Global

Special Report

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 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 Chart 1Share Of Jobs That Can Be Done At Home, By Country 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 Chart 3Many Employees Expect To Continue Working Remotely After The Pandemic Ends 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… 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 Chart 6In April, Online Sales Soared…   Chart 7…Especially In Certain Categories 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 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 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 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? 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 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 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 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   Chart 16Manufacturing Output Outside The Computer Sector Has Lagged Chart 17The US Has Relatively Few Robots 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… Chart 19…But Drug Production Is Mostly Done Overseas 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... Chart 21...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 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… Chart 24…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 Chart 26Number Of Countries Experiencing Serious Outbreak Of Infectious Disease   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 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 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 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 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 Chart 32The US Has Far Too Much Retail Space 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 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 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 Chart 4Any 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 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 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 Chart 8Autocatalysts Dominate Palladium Demand 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 Chart 10 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 Commodity Prices and Plays Reference Table Trades Closed In Summary of Trades Closed In

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Table 2Global Spread Products In Our Analysis An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Dear Client, There will be no Weekly Report on August 10, as the US Equity Strategy team will be on vacation for the week. Our regular publication schedule will resume on Monday August 17, 2020 with a Special Report by my colleague Chester Ntonifor, BCA’s Chief FX Strategist on the interplay of the style bias and the US Dollar. We trust that you will find this Report both informative and insightful. Kind Regards, Anastasios Feature Before getting to our analysis on why cyclicals will best defensives, we want to address our definition of cyclicals and defensives, where we think tech stands and why, discuss what our current positioning is and what time horizon we are targeting for this portfolio bent. Cyclicals And Defensives Definition Table 1 is a stripped down version of our current recommendations table and shows that our cyclicals definition is one of deep cyclicals including industrials, materials, energy and the information technology sector. Utilities, consumer staples, health care and telecom services (which is currently categorized as a GICS2) comprise our defensives universe. Table 1US Equity Strategy's Cyclicals Vs. Defensives Current Recommendations Tech Is Still Cyclical Importantly, we still consider the tech sector a deep cyclical and not a safe haven sector. While the COVID-19 fallout has acted as an accelerant especially to a faster absorption of goods and services of the tech titans, that is not a de facto change in the behavior of these still cyclical stocks.  As a reminder tech stocks have 60% export exposure or 20 percentage points higher than the broad market. The implication is that US tech trends should follow the ebbs and flows of the global economy. Contrary to popular belief that technology equities behaved defensively recently, empirical evidence gives credence to our hypothesis that technology stocks remain cyclical: from the Feb 19 SPX peak until the March trough the IT sector underperformed all four defensive sectors (Chart of the Week). In marked contrast, tech has left in the dust defensive sectors since the March bottom, cementing its cyclical status. Chart of the WeekTech Remains A Cyclical Sector Current Positioning With regard to our broader technology positioning, we are currently neutral the S&P tech sector, overweight the S&P internet retail index (which Amazon dominates) that sits under the S&P consumer discretionary sector and underweight the S&P interactive media & services index (which includes Alphabet and Facebook) that falls under the newly formed S&P communications services sector. Thus, our broadly defined tech sector exposure remains neutral. Meanwhile, last week we boosted the S&P materials sector to overweight and that move pushed our cyclicals/defensives bent marginally to preferring deep cyclicals to defensives (please see market cap weights in Table 1). Timing Is Key This portfolio bent may run into some near-term trouble as we expect a flare up of (geo)political risks (please see here and here), but once the election uncertainty lifts, hopefully in late-November/early-December, from that point onward and on a 9-12 month time horizon cyclicals should really start to flex their muscles versus defensives.  The purpose of this Special Report is to identify the top ten drivers of the looming cyclicals versus defensives outperformance phase on a cyclical time horizon. What follows is one page one chart per key reason, in no particular order of importance. 1.)    Dollar The Reflator Time and again we have highlighted the boost that internationally exposed sectors get from a weakening greenback. Cyclicals are the primary beneficiaries of such a backdrop as a lot of these deep cyclical companies garner over 50% of their sales from abroad. We recently updated in a Special Report the breakdown of GICS1 sectors’ foreign sourced revenues and more importantly their performance during US dollar bear markets. Cyclicals clearly have the upper hand. Chart 1 shows this tight inverse correlation, irrespective of what USD index we use. Finally, looking ahead a falling greenback will act as a relative profit reflator (US dollar shown inverted, bottom panel, Chart 1), especially given that most of the defensive sectors are landlocked in the US and do not get a P&L fillip from positive translation gains. Chart 1CHART 1 2.)    Global Growth Recovery Not only does the debasing of the US dollar bode well for Income Statement (I/S) relative translation gains, but also serves as a tonic to global growth. In other words, a final demand recovery is in the works on the back of a pending virtuous cycle: a depreciating dollar lifts global growth, and an increase in trade brings more US dollars in circulation further weakening the greenback (top panel, Chart 2). Our Global Trade Activity Indicator also corroborates the USD message and underscores a global growth recovery into 2021 (second panel, Chart 2). Tack on the meteoric rise in the G10 economic surprise index (third panel, Chart 2) and factors are falling into place for a synchronized global economic recovery including a V-shaped US rebound from the depths of the recession in Q2 (ISM manufacturing survey shown advanced, bottom panel, Chart 2). Chart 2CHART 2 3.)    US Capex To The Rescue The latest GDP report made for grim reading. US capex collapsed 27% last quarter in line with the fall it suffered in Q1/2009. Not even bulletproof software investment escaped unscathed and contracted for the first time in seven years, albeit modestly. However, if the looming recovery resembles the GFC episode when real non-residential investment soared 40 percentage points from that nadir in the subsequent five quarters, then a slingshot rebound will ensue by the end of 2021. Importantly, our US capex indicator has an excellent track record in leading the relative share price ratio and confirms that a capex trough is already in store, tracing out the bottom hit during the Great Recession (top panel, Chart 3). Regional Fed surveys also signal that a capex boom looms in the coming quarters (middle panel, Chart 3). And, so do cheery CEOs that expect a sizable investment recovery in the next six months, according to the Conference Board survey (bottom panel, Chart 3). All of this is a harbinger of a cyclicals outperformance phase at the expense of defensives. Chart 3CHART 3 4.)   Chinese Capex On The Upswing (Fiscal Easing) Across the pacific, Chinese excavator sales have gone vertical. While we take Chinese data with a grain of salt, Komatsu hydraulic excavator demand growth in China has averaged 45% on a year-over-year basis in the quarter ending in June. This Japanese company’s data, which has been unaffected by the US/Sino trade war, corroborates the Chinese official statistics (top panel, Chart 4). Infrastructure spending is also on the rise in China following an abrupt halt in projects started early in 2020. This revving of the investment spending engine is bullish for the broad commodity complex including US cyclicals (bottom panel, Chart 4). Chart 4CHART 4 5.) Chinese Monetary Easing None of the above investment recovery would have been possible had the Chinese authorities not opened up the liquidity spigots. Monetary easing via the sinking reserve-requirement-ratio (RRR) has been instrumental in engineering an economic rebound (RRR shown inverted, third panel, Chart 5). The credit-easing channel has been also important in funneling cash toward investment, and the climbing Li Keqiang index is evidence that sloshing liquidity is being put to good use (bottom & second panels, Chart 5). Finally, Chinese loan demand data also confirms that an economic recovery is in the offing and heralds a US cyclicals versus defensives portfolio tilt (top panel, Chart 5).  Chart 5CHART 5 6.)   Firming Financial Market Data (Chinese And EM Equity Market Outperformance) Typically, financial market data are early in sniffing out a turn in economic data. This anticipatory nature of financial markets is currently signaling that EM in general and Chinese economic growth in particular will make a significant comeback in the coming quarters. Importantly, Chinese bourses and the MSCI EM equity index (in USD) have recently started to outperform the ACWI and the SPX (Chart 6). Both of these equity markets are more cyclically exposed than the defensive US and global indexes because of the respective sector composition and have paved the way for a sustainable rise in the US cyclicals/defensives share price ratio (Chart 6).   Chart 6CHART 6 7.)    Transition From Deflation To Inflation Similarly to the EM and Chinese equity market outperformance of their DM peers, commodity prices are putting in a bottom and forecasting a brighter global trade backdrop for the rest of the year (top panel, Chart 7). The depreciating US dollar is also underpinning the commodity complex and this should serve as a catalyst for an exit from the recent global disinflationary backdrop, especially corporate wholesale price deflation. Domestically, the prices paid subcomponent of the ISM manufacturing survey is firming and projecting that relative pricing power will favor cyclicals versus defensives (bottom panel, Chart 7). Chart 7CHART 7 8.)   Profit Expectations Have Turned The Corner Sell-side extreme pessimism has given way to mild optimism as depicted by the now positive relative Net Earnings Revisions (NER) ratio (third panel, Chart 8).  Importantly, despite the spike in the relative NER ratio, the bar has not risen enough both on a relative profit growth and revenue growth basis in order to short circuit the recovery in the relative share price ratio (second & bottom panels, Chart 8).  Chart 8CHART 8 9.)   Alluring Valuations The relative Valuation Indicator remains below the neutral zone offering a cushion to investors that are contending to execute a cyclicals versus defensives portfolio bent (Chart 9).   Chart 9CHART 9 10.) Enticing Technicals Lastly, cyclicals are still unloved compared with defensives as our relative Technical Indicator (TI) highlights in Chart 10.  In fact, our relative TI also hovers below the neutral zone, near a level that has marked previous playable recovery rallies (bottom panel, Chart 10). Chart 10CHART 10     But Monitor Three Key Risks Over the coming 12 to 18 months, investors should prepare their portfolios for an outperformance phase of cyclical sectors relative to defensives. Nonetheless, we are closely monitoring a number of key risks that can put our view offside. First, the relentless rise of ex-Vice President Biden in the polls on PREDICTIT, the rapidly increasing probability of a “Blue Sweep” in the upcoming elections, and the non-negligible risk of a contested election (as discussed in a joined Special Report with our sister Geopolitical Strategy service last week), all pose a short-term threat to the benign election backdrop priced into stocks. Were a risk-off phase to materialize in the next three months, as we expect, then cyclicals would take the back seat versus defensives, at least temporarily (bottom panel, Chart 11). Second, what worries us most is that Dr. Copper and crude oil (another global growth barometer), especially compared with gold, have yet to confirm the global growth recovery. In other words, the fleeting oil-to-gold and copper-to-gold ratios underscore that the liquidity-to-growth handoff has gone on hiatus. While we are not ready to throw in the towel yet, these relative commodity signals are disconcerting, and were they to deteriorate further, they would definitely undermine our optimistic view on global growth (top and second panels, Chart 11). Finally, it is disquieting that our relative profit growth models have no pulse. They represent a significant risk to the relative earnings-led rebound which the rest of the indicators we track are anticipating (third panel, Chart 11). Chart 11Three Key Risks We Are Monitoring Bottom Line: On balance, a looming global growth recovery and pending global capex upcycle, a softening US dollar, commodity price inflation and Chinese monetary easing will more than offset the trifecta of rising election-related risks, the current unresponsiveness of our relative profit growth models and the lack of confirmation of a liquidity-to-growth transition. This will pave the way for a cyclicals outperformance phase at the expense of defensives.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com  

  Markets have shrugged off the rise in COVID-19 cases in the US and new clusters in other places such as Spain, Hong Kong, Melbourne, and Tokyo (Chart 1). The MSCI All-Country World Index is now only 4% off its all-time high in February. We don’t see the markets ignoring reality for much longer. Economic activity remains very subdued (Chart 2), which will eventually cause a significant rise in bankruptcies and problems for banks. Nevertheless, the unprecedented monetary and fiscal stimulus will be increased further in coming weeks, which should prevent a big shift towards pessimism for a while. The crunch time will come in the northern-hemisphere winter, when COVID cases in North America and Europe are likely to rise sharply again. Risk assets at their current levels are not pricing in those risks. Recommended Allocation   Chart 1COVID Cases Are Still On The Rise Chart 2Activity Remains Subdued Markets are driven by the second derivative of growth. It is not surprising, then, that equities began to rally in March, exactly when economic data stopped deteriorating, even though it remained atrocious (Chart 3). Real interest rates have also continued to fall, even as risk assets rallied; this further fueled the rally, since the theoretical value of equities rises as the rate at which they are discounted falls (Chart 4). Chart 3Data Stopped Deteriorating In March Chart 4Real Interest Rates Have Continued To Fall But the question now is: Can the data continue to improve? PMIs will fall back towards 50, and economic releases are unlikely to surprise so strongly on the upside. In the US, as a result of the rise in COVID-19 cases and renewed (albeit mostly moderate) government restrictions on activity, consumer confidence has started to weaken again and initial unemployment claims to pick up (Charts 5 and 6). Even though the Fed will remain ultra-dovish, real rates will not fall much further from their current level, which is the lowest since TIPS started trading in the late 1990s. Chart 5Consumer Confidence Is Weakening Again Chart 6The Jobs Market Has Stopped Improving Chart 7Will Money Supply Growth Peak? Money supply growth has grown rapidly, as a result of the increase in central-bank balance-sheets and the rush of companies to borrow to shore up their cash positions (Chart 7). The increase in excess liquidity has also been a force behind the rise in risk assets. But money supply growth is likely to slow from now. At least partly offsetting these risks will be further fiscal stimulus. BCA Research’s Geopolitical strategists see Congress approving a big new package of around $2.5 trillion, mainly because of widespread popular support for an extension of more generous unemployment benefits (Table 1). Agreement should come before the scheduled recess on August 10 (if it doesn’t, this would trigger a market selloff). The recent agreement between European Union leaders on a EUR750 billion fiscal package was a major breakthrough, since it represented joint borrowing backed by the rich northern European countries to provide transfers to the poorer periphery. Table 1There Is Much Public Support For Fiscal Stimulus Further upside may come as the many investors who have missed the rally since March capitulate and buy risk assets. Investor sentiment is currently unusually polarized. Speculative individuals and hedge funds are very bullish (Chart 8). But more conservative pension funds, wealth managers, and individual investors, mostly remain cautious, as evidenced by the AAII weekly survey, in which many more investors say they expect the stock market to fall over the next six months than to rise (Chart 9). Cash levels remain high by historical standards (Chart 10). Although only a minority of investors turned positive in March, a recent academic study demonstrated how hedge funds and small active institutions have a disproportionate influence on price movements (Chart 11). A downside risk, then, would be if these investors decided to take profits or turned more bearish. Chart 8Hedge Funds Are Bullish... Chart 9...But Retail Investors Very Cautious Chart 10Cash Holdings Remain Elevated Chart 11Some Smaller Investors Have A Big Impact We have argued, since the pandemic began, that investors should not take high-conviction bets in such an uncertain environment. They should, rather, design portfolios which are robust under various scenarios. After the 43% rise in global equities since March, we cannot recommend an above-benchmark weighting, since downside risks are not priced in. We remain neutral on global equities. However, fixed-income instruments look even more unattractive at the current low level of rates; we remain underweight. We recommend hedging via a large overweight in cash, which leaves dry powder for when a better buying opportunity arises. Currencies: A key (as always) to the macro view is what happens to the US dollar. Many of the drivers of the dollar – interest-rate differentials, valuation, momentum, and relative money-supply growth – point to it weakening further (Chart 12). The trade-weighted dollar is already off 9% from its March peak. We turned bearish on the USD in our Quarterly published at the beginning of July. It is too early, however, to declare that the dollar bull market, which began in 2012, is definitely over. Chart 12Dollar Indicators Are Bearish... Chart 13…But Short USD Is Now A Consensus A new downturn in the global economy would push the dollar back up again, since it is a safe-haven currency. Shorting the dollar, especially against the euro, is now a consensus position, and so a near-term reversal is quite likely (Chart 13). But, over the next 12-18 months, a move above 1.22 for the euro and towards 100 for the yen is possible. We will continue to analyze whether the dollar could be entering a bear market, since this would necessarily make us more structurally positive on commodities and emerging markets. Equities: A pickup in global growth and a weakening US dollar might prove positive for cyclicals and value stocks in the long run, which would cause European and EM equities to outperform. Given the current uncertainty, however, we cannot recommend that stance and therefore continue to prefer “growth defensives” such as Health Care and Technology, which implies an overweight on the overall US market. Valuations in the Health Care sector remain attractive (Chart 14). Companies in the (broadly defined) Tech sector are beneficiaries of the pandemic, generally have robust balance-sheets, and should continue to see strong earnings growth for some years. And, while Technology is clearly expensive, valuations are still nowhere as excessive as in 2000 (Chart 15). For Tech to crash would require either that it go ex-growth, or that there is significant regulatory action. Chart 14Health Care Still Attractively Valued Chart 15Tech Still Way Below Bubble Levels Chart 16Europe No Longer So Dominated By Financials Neither of these seems likely for now. Euro zone equities are less dominated than they were by Financials, but remain more cyclical than the US, with very few internet-related names (Chart 16).   Fixed Income: Central banks will remain very dovish and, as Fed chair Jerome Powell has emphasized, are not even thinking about thinking about tightening policy. This suggests that nominal rates will rise only moderately, even if growth continues to pick up. The Fed still has plenty of room to ease further if needed, since the programs it rolled out in March have barely been taken up yet (Table 2). We thus recommend a neutral position on duration. We find TIPS attractive as a hedge against an eventual spike in inflation. The 10-year breakeven inflation rate implied in TIPS remains around 100 basis points below being compatible with the Fed achieving its 2% PCE inflation target in the long run (Chart 17). The announcement in September of the results of the Fed’s 18-month review of its policy framework, which is likely to intensify its efforts to achieve the inflation target, could push breakevens up a bit further. In credit, we continue to recommend buying whatever central banks are buying, mostly investment-grade corporate bonds and the top end of the US junk bond market. Though spreads have fallen a long way, they are still well above end-2019 levels, and look attractive in a world of such low government bond yields (Chart 18). Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Chart 17TIPS Still Pricing Low Inflation For A Decade Chart 18Credit Spreads Could Fall Further Commodities: The weakening US dollar and continued expansion of Chinese stimulus (Chart 19) should be positive for industrial metals prices over the next six to nine months. Oil prices also have some further upside, since the OPEC 2.0 agreement to restrict supply is being adhered to, and demand will gradually pick up (although air travel will remain depressed, more commuters are using their cars as they avoid public transport). BCA Research’s Energy Service forecasts Brent crude to average $44 in the second half of this year, and $65 in 2021 (up from the current $43). Gold has already run up a lot and is now close to a record high price in real terms, with sentiment very optimistic (Chart 20). Chart 19China Stimulus Positive For Metals Nonetheless, in an environment of very low real rates, it represents a good hedge against extreme tail risks, and therefore we continue to recommend a moderate position as an insurance. Chart 20Gold Looking Rather Toppish Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation  

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of July 31, 2020.  The model has not made any meaningful adjustment to the top overweight countries with the top four remaining the US, Spain, Australia, and Sweden. Within the underweight countries, however, the UK has dropped out of the top four, replaced by Germany. Japan, France, and Switzerland remain in the top 4 underweight countries, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark by 73 bps in July, with positive contributions from both the Level 1 and the Level 2 models. The Level 2 model outperformed its benchmark by 176 bps, thanks largely to the underweight in Japan and the UK, as well as the overweight in Sweden. The Level 1 model outperformed by 27 bps due to the large overweight in the US. Since going live, the overall model has outperformed its MSCI World benchmark by 390 bps, with 714 bps of outperformance from the Level 2 model, and 74 bps of outperformance from the Level 1 model. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1)   Chart 3GAA Non US Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of July 31, 2020. The model’s relative tilts between cyclicals and defensives did not change compared to last month. The model continues to maintain its cyclical stance driven by an improvement in its global growth proxy and remains exposed to cyclical sectors. Over the past month, the model outperformed its benchmark by 32 basis points. Year-to-date, the model has outperformed its benchmark by 144 basis points, and 149 basis points since inception. Chart 4Overall Model Performance Table 3Overall Model Performance The model’s global growth proxy improved – driven by appreciating EM currencies and rising metal prices, and therefore continues to remain positive on cyclical sectors. Global monetary easing and low rates should keep the liquidity component favoring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, multiple sectors continue to be near the expensive and cheap zones – mainly Info Tech and Consumer Discretionary (expensive), and Real Estate and Consumer Staples (cheap). The model awaits confirming momentum signals to change recommendations for those sectors. Table 4Current Model Allocations The model is now overweight four cyclical sectors in total. These are Information Technology, Consumer Discretionary, Communication Services, and Materials. 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 Senior Analyst amrh@bcaresearch.com