has to a degree stabilized, trade negotiations with the U.S. continue, and because the authorities have not abandoned their wish to delever the economy – it is notable that shadow-bank credit creation has not rebounded (Chart 11). Both fiscal and monetary stimulus will need to be ramped up in the second half if we are to see a repeat of 2016’s China-driven risk rally. Investors should see this as a put option – if Chinese growth slows again, and the trade talks break down (both of which are likely), the authorities will roll out a stimulus on the scale of their previous efforts. Chart 10China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? What is the biggest risk to our sanguine view? With global stocks up 16% and U.S. stocks 20% year-to-date, the bottoming-out of the manufacturing cycle and greater monetary easing may already be priced in. Chart 12 shows that year-on-year stock market moves typically follow the manufacturing PMIs closely. Even if stock prices remain only at their current level to year-end, they are already discounting a sharp bounce in the PMIs. Fixed Income: If we are right about the macro environment, U.S. Treasury bond yields should rise from their current 2%. Yields usually move in line with consensus GDP forecasts (Chart 13). Economists have cut their 2020 forecast to only 1.8% (from 2.5% for this year). If the 2020 number is revised up, as we expect, Treasury yields have some room to move back up. Moreover, the Fed is unlikely to cut rates twice more by year-end as the futures market implies. Therefore, we stay underweight duration. We have a neutral stance on credit, but this asset class should produce reasonable excess returns over coming quarters given current spreads (Chart 14). U.S. high yield (especially B and below) and eurozone investment grade bonds (which the ECB may start buying again) look attractive. Chart 13Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Equities: Given the uncertainties over the timing and strength of Chinese stimulus, we remain cautious on Emerging Markets and euro area stocks, the most obvious beneficiaries of this. Both regions have structural headwinds (excess foreign-currency debt in the case of EM, the fragile banking system and flattening yield curve for Europe) which mean that, even when Chinese stimulus comes, their outperformance may prove short-lived. For now, we prefer U.S. equities, although we recognize that upside for this year is limited. The key will be whether earnings can surprise analysts’ (over cautious) forecast of only 3% EPS growth in 2019. This seems likely since the Q2 earnings season, with almost half of companies having reported, is coming in at close to 80% beats on the bottom line. To hedge against the upside risk of Chinese stimulus, we continue to recommend building a position in Australian equities and in the Industrials sector. China’s stimulus remains key, but so far it has been half-hearted. Currencies: The U.S. dollar is a counter-cyclical currency and should start to depreciate once signs of a manufacturing recovery become apparent. Moreover, the Fed’s dovish move – and the fact that it has significantly more room to ease than other large DM central banks – should also prove to be dollar bearish eventually (Chart 15). One key cross to watch for signs that the global cycle is bottoming is AUD/JPY, since the Australian dollar is a very cyclical, and the Japanese yen a very defensive, currency (Chart 16). Chart 15Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Commodities: We continue to have a bullish outlook for oil. Although developed-world demand growth has slowed slightly this year, OPEC supply constraints mean that inventories should draw down further (Chart 17). We expect Brent crude to average $74 a barrel in 2H2019 (from $65 today). Gold has performed well this year, up 11%. Our colleagues in BCA’s Foreign Exchange Strategy and Commodity & Energy Strategy services conclude that this has largely been because of monetary and financial factors, mostly lower real rates (Chart 18).2 In the coming months, while rates may rise, gold should be helped by a weaker USD. We are neutral on the metal and see it more as an insurance asset. Our FX and Commodity strategists concur with GAA’s long-standing view that gold is a useful portfolio diversification tool to protect against financial, geopolitical, and inflation risks. Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see BCA’s Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open,” dated 19 July 2019, available at www.bcaresearch.com. 2      Please see Commodity & Energy Strategy Special Report, “All That Glitters…And Then Some,” dated 25 July 2019, available at ces.bcaresearch.com.   GAA Asset Allocation  

Feature GAA DM Equity Country Allocation Model Update Chart 1GAA DM Model Vs. MSCI World The GAA DM Equity Country Allocation model is updated as of July 31, 2019.  The quant model reversed its abnormal upgrade of Sweden in the previous model update. In hindsight, the model’s behavior when a bond yield moves close to zero needs to be watched closely. Currently, the model still favors Spain, Italy, Germany, Netherland and Australia at the expenses of U.S., Japan, U.K., France and Canada, as shown in Table 1.  As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed the MSCI World benchmark by 94 bps in July, largely driven by 146 bps of underperformance from the Level 2 model, and 26 bps of underperformance from the Level 1. Directionally, 7 out of the 12 choices generated positive alpha. However, the overweight in Sweden and Spain generated outsized underperformance. Since going live, the overall model has outperformed by 94 bps, with 297 bps of outperformance by the Level 2 model, offset by 42 bps of underperformance from the Level 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of July 31, 2019. Chart 4Overall Model Performance The model’s tilts between cyclicals and defensives have changed compared to last month. Following the Fed’s decision to cut interest rates yesterday, the liquidity component shifted its inputs to phase 4 – a period in which the central bank is cutting rates, while simulative monetary conditions persist. Although this should favor most cyclical sectors, the lack of evidence of global growth bottoming is tilting the model to favor a mixed bag of sectors. The valuation component continues to remain muted across all sectors. The model is now overweight 4 sectors in total, 2 cyclical and 2 defensive sectors. These are Consumer Discretionary, Information Technology, Consumer Staples, and Healthcare. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes

Special Report

Highlights A decade after the financial crisis, yield remains scarce: The global count of bonds trading at negative yields seems to grow every week, squeezing a broad swath of investors who are desperate for coupon income. Increasingly accommodative monetary policy is not on income investors’ side, … : Dovish pivots from the Fed and the ECB ensure that low-to-negative yields won’t go away soon. … but it is quite friendly for maturity transformation strategies in the near term: Borrowing short to lend long is far from a fail-safe strategy, but it should dovetail nicely with reflationary Fed policy for at least the rest of the year. The time is ripe for returning to the agency mortgage REITs: Among public securities, agency mortgage REITs offer the most direct exposure to maturity transformation. Feature Economic data and corporate earnings releases remain mixed enough to provide both bulls and bears with ample support for their leanings. The debate within BCA remains spirited, and is emblematic of the debate among investors. Per the financial media, it seems as if the scolds are getting the most attention,1 even as the S&P 500 keeps setting new highs. One thing that both camps agree on, however, is that nothing is cheap. Equities are not terribly expensive, but bonds appear to have little chance of matching their historical return profile. Investors seeking income, from individuals and advisors, to pension funds, life insurers and endowments needing to meet a fixed schedule of liabilities, are under siege a decade into ZIRP and NIRP. With rate cuts on the horizon in the U.S., and the ECB preparing to ramp up accommodation, the pressure on income-seeking investors to throw caution to the wind and ignore credit quality shows no sign of abating. Maturity transformation – borrowing short to lend long – fits the Fed’s reflationary goals like a glove, and offers an alternative to abandoning credit standards. Contrary to popular belief, banks no longer pursue maturity transformation. Chastened by the savings-and-loans’ demise in the ‘80s, they make heavy use of swaps to keep a tight rein on asset-liability mismatches. Maturity transformation is agency mortgage REITs’ raison d’être, however, and aside from some hedging to ensure survival in the face of adverse interest-rate moves, they actively embrace it. The Agency mREIT Formula Mortgage REITs (“mREITs”) finance real estate investment, either by lending directly to property owners or by purchasing mortgages and/or mortgage-backed securities (“MBS”). Agency mREITs invest solely or predominantly in instruments issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. MBS issued by these entities are explicitly backed by the full faith and credit of the United States and bear little to no credit risk. The agency mortgage REITs stumbled ahead of all four of the yield curve inversions they’ve experienced, and six years of flattening has ground down their share prices. Despite the negligible credit risk in their investment portfolios, agency mREITs themselves are far from riskless – leveraged carry trading strategies are not for the faint of heart – but they have performed much better than non-agency mREITs, some of which go bust in every cycle. The agency mREITs are a much purer play on the term structure of rates than their non-agency peers. Their borrow-short-to-lend-long model is intentionally designed to exploit the yield curve’s typical upward slope. Though they stumble ahead of inversions (Chart 1), they are an attractive portfolio component when the fed funds rate outlook is benign and the curve is poised to steepen. Chart 1The Steeper The Better Banks are happy to lend against pristine collateral for short timeframes, allowing agency mREITs to build RMBS portfolios 10 times the size of their equity capital. Figure 1 illustrates the mechanics of building an agency mREIT portfolio. A new mREIT first raises equity in a public offering and uses the proceeds to purchase a portfolio of agency-backed residential MBS (“agency RMBS”). It then uses the portfolio as collateral for a secured repurchase (“repo”) loan, typically with a 30-, 60- or 90-day term, the proceeds of which it recycles into more agency RMBS.  With banks and brokers lending 95 cents on the dollar against agency collateral, an agency mREIT can easily amass asset portfolios several times the value of its equity capital. As long as portfolio income exceeds the sum of repo interest and operating expenses, it will be profitable. Table 1 lists all of the constituents of our Agency Mortgage REIT Index since its 1998 inception, along with the current constituents’ price-to-book multiples, dividend yields, betas versus the S&P 500 and leverage ratios. As a group, the agency mREITs have high dividend yields, low equity betas and considerable leverage. Table 1Agency Mortgage REIT Index Constituents Low beta and high leverage could be a nice mix when the economy is mushy and the Fed and other major central banks are ramping up accommodation. Then And Now The last time we recommended the agency mREITs (June 2011 through September 2012), they handily outperformed the S&P 500 and the Bloomberg Barclays High Yield Index on a total return basis (Chart 2). Uninspiring growth and easy monetary policy proved to be a potent mix for agency mREIT outperformance. The backdrop looks similar to us now, and we expect that the agency mREITs will outdistance high-yield corporate bonds over the rest of the year. They may be hard-pressed to top the S&P 500 under more constructive economic and market scenarios, but they should help protect other equity exposures in the event that economic growth and equities slump. Chart 2The Agency Mortgage REITs Boosted Our Returns In 2011-12, ... The Incredible Shrinking Stock Price Agency mREITs trade on their price-to-book multiples, but REIT rules leave the companies with little chance to grow book value. REITs have to distribute 90% of their annual income to shareholders to maintain their tax-preferred status, and they pay no income tax at the corporate level if they distribute all of it. The upshot is that mREITs have no retained earnings, which stymies them from growing book value.   In exchange for optimal tax efficiency, REITs give up the potential to compound their way to growth. Chart 3...But They've Run Into Headwinds Since Price-to-book multiples swung wildly in the group’s first decade, but have settled into a tight post-crisis range (Chart 3). If book value can’t grow, and multiples are capped around 1, stock price appreciation is unlikely to contribute to total returns. History suggests that investors should actually expect some modest drag from capital losses; all but one of the stocks in our Agency mREIT Index have declined since their inclusion2 (Chart 4). The drag follows from the constraints of the REIT rules; companies that can’t retain earnings and have already reached their borrowing capacity can only grow by issuing stock, but companies only receive about 95% of the proceeds from offerings after underwriting fees.3 The practical takeaway is that the agency mREITs are not a through-the-cycle play, and investors should only add them to their portfolios when they are comfortable that price declines are not likely to undermine dividend distributions. Honey, I Shrunk The Share Price. Agency mREIT Vulnerabilities The agency mREIT model has three inherent vulnerabilities: it relies on maturity transformation, it employs copious amounts of leverage, and it has convexity working against it. None is likely to prove fatal for entities that are reasonably prudent about hedging rate exposures, limiting leverage, and guarding against prepayments, but double-digit annual returns are not pre-ordained. Each management team makes its own hedging choices, but all agency mREITs maintain considerable duration mismatches. Unexpected changes in the term structure of rates have the potential to upend shareholder returns. Chart 5Repo Funding Is Reliable Our index constituents have a considerable amount of leverage. With 5-cent haircuts on agency repo financing, mREITs can theoretically build an agency MBS portfolio equivalent to 20 times the value of its equity capital. Maximal leverage would leave very little room to maneuver under duress, but leverage around ten times has not historically posed a problem. Given that agency MBS is gilt-edged collateral, we expect that the agency mREITs will be able to roll over their repo financings in a stress scenario, just as they were able to amidst the crisis (Chart 5). Interest rate volatility is also a headwind, independent of the level of rates. Under standard U.S. mortgage terms, MBS investors implicitly grant options to borrowers by allowing them the unlimited right to prepay their obligations without penalty (see Box). Options increase in value as the volatility of their underlying reference asset increases, so MBS values move inversely with changes in interest rate volatility. The good news for the mREITs is that increasingly accommodative Fed and ECB policy should act to tamp down rate volatility in the near term. The agency mREIT model proved its resiliency at the height of the crisis. Even in times of peak stress, it’s possible to borrow against the best collateral.   Box An Equity Investor’s Guide To Negative Convexity Even for fixed income lifers, mortgages can be a dauntingly complex product, largely because of borrowers’ ability to prepay their loans, without penalty, at any time.  This prepayment option gives mortgages and MBS what fixed income professionals call “negative convexity.” Long-duration, non-callable bonds are said to be positively convex.  That is, their value increases at an increasing rate as interest rates fall and decreases at a decreasing rate as interest rates rise.  Mortgage borrowers’ prepayment option prevents mortgage lenders from enjoying the full effect of convexity because the more the present value of a mortgage’s future payment stream rises as rates fall, the less likely lenders will realize it as savvy borrowers refinance into one offering a lower interest rate. This effect is called negative convexity and it is why mortgage investors must be compensated with higher yields.  Fannie, Freddie and Ginnie securities therefore yield more than Treasuries, even though both are backed by the full faith and credit of the U.S. Treasury.   With the exception of 2018’s backup, mortgage rates are where they’ve been since late 2014. There may not be many more loans worth refinancing. An unexpected rash of refinancings (“refis”) would squeeze agency mREIT income via mark-to-market losses and unwelcome exposure to reinvestment risk. More borrowers refi when rates decline, squeezing earnings, and cutting into, or even potentially wiping out, the benefit of lower funding costs. Although refi application activity has not always exhibited a tight correlation with agency mREIT returns, refis are a threat to agency mREIT earnings. Although we expect rates to remain in a fairly narrow range consistent with mushy growth and quiescent inflation expectations, it is our sense that they have bottomed and that refi activity, in turn, has already peaked (Chart 6). Chart 6Prepayments May Be Ready To Taper Off   Why Now? An equally-weighted basket of agency mREITs has outperformed both the S&P 500 and the Bloomberg Barclays High Yield Corporate Bond Index by two-and-a-half percentage points (“ppt”) on an annualized total return basis over its 21-plus-year history (Chart 7). They do not always outperform, however, and since we closed our position at the beginning of October 2012, the agency mREITs have lagged large-cap equities and high-yield bonds by ten-and-a-half and three ppt, respectively, on an annualized total return basis. Chart 7The Agency REITs Have Had A Strong Career, But The Last Seven Years Have Been Rough Rising rates and curve-flattening normally spell the end of agency mREIT outperformance, but we feared in the fall of 2012 that the Fed was killing the group with kindness. Ultra-accommodative policy encouraged refis while the Fed itself was actively bidding up agency MBS prices with QE3. Refis impaired the value of the legacy portfolios because they triggered losses on positions that had been marked-to-market above par. Higher prices helped the legacy portfolio holdings but forced the mREITs – in the midst of an epic three-year run of capital raising via secondary equity offerings – to put new capital to work at the top of the market. The policy backdrop appears more conducive to relative agency mREIT outperformance now. Faced with sluggish global growth and stubbornly low inflation expectations, the Fed is poised to cut rates for the first time since 2008. We expect the Fed will deliver a 25-basis-point cut at the conclusion of tomorrow’s FOMC meeting, and another one in September, and then refrain from hiking again until at least the first quarter. Nothing outperforms forever. The agency mREITs make a much better cyclical investment than a structural investment. Reflationary monetary policy should produce a steeper curve as growth and inflation expectations revive (Chart 8). A steeper curve will boost agency mREITs’ earnings by widening their net interest margins, allowing for increased dividend payments and fatter total returns. Given that we expect curve steepening, we do not worry that rate cuts will spark a wave of prepayments. As Chart 6 showed, 2018-vintage mortgages would seem to be the only ones issued over the last five years that are worth refinancing. Chart 8Rate Cuts Typically Promote A Steeper Curve Investment Implications Reflationary policy is a good backdrop for agency mREIT performance because it’s likely to promote a steeper curve. A steeper curve is manna from heaven for maturity transformation strategies, and it would boost mREIT income while reducing the potential for the capital losses that eat away at double-digit dividend yields. We are not counting on capital gains, but if peak inversion is behind us, the group’s multiple has a chance to expand. The bottom line is that several factors may have come together to bring the curtain down on the agency mREITs’ extended underperformance. We recommend that investors stick to the constituents in our index basket if they choose to add agency mREIT exposure to their portfolios. The leading mREIT ETFs, REM and MORT, provide one-stop access to the mREIT universe, but they come with considerable non-agency and commercial exposure. We are constructive on credit performance, but we think the best opportunities reside in the pure-play maturity transformation offered by the agency mREITs. We recommend funding agency mREIT exposure in balanced portfolios by diverting allocations from equities and high-yield positions. We plan on holding the mREITs for six months for now, but we’re open to staying with them longer. We expect that agency mREITs will boost risk-adjusted returns at least until the Fed first hikes again, and possibly even longer if inflation expectations revive. We therefore intend to maintain agency mREIT exposure through the end of the year, and are open to holding onto it for longer if conditions remain supportive. Our initial six-month recommendation in June 2011 remained in place for sixteen months, and we’d be pleased if this one had similar staying power.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com     Footnotes 1      De Aenlle, Conrad, “Is It Time to Fight the Fed?” New York Times, July 14, 2019, p. BU13. The experts quoted in the lead article in the Times’ latest quarterly mutual fund and ETF section were uniformly bearish on U.S. equities, in keeping with the author’s “iffy-to-awful” characterization of the economic backdrop. 2      Dynex (DX) is only included in our index from the beginning of 2001, when it switched to a pure agency strategy after nearly capsizing. Since its 1988 IPO, DX’s stock price has shrunk at an annualized rate of 3.9%. 3      The built-in drag from issuance is exacerbated by the lamentably common industry practice of issuing stock at a discount to book value, which dilutes incumbent shareholders’ investments.

While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (see chart). Bottom Line: On a cyclical 3-12 month time horizon we remain cautious on the broad equity market.

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Chart 5...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Recently BCA editors hotly debated the interplay between the ISM manufacturing and ISM services surveys and the implications for the economy and most importantly for the equity market. While the ISM manufacturing is at best coincident with SPX momentum, the difference between ISM manufacturing and ISM services appears to have leading properties with regard to the stock market especially since the onset of the GFC. Manufacturing leads services as the former is the most cyclical and hyper sensitive part of the U.S. economy despite the 10% weight in GDP most developed markets’ manufacturing bases have. Such cyclicality is most evident in the relative survey results. In other words when manufacturing trails services, stocks suffer and vice versa (see chart). Recently the gulf between the surveys has been widening warning that equities will soon run out of steam. Bottom Line: Resist the temptation to add risk to your portfolio by chasing this market.  A cautious broad market cyclical (3-12 month horizon) stance is still warranted.