Health Care Equipment

Highlights Gold prices will continue to be challenged by conflicting information flows regarding US monetary policy; higher inflationary impulses from commodity prices and supply-chain bottlenecks; global economic policy uncertainty, and risks to EM economic growth (Chart of the Week). Concern over the likely tapering of the Fed's asset-purchase program this year, rate hikes next year and fiscal-policy uncertainty will support rising interest-rate risk premia and a stronger USD. These will remain headwinds for gold. Going into the Northern Hemisphere's winter, risk premia in fossil-fuel prices are at or close to their zeniths, as is the Bloomberg commodity index. This will keep short-term inflation elevated. Heightened geopolitical tensions – particularly between Western democracies and China – will keep the USD well bid by risk-averse investors. The commodity-induced element of PCEPI inflation will be transitory. Uncertainty over US monetary policy and rising geopolitical tensions, however, will remain part and parcel of gold fundamentals indefinitely. The trailing stop on our long 1Q22 natural gas call spread – long $5.00/MMBtu call vs. short $5.50/MMBtu call – was elected, leaving us with a 20% gain. We will not be re-setting the spread at tonight's close, due to the difficulty in taking a price view in markets with extremely high weather-related uncertainty. Feature The quality of information informing the analysis of gold markets is highly uncertain at present. US monetary policy uncertainty and the future of Fed chairman Jerome Powell keep expectations twitchy when it comes issues like the tapering of the Fed's asset-purchase program. Our colleagues at BCA's US Bond Strategy expect the Fed will announce a taper in asset purchases by November 2021 which will end in June 2022.1 But the tapering really is not, in our estimation, as big a deal as inflation and inflation expectations, which will drive the Fed's rate-hiking timetable. Chart of the WeekUncertainty Weighs On Gold Uncertainty Weighs On Gold Uncertainty Weighs On Gold The first Fed rate hike expected by our bond desk likely will come at the end of next year. Our colleagues expect the Fed will want to check off three criteria before increasing interest rates (Table 1). The inflation targets – actual and expected – already have been checked off, leaving the labor market's recovery as the only outstanding issue on our internal checklist. By December 2022, once the maximum employment criterion has been met, the Fed will commence with rate hike.2 Subsequent rate hikes will depend on inflation expectations. Table 1A Checklist For Liftoff Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold Uncertain Inflation Expectations The higher inflation that checks off our bond desk's list resulted from COVID-19-impacted services and tight auto markets (Chart 2). We also find evidence commodities feed into inflation expectations and realized inflation, both of which are key variables for the Fed (Chart 3). Transitory effects – chiefly supply-chain bottlenecks and a global scramble for coal, gas and oil – have lifted realized inflation in 2H21, and have taken the Bloomberg commodity index to record levels (Chart 4). Nonetheless, given the fundamental backdrop for the key industrial commodities – chiefly oil, gas, coal and base metals – the inflationary impulse from commodity markets could persist indefinitely into the future, in our estimation. In order to incentivize the investment in base metals needed to literally build out the renewable energy infrastructure, the grids that support it and the electric vehicles that will supplant internal-combustion-engine technology, higher energy and metals prices will be required for years.3 This will be occurring as the production of traditional energy sources – i.e., fossil fuels – winds down due to lower investment over the next 10-20 years. This also will result in higher and more volatile oil and gas prices. Chart 2Inflation Meets Fed Targets Inflation Meets Fed Targets Inflation Meets Fed Targets Chart 3Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations All of these real-economy factors will feed into higher inflation over time, which will present the Fed with difficult choices regarding monetary policy and interest rates. Chart 4Record Commodity Index Levels Record Commodity Index Levels Record Commodity Index Levels USD Strength Suppresses Inflation And Gold Prices  It is worthwhile noting the current USD strength is suppressing inflation. However, it is not suppressing commodity prices entirely, as Chart 4 shows. The transitory weather-related price increases in energy commodities will pass, either when winter ends or if a less severe winter hits the Northern Hemisphere. We continue to expect a lower dollar, as the Fed's accommodative monetary policy remains in place. Even after the Fed tapers its asset-purchase program, policy will remain loose. The large fiscal packages that most likely will be approved by the US Congress will swell the US debt and budget deficits, which likely will weaken the USD over time. On a purchasing-power-parity basis (PPP) we also expect a weaker dollar (Chart 5). We also are expecting the availability of more efficacious vaccines in EM economies to boost economic activity, which will strengthen incomes and local currencies vis-à-vis the USD. Chart 5Weaker USD Expected On A PPP Basis Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold The risk to this USD view – which would support gold prices – remains the heightened geopolitical tensions between Western democracies and China, which will keep political uncertainty elevated and will keep the USD well bid by risk-averse investors. Persistent USD strength would restrain inflation, and weaken the case for owning gold. Investment Implications We remain bullish gold over the medium- and long-term, expecting higher inflation and inflation expectations to lift demand for this safe haven. However, persistent commodity-induced inflation could force the Fed to tighten monetary policy more than is currently expected to get out ahead of higher inflation and inflation expectations. This could lead to stagflation, wherein inflation runs high but growth stalls as interest rates move higher. Persistent geopolitical risk also will keep risk-averse investors well bid for the USD. Commodities Round-Up Energy: Bullish First-line US natural gas prices were down ~ 9% as we went to press, following reports Russia would make more gas available to European buyers. This report apparently was later contradicted by a Gazprom official, who said Russian inventories still were being filled ahead of winter.4 WTI crude oil prices came close to hitting a seven-year high early in the trading day Wednesday, then promptly retreated (Chart 6). The news flow is indicative of the extreme sensitivity of gas and oil buyers going into the coming winter. Base Metals: Bullish Earlier this week, the Peruvian government struck an deal with MMG Ltd, owner of the Las Bambas mine, and the local community around the site, which reportedly will involve hiring local residents to provide services to the mine, including helping transport minerals and maintaining key transit roads. The community had been protesting to seek more of the income from the mine, and created blockades en route to the site, which threatened ~ 2% of global copper supply. Peru's newly elected president, TK Castillo, rose to power on the promise to redistribute mining wealth to Peruvian citizens. This was his first negotiation with a mining company since his election in July. MMG’s major shareholder is China Minmetals Corp. The Leftist president will need to balance the interests of local stakeholders on the one hand, while ensuring the world’s second largest copper producing nation is still attractive to international miners. Precious Metals: Bullish In 2021, the World Platinum Investment Council expects the platinum to swing to a physical surplus of 190k oz, which reverses an earlier forecast for a deficit made in the Council's 1Q21 report (Chart 7). Demand is forecast to increase year-over-year, spurred by increases in automotive, industrial and jewelry demand. On the supply side, growth in South Africa's mined output growth will keep markets in a surplus for 2021. According to SFA Oxford, gross palladium demand and refined supply for 2021 are expected to be at 10.03mm oz, and 6.77mm, respectively. Palladium balances (ex-ETFs) are projected to remain in a physical deficit of 495k ounces for 2021. Chart 6 WTI LEVEL GOING UP WTI LEVEL GOING UP Chart 7 Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Footnotes 1     Please see Damage Assessment, published by BCA Research's US Bond Strategy on September 28, 2021. 2     Please see 2022 Will Be All About Inflation, published by BCA Research's US Bond Strategy on September 14, 2021, which notes the concept of maximum employment is not a well-defined term. 3    Please see La Niña And The Energy Transition, which we published last week. 4    Please see Energy price surge sends shivers through markets as Europe looks to Russia published by reuters.com on September 6, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Highlights The equity risk premium has turned negative for the first time since 2002. It follows that any significant rise in bond yields will cause risk-asset prices to collapse, quickly flipping any incipient inflationary shock into a deflationary shock. Shorting bonds yielding 2 percent is a ‘widow maker’ trade, as anybody who has tried this with a long list of government bonds has learned to their cost, the most recent being UK gilts. Hence, the next on the list for the ‘widow maker’ is shorting the US 30-year T-bond which is now yielding 2 percent. In fact, the US 30-year T-bond is a must-own structural investment. Fractal analysis: Medical equipment versus healthcare services. Feature Chart of the WeekThe Equity Risk Premium Turns Negative For The First Time Since 2002 The Equity Risk Premium Turns Negative For The First Time Since 2002 The Equity Risk Premium Turns Negative For The First Time Since 2002 Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. For example, the US 10-year Treasury Inflation Protected Security (TIPS) and the UK 10-year index linked gilt are yielding -1.3 percent and -2.8 percent respectively. Meaning that anybody who buys and holds these bonds to redemption is guaranteed a deeply negative 10-year real return. Meanwhile, in nominal yield space, 10-year government bonds yield -0.35 percent in Germany and Switzerland, 0.7 percent in the UK, and 1.3 percent in the US. What about equities? Unlike a bond’s redemption yield, equities do not offer a guaranteed long-term return for buy-and-hold investors. So, some analysts assume that the equity market’s earnings yield is the proxy for this long-term return. According to these analysts, the US equity market’s earnings yield of 4.4 percent means that it will deliver a prospective long-term real return of 4.4 percent per annum. Compared to the 10-year TIPS real yield of -1.3 percent, they argue that this offers an excess return or ‘equity risk premium’ of a comfortable +5.7 percent. Therefore, claim these analysts, equities are reasonably valued, relative to bonds, and in absolute terms.  But as we will now demonstrate, this analysis is deeply flawed. The Equity Risk Premium Has Turned Negative The equity market’s earnings yield is a valuation metric, so clearly there is some connection between it and the prospective return delivered by the equity market. Nevertheless, the crucial point to grasp is that: The equity market’s earnings yield does not equal its prospective return. Charts I-2 - I-3 should make this point crystal clear. As you can see, the earnings yield rarely equals the delivered prospective 10-year return, either real or nominal. When the earnings yield is elevated, the prospective return turns out higher. Conversely, when the earnings yield is depressed, as now, the prospective return turns out to be much lower. Chart I-2The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... Chart I-3...Or In Nominal ##br##Terms ...Or In Nominal Terms ...Or In Nominal Terms Therefore, to take the current earnings yield of 4.4 percent and subtract the real bond yield of -1.3 percent to derive an equity risk premium of +5.7 percent is analytically flawed, just as it is analytically flawed to subtract apples from oranges. To derive the equity risk premium, the correct approach is first to translate the earnings yield into a prospective 10-year return based on the established mathematical relationship between these variables. Chart I-4 does this and shows that, based on a very tight mathematical relationship through the past thirty five years, an earnings yield of 4.4 percent translates into a prospective 10-year nominal return of just 1 percent. Chart I-4We Must Mathematically Map The Earnings Yield Into A Prospective Return... We Must Mathematically Map The Earnings Yield Into A Prospective Return... We Must Mathematically Map The Earnings Yield Into A Prospective Return... Having translated the earnings yield into a prospective 10-year nominal return of 1 percent, we can now make an apples-for-apples comparison with the 10-year T-bond yield of 1.3 percent (Chart I-5). Chart I-5...And Only Then Subtract The Bond Yield ...And Only Then Subtract The Bond Yield ...And Only Then Subtract The Bond Yield Derived correctly therefore, the equity risk premium has turned negative for the first time since 2002 (Chart of the Week). We deduce that the equity market is very richly valued both in absolute terms and relative to bonds. And crucially, that this rich valuation is contingent on bond yields remaining ultra-low, or going even lower. Shorting Bonds Yielding 2 Percent Is A ‘Widow Maker’ All of which brings us to one of the most pressing questions we get from clients. When a bond is offering a feeble yield, what is the point in owning it? Maybe the best people to answer are the casualties of the now infamous ‘widow maker’ trades. The original widow maker trade was the idea that the yield on the Japanese Government Bond (JGB), at 2 percent, was so feeble that there was no point in owning it. Furthermore, with massive Japanese fiscal stimulus coming down the pike, the ‘no-brainer’ investment strategy was not just to disown the JGBs, but to take an outright short position, as it seemed that the only direction that JGB yields could go was up. In fact, JGB yields did not go up, they continued to trend down. As feeble yields became even feebler, the owners of the short positions got carried out of their careers, feet first. Meanwhile, those investors who owned 30-year JGBs yielding a ‘feeble’ 2 percent in 2013 reaped returns of 75 percent, and even now, are sitting on handsome profits of 55 percent. Some people protest that Japan is an exceptional and isolated case, rather than a template for economies which will not repeat their putative policy-errors. Such protests have always struck us as factually wrong, blinkered, and even prejudiced. Nevertheless, let’s indulge these prejudices with a simple rejoinder – forget Japan, what about Switzerland, or the UK? (Chart I-6) Chart I-6Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Meanwhile, those investors who owned 30-year UK gilts yielding a ‘feeble’ 2 percent in 2018 reaped returns of 40 percent, and even now are sitting on tidy profits of 30 percent. Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Bear in mind that a 30-year bond yielding a feeble 2 percent will deliver a cumulative return of more than 80 percent to redemption. And that if the feeble yield becomes even feebler, this return will get front-end loaded, creating widow makers for the short positions and spectacular gains for the long positions, as witnessed in JGBs and UK gilts. The 30-Year T-Bond Is A Must-Own Structural Investment The next candidate for the widow maker is shorting the US 30-year T-bond, which is yielding, you guessed it, 2 percent. Remember that while Japan may not be a great template for the US, the UK certainly is – because the US and UK have very similar economic, financial, political, social, and cultural structures. Until recently therefore, bond yields in the US and UK were moving in near-perfect lockstep (Chart I-7). Chart I-7The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock So, what happened? The one word answer is: Brexit. The recent difference between US and UK bond yields is simply that the UK has had one more deflationary shock than the US. Put the other way around, the US is just one deflationary shock away from a UK level of bond yields – meaning the 30-year yield not at 2 percent, but at 1 percent. But why can’t the next shock be an inflationary shock resulting in much higher yields? The simple answer is that the equity risk premium has turned negative for the first time since 2002. Moreover, as we pointed out in The Road To Inflation Ends At Deflation the extremely rich valuation of $300 trillion of global real estate is also highly contingent on ultra-low bond yields. It follows that any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. In a $90 trillion global economy, this will quickly flip any incipient inflationary shock into a deflationary shock. Any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. We conclude that the US 30-year T-bond is a must-own structural investment. Fractal Analysis Update As hospitals have rushed to clear their backlog of non-pandemic treatments and procedures, medical equipment stock prices have surged. This is particularly true for US medical equipment (ticker IHI) which, since June, is up by 25 percent versus US healthcare services (Iqvia, Veeva, or loosely proxied by ticker XHS). Given that the backlog of treatments will eventually clear, and that the intense rally is now extremely fragile on its 65-day fractal structure (Chart I-8), a recommended countertrend trade is to short US medical equipment versus healthcare services. Set the profit target and symmetrical stop-loss at 8.5 percent.  Chart I-8The Intense Rally In Medical Equipment Stocks Has Become Fragile The Intense Rally In Medical Equipment Stocks Has Become Fragile The Intense Rally In Medical Equipment Stocks Has Become Fragile   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Upgrade The Health Care Sector To An Overweight: Expressed through an overweight position in Health Care Equipment and Services, and an equal weight position in Pharmaceuticals and Biotech The Sector Faces A Few Tailwinds: Recovery of delayed elective procedures and hospital visits will accelerate health care sector sales and profit growth into the balance of the year Aging baby boomers and longer life expectancy will further boost health care spending The Democratic Party’s “blue wave” victory in 2020 has had little effect on health care policy, as the Biden administration has sidelined the party’s most ambitious proposals to deal with the pandemic. This is hardly a tailwind, but the political backdrop for the sector is better than was initially expected There Are Also Headwinds: Reducing or capping drug prices is a bipartisan interest, and may result in imports, price regulation, or inflation indexing, further increasing price pressures The Biden administration’s anti-trust stance may preclude mergers that allow medtech companies to acquire new technology and help hospitals realize economies of scale and preserve razor thin margins Patent expiration for blockbuster drugs is expected to peak in 2023, reducing overall drug spending by $160 billion from 2019 to 2023, and further increasing price pressure from the generic drug manufacturers Overweight Health Care: This as a defensive sector, which will fare well during the slowdown stage of the business cycle. Its performance will also be aided by post-Covid-19 tailwinds. The sector is cheap, and profitability is improving (Chart 1, top panel). Overweight Health Care Equipment And Service Providers: We prefer this industry group to Pharmaceuticals and Biotech, as it faces less intense price pressures, does not face bipartisan political scrutiny, is more profitable, and enjoys resilient profit margins (Chart 1, second panel). Equal Weight Pharma: This industry faces many challenges, such as upcoming patent cliff and generic competition, political and regulatory uncertainty, and declining profitability, which explains the significant valuation discount but makes it risky (Chart 1, bottom panel). Feature In conjunction with our colleagues from the US Political Strategy Team (USPS), today we publish a “deep dive” report on the US Health Care sector. The sector faces significant long-term political and regulatory headwinds, and understanding the political landscape is necessary to making the right investment decisions. The Health Care sector consists of two industry groups: Pharmaceuticals and Biotech, and Health Care Equipment and Services. In this report, we will assess the overall attractiveness of the sector in terms of its investment characteristics, as well as its outlook in the context of the current macroeconomic backdrop and potential political developments. Further, we will drill down into each industry group to provide more granular investment recommendations. We upgrade the Health Care sector to an overweight, expressed through an overweight position in Health Care Equipment and Services, and an equal weight position in Pharmaceuticals and Biotech. Chart 1Fundamentals Are Improving Fundamentals Are Improving Fundamentals Are Improving Recent Performance Being a defensive sector, Health Care outperformed the S&P 500 by about 12% in the midst of the pandemic, only to lag the market during the recovery rally (Chart 2). Chart 2Health Care Outperformed During The Lockdowns, But Lagged In A Recovery Rally Health Care Outperformed During The Lockdowns, But Lagged In A Recovery Rally Health Care Outperformed During The Lockdowns, But Lagged In A Recovery Rally Chart 3Health Care Sector Breakdown By Key Segment Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Health Care Sector Overview Health Care sector is very important to the US economy. After all, the US commands the highest health care spending in the world – 17% of GDP, $500B in sales annually. The sector constitutes about 13% of the S&P 500 index by market capitalization and is split equally between Pharmaceuticals and Biotech, and Health Care Equipment and Services, which itself consists of Health Care Providers and Equipment Manufacturers (Chart 3). Health Care Providers is a category which includes major hospitals, health insurers, and pharmacy chains, is the largest segment of the sector, and contributes 49% of the sector revenue. However, this is an industry under a significant price pressure from well-organized buyers such as private and government health insurance and has EBIT margins of only 8%. Pharma and Biotech is the second largest segment and delivers 33.5% of the sector revenue. This industry group faces its own unique challenges, such as patent expirations, politics, and competition from generic drug manufacturers. Yet, thanks to limited time patent protection, this industry manages to achieve EBIT margins of 12.2%. Health Care Equipment and Services is the smallest, contributing only 17% of all sector revenue, but it is the most promising and profitable segment, with EBIT margins circa 20%. The medical devices industry was able to preserve some its pricing power. Health Care Sector Tailwinds Recovery of Delayed Procedures And Hospital Visits Continues While health care earnings were relatively resilient throughout 2020, growth will accelerate into the balance of the year thanks to the recovery of delayed elective procedures and hospital visits following the easing of lockdown measures. These procedures are not only most lucrative for hospitals, but also increase demand for prescription drugs and translate into profits for medtech. Moreover, there is still a significant backlog of delayed procedures to work through. According to CFRA, medical utilization will not only recover, but will also increase by about 3% over a 2019 base by the year-end. Aging Baby Boomers Will Further Accelerate Health Care Spending Global demographic trends bode well for long-term health care spending: The share of the world’s population aged 65 years or over increased to 9.3% in 2020. People live longer thanks to medical innovations and increases in per-capita spending on health care. Longer life expectancy contributes to the rising incidence of chronic diseases, increases in spending on prescription drugs, medical facilities, and services. It also helps that in the developed world, and in the US in particular, baby boomers are the most affluent demographic group. The M&A Environment Has Been Hot M&A activity is booming for Health Care Equipment and Services. Medical equipment companies continue to seek to increase their exposure to nascent technologies with significant growth potential, while hospital chains consolidate to realize economies of scale and increased influence over suppliers and customers. However, as for pharma, many companies already carry high levels of debt, which precludes significant M&A activity. Blue Wave Has Had Little Effect On Health Care Policy (So Far) In principle, the blue wave was perceived as unfavorable to the Health Care sector, but in practice, so far, its effect has been neutral. The narrow margins in the House (4 seats) and Senate (0 seats, de facto 1 seat) reduce the effectiveness of the blue wave. Moreover President Biden has sidelined the party’s interests on health care for the time being. He did not include a public health insurance option in his American Families Plan, nor did he push for Medicare to take an active role in negotiating drug prices. He even sidelined the Democrats’ plan to expand the eligibility age for Medicare. Of course, he is still formally committed to these policies, and he will try to revisit health care in 2022. But by then it will be campaign season for the 2022 midterms and the odds of getting significant legislation passed will fall sharply. Of course, the current White House health care policy is hardly a tailwind. It is still conceivable (albeit low odds) that House Speaker Nancy Pelosi could convince the Senate leadership to insert the party’s more ambitious aims into the American Families Plan as the final draft of this fall’s budget reconciliation bill is prepared. Plus the Department of Health and Human Services will unveil a slew of new rules and regulations as the administration tries to compensate for the lack of bold initiatives. But on the margin the political backdrop for the sector is less negative than initially expected. Health Care Sector Headwinds While the sector enjoys these tailwinds, there are a few dark clouds gathering on the horizon, creating a lot of uncertainty and a more challenging policy backdrop. Reducing Or Capping Drug Prices Is A Bipartisan Issue Reducing or capping the price of drugs is one of the few bipartisan legislative priorities. Trump focused on this issue as well as Biden, which shows it is a vote getter as both parties are courting older voters. Executive orders are pushing key federal agencies to promote generics and biosimilars to reduce name-brand drug prices. Some of the ideas being circulated are: Allow drug imports from Canada and other countries (a big legal battle looms but the initiative is bipartisan and popular). Negotiate drug prices over Medicare with pharmaceuticals instead of having the companies freely set the prices. Limit high-launch prices of novel specialty drugs. (The administration is still formally committed to this.) Link drug price increases to inflation or an International Pricing Index. (Likely to occur at some point.) Having said that, while the situation remains fluid, so far health care and drug prices have not been a priority for Biden. A single lost vote in the Senate could derail his signature American Jobs and Families Plan reconciliation bill. Therefore he wants the bill to focus on $200 billion in subsidies for the existing Affordable Care Act. He does not want to add new controversial measures and revive the Obama administration’s bruising political battles over government involvement in health care. He also does not want to take any actions seen as punitive for the industries that cared for people during the pandemic and invented the vaccines. Biden Administration Anti-Trust Stance Biden’s administration is positioning itself to be very forward on anti-trust issues, which is a big change from the previous administration. Executive Order 14036 on anti-trust and competition takes aim at hospital consolidation, which is said to cause a low supply of health care and higher prices. Indeed, hospitals have been gobbling up smaller providers for over a decade to prop up their razor thin margins. Other M&As across the sector have occurred, like drug retailers buying insurers. The order also says that health insurers need to standardize the options they provide – limiting company flexibility and straight-jacketing pricing schemes. This policy development has a caveat, which may mitigate some of the clauses. The executive order does not involve concrete action that would stop this process. But it does exhort the Department of Health and Human Services and the Federal Trade Commission to develop new rules. Note that there are legislative constraints to muscular anti-trust enforcement, namely that new interpretations of anti-trust are unlikely to pass judiciary review. Therefore, there is a need for new legislation to overrule the judiciary/courts. But, as mentioned, Biden is not willing to risk his larger legislative priorities and hardly any big bills will pass in 2022. This means that the primary risk for now comes from agency rule-making, or new executive orders. Hence there is a shift in executive approach to these issues that will create a lot of uncertainty and put downward pressure on the performance of the sector. This risk could grow later, after the market prices in the positive news that Biden has not prioritized bold legislation in this sector. Patent Cliff Patent cliff is one of the key headwinds the pharmaceutical industry is facing: patent expiration for blockbuster drugs with global revenues exceeding $1B, is expected to peak in 2023. According to IQVIA, the decrease in spending on branded medicines is expected to reduce overall drug spending by $160 billion from 2019 to 2023. Macroeconomic Backdrop Is Favorable To The Health Care Sector Growth Is Slowing: Defensives Rule The business cycle has shifted into a slowdown stage. The earnings cycle has also peaked (Chart 4). We have written about this over the past few weeks, and by now it is baked into the market consensus. To position for a slowdown, we recommended rotation to Growth in the beginning of June. Defensive sectors like Health Care also thrive when growth rolls over. In fact, according to our analysis (Chart 5), Health Care and its constituent Industry Groups tend to do even better than Growth style during a slowdown. Chart 4Earnings Have Rolled Over Earnings Have Rolled Over Earnings Have Rolled Over Chart 5Health Care Outperforms During The Slowdown Stage Of The Business Cycle... Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Health Care is also a sector that benefits from rate stabilization, as it can be characterized as a “stable, quality growth”, as much of its cash flow growth extends far into the future (Chart 6). Chart 6...And When Rates Are Falling Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Health Care Is A Domestic Industry Health Care is a relatively domestically focused industry, as it derives about 39% of its sales from outside the US – compared with 42% for the S&P 500, and 58% for the Technology sector. As a result, investors perceive Health Care to be a safe haven in times of appreciating USD, as its earnings are more insulated from currency moves. As a result, Health Care relative returns are positively correlated with the DXY (Chart 7). The dollar has been appreciating since the beginning of June, which bodes well for the outperformance of the sector (Chart 8). Chart 7Health Care Is Domestically Focused And Is Insulated From An Appreciating Dollar Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Chart 8Positive Correlation With The Dollar Positive Correlation With The Dollar Positive Correlation With The Dollar Fundamentals Sector Is Cheap The Health Care sector is inexpensive and is trading with an about 20% discount to the S&P 500, both on a trailing and forward basis. According to the BCA Valuation Indicator, it’s trading 2 std below its long-term average (Chart 9). Within the sector, Pharma and Biotech is the cheapest industry group and its valuation discount is dictated by its unique challenges (Table 1). Chart 9Unloved & Undervalued? Unloved & Undervalued? Unloved & Undervalued? Table 1Summary Of Valuations And Growth Expectations Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Earnings Growth Expectations Are Stable For Health Care Valuation discount may be explained by the fact that sector earnings growth expectations for the next 12 months are about half of those for the broad index, i.e., 10% vs 20% (Table 1). For Q2-21, analysts expect YoY growth of 36% for the sector and 68% for the S&P 500. However, this earnings differential is misleading as Health Care earnings were resilient throughout the pandemic, while the cyclical components of the S&P 500 have collapsed. Thus, differences in expectation are mostly due to the 2020 base effect. Indexing 12 months forward EPS to one in July 2019, we see that Health Care earnings have been stable, and now exceed the level of S&P 500 earnings (Chart 10). Chart 10Health Care Earnings Are Resilient Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Margins Are Under Pressure While immediate earnings growth expectations look good, the degree to which the sector is losing pricing power is a source for concern (Chart 11). Health Care sector margins have been eroding for years now (Chart 12). Pricing pressure is a perennial concern for the sector as third-party payers, including the government and private health insurance chains seek to reduce the mounting costs of health care in the US. Chart 11Pricing Power Is Fading Pricing Power Is Fading Pricing Power Is Fading Chart 12Margins Have Been Eroding For Years Margins Have Been Eroding For Years Margins Have Been Eroding For Years Medicare and Medicaid have recently become a larger proportion of revenues for health care facilities, which is unfavorable for these companies because government health programs tend to have lower reimbursement rates than private sector payers. In turn, large hospital chains put price pressure on drug manufacturers and medical equipment suppliers. Lastly, Pharma faces competition from the generic drug manufacturers with which they have little product differentiation. R&D And Capex Are Rebounding During the pandemic, aiming to preserve cash in their war chests, companies in the sector have reduced their investments into R&D and Capex. More recently, both Capex and R&D have rebounded, cutting into margins. Indeed, the Health Care sector, especially pharma and medtech, is held hostage to R&D and Capex. EvaluatePharma estimates that large investments, typically around $4 billion in R&D, are required for pharma companies before any new products could be approved to be marketed. R&D is the “backbone” of novel drugs, and thus, the extent of R&D spending serves as an important metric to show a company’s commitment to finding new drugs. Medtech is held to similar demands as companies spend more and more to research and develop innovative new products, which are also subject to FDA approval. The only silver lining is that some analysts forecast that increased use of big data analytics or artificial intelligence to enhance processes has the potential to reduce growth in R&D and Capex (Chart 13 & Chart 14). Chart 13Capex Picked Up... Capex Picked Up... Capex Picked Up... Chart 14...So Did R&D ...So Did R&D ...So Did R&D Technicals Suggest Healthcare Is Oversold According to the BCA Technical Indicator, the Health Care sector is significantly oversold. This is a contrarian indicator, and positioning suggests that the sector is ripe for a rebound (Chart 15). Cash Yield Is Expected To Pick Up Last but not least, Health Care is one of the highest cash yielding sectors in the S&P 500. In Q1-21 the sector paid shareholders around $20B, the third highest payout in the index behind Financials and Tech. Cash yield is currently around 3% and the sector is in a strong position to ramp up payouts as its cash flows rebound. Chart 15A Good Entry Point A Good Entry Point A Good Entry Point Pharmaceuticals And Biotech Faces Many Challenges Pharmaceuticals is one of the most challenging businesses to be in: not only does R&D takes years, and thousands, if not millions, of chemical compounds tested, but also there is absolutely no guarantee of success. And each promising compound has to go through rounds of arduous FDA trials to get approval for a new drug. The price of the new drug is protected for ten to twenty years, after which the original manufacturers face competition from generic drug manufacturers. Generics already account for the majority of drug spending around the world. Many traditional manufacturers have entered the generic drug manufacturing business: if you can’t beat them, join them! As such, the covid-19 vaccine rollout was the biggest catalyst for pharma sales this cycle with millions of people still awaiting their first shot in both developed and emerging countries. Given the steady drip of news about emerging virus variants, we can assume that the pandemic-driven demand for pharma products is here to stay. However, there is a caveat to the story. A number of pharma producers, such as AstraZeneca and Johnson & Johnson, pledged to supply vaccines not for profit, which is also evident in the data. Chart 16& Chart 17 show that while pharma sales took off during the pandemic, both EBIT and margins contracted. Chart 16Vaccines Boost Sales... Vaccines Boost Sales... Vaccines Boost Sales... Chart 17...But Not Profits ...But Not Profits ...But Not Profits Of course, decline in profits and margins was transitory since the pandemic also reduced hospital visits for non-Covid patients as well as delayed other procedures like non-urgent surgeries that both require drug usage. As demand for these two categories that positively contribute to profits and margins is starting to bounce back, we expect bottom-line growth numbers to recover for pharma stocks. However, we are more concerned about a longer-term trend in Pharma margins: here we see the effect of patent cliff, the ubiquitous shift to generics, and price pressures from insurers and hospital chains. The political backdrop exacerbates the situation: reducing or capping the price of drugs is one of the few bipartisan priorities, which creates a lot of uncertainty for the industry, and could be a drag on margins for years to come. This poisoned chalice that the industry is facing explains why Pharma trades with a 34% discount to the S&P 500 PE NTM, and 17% discount to Health Care (14.3x, 21.6x and 17.3x respectively). This is the largest discount in the past 25 years. This valuation discount is likely to close – after all, there is a price for everything. However, for now we remain cautious about the prospects for Pharma and Biotech, especially in the context of political uncertainty. Health Care Equipment And Services Is Thriving Increases in hospital visits and resumption of elective medical procedures is great news both for the medical service providers and for medical equipment manufacturing. With 56% of Americans age 12 or older vaccinated, medical utilization is swiftly recovering. Chart 18 shows that sales for the industry group have surged by nearly 20% from the darkest days of the pandemic. This industry group was also able to manage costs during the downturn and exited the pandemic with higher margins. Also, unlike Pharma and Biotech, this industry group is not experiencing a long-term margin erosion trend. Pricing pressures for this industry group are less severe than for Pharma. Competition in certain product categories is often limited to several key players due to various challenges, such as regulation, product liability, and substantial R&D and Capex outlays required to enter the industry. As such, sales growth translates into income growth (Chart 19), and the industry group is able to maintain its margins. Chart 18Equipment Manufacturers Are Thriving Equipment Manufacturers Are Thriving Equipment Manufacturers Are Thriving Chart 19Strong Earnings All-around Strong Earnings All-around Strong Earnings All-around Further, political pressures on the industry group appear less severe than those on Pharma and Biotech. True, Democrats are inclined to tax devices and impose price caps, but their initiatives to expand health care access increase overall demand for equipment and services. Another sign, that the current administration focus is not on equipment and services, is that President Biden temporarily exempted medical tech from his “right to repair” executive order, which prevents manufacturers from restricting the right of third parties to repair their devices. While it is a small issue, it signals that Biden is not aggressive on this industry thus far. Overall, we believe that Health Care Equipment And Services is attractive, and it is less affected by some of the negative trends in the sector, but benefits from reopening and demographic tailwinds. Investment Implications Upgrade Health Care Sector - Overweight Health care sector earnings are aided by a number of secular and structural tailwinds: Recovery in hospital visits and volume of elective procedures which also translates into pickup in the use of health care equipment and drugs A large and affluent cohort of aging baby boomers who enjoy a longer life expectancy, but also will spend more on medical procedures and prescription drugs Political backdrop is less negative than expected – and longer-term political risks will likely be stalled for campaigning in 2022 US growth rolling over is also favoring Health Care as a defensive sector that tends to outperform during period of economic slowdown. Further, this sector is cheap and stable earnings growth looks favorable compared to the broad market. Pharmaceuticals And Biotech Industry Group – Equal Weight Like the rest of the sector, this industry group is enjoying post-covid-19 recovery tailwinds. Sales growth has stabilized, but profit margins are perennially depressed. We do believe that over the short term both profits and margins may rebound. However, we are concerned about structural headwinds: political backdrop is unfavorable and will add to the price pressures traditional pharma is facing from generic competition, exacerbated by an upcoming patent cliff. Health Care Equipment and Service Providers – Overweight Like Pharma, this industry group benefits from a resurgence of hospital visits and an increase in the volume of medical procedures. However, it faces much fewer headwinds: the Biden administration has not made the regulation of hospital and medical equipment manufacturers as one of its legislative priorities. This industry group also faces fewer pricing pressures than Pharma. Health Care Equipment and Service Providers is trading with a slight discount to a broad market, while its profitability and margins are expected to pick up significantly. Bottom Line: Overweight Health Care, which is a defensive sector and will fare well in the slowdown stage of the business cycle. Its performance will also be aided by post-covid-19 tailwinds such as resumption in the delayed elective procedures, a significant demand for health care from aging baby boomers, and benign political backdrop. Within the sector we favor Health Care Equipment and Service Providers over Pharmaceuticals and Biotech, as this industry group faces less intense price pressures, is more profitable, and enjoys resilient profit margins, and is currently is flying under “regulatory radar”. Pharma not only suffers from upcoming patent cliff and generic competition, but also faces potential regulatory pressures: these headwinds have affected its long-term profitability and weigh on its performance and valuations.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com     Recommended Allocation Checking The Pulse: Deep Dive Into The Health Care Sector Checking The Pulse: Deep Dive Into The Health Care Sector Footnotes  

Highlights Over the short term – 1-2 years – the pick-up in re-infection rates in Asia and LatAm states with large-scale deployments of Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery (Chart of the Week). The UAE-Saudi impasse re extending the return of additional volumes of OPEC 2.0 spare capacity to the oil market over 2H21 will be short-lived.  The UAE's official baseline production will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly.  Over the medium term – 3-5 years out – the risk to the expansion of metal supplies needed for renewables and electric vehicles (EVs) will rise, as left-of-center governments increase taxes and royalties, and carbon prices move higher. Rising metals costs will redound to the benefit of oil and gas producers, and accelerate R+D in carbon- and GHG-reduction technologies. Longer-term – 5-10 years out – the active discouragement of investment in hydrocarbons will contribute to energy shortages. In anticipation of continued upside volatility in commodity prices and share values of oil, gas and metals producers, we remain long the S&P GSCI and COMT ETF, and long equities of producers and traders via the PICK ETF. Feature Our conversations with clients almost invariably leads us to considering the risks to our long-standing bullish views for energy and metals. This week, we reprise some of the highlights of these conversations. In the short term, our bullish call on oil is underpinned by the assumption of continued expansion in vaccinations, which we believe will lead to global economic re-opening and increased mobility, as the world emerges from the devastation of COVID-19. This expectation is once again under scrutiny. On the supply side, the very public negotiations undertaken by the UAE and the leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and Russia – over re-basing the UAE's production reminds investors there is substantial spare capacity from the coalition available for the market over the short term. The slow news cycle going into the US Independence Day holiday certainly was a fortuitous time to make such a point. Chart of the WeekWorrisome Uptick Of COVID-19 Cases Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views KSA-UAE Supply-Side Worries The abrupt end to this week's OPEC 2.0 meeting was unsettling to markets. Shortly after the meeting ended – without being concluded – officials from the Biden administration in the US spoke with officials from KSA and the UAE, presumably to encourage resolution of outstanding issues and to get more oil into the market to keep crude oil prices below $80/bbl (Chart 2). We're confident the KSA-UAE impasse re extending the return of additional volumes of spare capacity to the oil market over 2H21 will be short-lived. The UAE's official baseline production number (i.e., its October 2018 output level) will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly. Coupled with a likely return of Iranian export volumes in 4Q21, this will bring prices down into the mid- to high-$60/bbl range we are forecasting. Chart 2US Pushing For Resolution of KSA-UAE Spat US Pushing For Resolution of KSA-UAE Spat US Pushing For Resolution of KSA-UAE Spat Longer term, markets are worried this incident is a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy, which has lifted oil prices 200% since their March 2020 nadir. At present, the producer coalition has ~ 6-7mm b/d of spare capacity, which resulted from its strategy to keep the level of supply below demand. A breakdown in this discipline – in extremis, another price war of the sort seen in March 2020 or from 2014-2016 – could plunge oil markets into a price collapse that re-visits sub-$40/bbl levels. In our view, economics – specifically the cold economic reality of the price elasticity of supply – continues to work for the OPEC 2.0 coalition: Higher revenues are realized by members of the group as long as relatively small production cuts produce larger revenue gains – e.g., a 5% (or less) cut in production that produces a 20% (or more) increase in price trumps a 20% increase in production that reduces prices by 50%. Besides, none of the members of the coalition possess the wherewithal to endure another shock-and-awe display from KSA similar to the one following the breakdown of the March 2020 OPEC 2.0 meeting. We also continue to expect US shale-oil producers to be disciplined by capital markets, and to retain a focus on providing competitive returns to their shareholders, which will limit supply growth to that which maintains profitability. Until we see actual evidence of a breakdown in the coalition's willingness to maintain its production-management strategy, we will continue to assume it remains operative. Worrisome COVID-19 Re-Infection Trends Reports of increased re-infection rates in Latin American and Asia-Pacific states providing Chinese Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery. Conclusive data on the efficacy of these vaccines is not available at present, based on reporting from Health Policy Watch (HPW).1 The vast majority of these vaccines were purchased in Latin America and the Asia-Pacific region, where ~ 80% of the 759mm doses of the two Chinese vaccines were sold, according to HPW's reporting. This will draw the attention of markets to this risk (Chart 3). Of particular concern are the increases in re-infection rates in the Seychelles and Chile, where the majority of populations in both countries were inoculated with one of the Chinese vaccines. Re-infections in Indonesia also are drawing attention, where more than 350 healthcare workers were re-infected after receiving the Sinovac vaccination.2 The risk of renewed global lockdowns remains small, but if these experiences are repeated globally with adverse health consequences, this assessment could be challenged. Chart 3COVID-19 Returning In High-Vaccination States Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Transition Risks To A Low-Carbon Economy Over the medium- to long-terms, our metals views are premised on the expectation the build-out of the global EV fleet and renewable electricity generation – including its supporting grids – will require massive increases in the supply of copper, aluminum, nickel, and tin, not to mention iron ore and steel. This surge in demand will be occurring as governments rush headlong into unplanned and unsynchronized wind-downs of investment in the hydrocarbon fuels that power modern economies.3 The big risk here is new metal supplies will not be delivered fast enough to build all of the renewable generation, EVs and their supporting grids and infrastructures to cover the loss of hydrocarbons phased out by policy, legal and boardroom challenges. Such a turn of events would re-invigorate oil and gas production. Renewable energy and electric vehicles are the sine qua non of the drive to achieve net-zero carbon emissions by 2050. However, the rising price of base metals will add to already high costs of rebuilding power grids to make them suitable for green energy. Given miners’ reluctance to invest in new mines, we do not expect metals prices to drop anytime soon. According to Wood Mackenzie, in 2019 the cost of shifting just the US power grid to renewable energy over the next 10 years will amount to $4.5 trillion.4 Given these cost and supply barriers, fossil fuels will need to be used for longer than the IEA outlined in its recent and controversial report on transitioning to a net-zero economy.5 To ensure that fossil fuels can be used while countries work to achieve their net zero goals, carbon capture utilization and storage (CCUS) technology will need to be developed and made cheaper. The main barrier to entry for CCUS technology is its high cost (Chart 4). However, like renewable energy, the more it is deployed and invested in, the cheaper it will become, following the trend seen in the development of renewable energy and EVs, which were aided by large-scale subsidies from governments to encourage the development of the technology. These cost reductions are already visible: In its 2019 report, the Global CCS Institute noted the cost of implementing CCS technology initially used in 2014 had fallen by 35% three years later. Chart 4CCUS Can Be Expensive Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Metals Mines' Long Lead Times In 2020 the total amount of discovered copper reserves in the world stood at ~ 870mm MT (Chart 5), according to the US Geological Service (USGS). As of 2017, the total identified and undiscovered amount of reserves was ~ 5.6 billion MT.6 The World Bank recently estimated additional demand for copper would amount to ~ 20mm MT p.a. by 2050 (Chart 6).7 Glencore’s recently retired CEO Ivan Glasenberg last month said that by 2050, miners will need to produce around 60mm MT p.a. of copper to keep up with demand for countries’ net zero initiatives.8 Even with this higher estimate, if miners focus on exploration and can tap into undiscovered reserves, supply will cover demand for the renewable energy buildout. Chart 5Copper Reserves Are Abundant Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Chart 6Call On Base Metals Supply Will Be Massive Out To 2050 Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views While recent legislative developments in Chile and Peru, which together constitute ~ 34% of total discovered copper reserves, could lead to significantly higher costs as left-of-center governments re-write these states' constitutions, geological factors would not be the main constraint to copper supply for the renewables energy buildout: Even if copper mining companies were to move out of these two countries, there still is about 570 million MT in discovered copper reserves, and nearly ten times that amount in undiscovered reserves. As we have written in the past, capital expenditure restraint is the principal reason the supply side of copper markets – and base metals generally – is challenged (Chart 7). Unlike in the previous commodity boom, this time mining companies are focusing on providing returns to shareholders, instead of funding the development of new mines (Chart 8). Chart 7Copper Prices Remains Parsimonious Copper Prices Remains Parsimonious Copper Prices Remains Parsimonious Chart 8Shareholder Interests Predominate Metals Agendas Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Of course, it is likely metals miners, like oil producers, are waiting to see actual demand for copper and other base metals pick up before ramping capex. Sharp increases in forecasted demand is not compelling for miners, at this point. This means metals prices could stay elevated for an extended period, given the 10-15-year lead times for copper mines (Chart 9). For example, the Kamoa-Kakula mine in the Democratic Republic of Congo (DRC) now being brought on line took roughly 24 years of exploration and development work, before it started producing copper. Technological breakthroughs that increase brownfield projects’ productivity, or significant increases in the amount of recycled copper as a percent of total copper supply would address some of the price pressures arising from the long lead times associated with the development of new copper supply. Another scenario with a non-trivial probability that threatens the viability of metals investing is a breakthrough – or breakthroughs – in CCUS technology, which allows oil and gas producers to remove enough carbon from their fuels to allow firms using these fuels to achieve their net-zero carbon goals. Chart 9Long Lead Times For Mine Development Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Investment Implications Short-term supply-demand issues affecting the oil market at present are transitory, and do not signal a shift in the fundamentals supporting our bullish call on oil. Our thesis based on continued production discipline remains intact. That said, we will continue to subject it to rigorous scrutiny on a continual basis. Our average Brent forecast for 2021 remains $66.50/bbl, with 2H21 prices averaging $70/bbl. For 2022 and 2023 we continue to expect prices to average $74 and $81/bbl, respectively (Chart 10). WTI will trade $2-$3/bbl lower. Our metals view has become slightly more nuanced, thanks to our client conversations. One of the unintended consequences of the unplanned and uncoordinated rush to a net-zero carbon future will be an improvement in the competitive position of oil and gas as transportation fuels and electric-generation fuels going forward. This will be driven by rising costs of developing and delivering the metals supplies needed to effect the net-zero transition. We expect markets will provide incentives to CCUS technologies and efforts to decarbonize oil and gas fuels, which will contribute to the global effort to arrest rising temperatures. This suggests the rush to sell these assets – which is underway at present – could be premature.9 In the extreme, this could be a true counterbalance to the metals story, if it plays out. Chart 10Our Oil Price View Remains Intact Our Oil Price View Remains Intact Our Oil Price View Remains Intact     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The monthly OPEC 2.0 meeting ended without any action to increase monthly supplies, following the UAE's bid to increase its baseline reference production – determined based on October 2018 production levels – to 3.8mm b/d, up from 3.2mm b/d. S&P Global Platts reported the UAE's Energy Minister, Suhail al-Mazrouei, advanced a proposal to raise its monthly production level under the coalition's overall output deal, while KSA's energy minister, Prince Abdulaziz bin Salman, insisted the UAE follow OPEC 2.0 procedures in seeking an output increase. We do not expect this issue to become a protracted standoff between these states. The disagreement between the ministers is procedural to substantive. Remarks by bin Salman last month – to wit, KSA has a role in containing inflation globally – and his earlier assertions that production policy of OPEC 2.0 would be driven by actual oil demand, as opposed to forecasted oil demand, suggest the Kingdom is not aiming for higher oil prices per se. Base Metals: Bullish Spot benchmark iron ore (62 Fe) prices traded above $222/MT this week in China on the back of stronger steel demand, according to mining.com (Chart 11). Market participants are anticipating further steel-production restrictions and appear to be trying to get out in front of them. Precious Metals: Bullish The USD rally eased this week, allowing gold prices to stabilize following the June Federal Open Market Committee (FOMC) meeting. In the two weeks since the FOMC, our gold composite indicator shows that gold started entering oversold territory (Chart 12). We believe gold prices will start correcting upwards, expecting investor bargain-hunting to pick up after the price drop. The mixed US jobs report, which showed the unemployment rate ticked up more than expected, implies that interest rates are not going to be raised soon. Our colleagues at BCA Research's US Bond Strategy (USBS) expect rates to increase only by end-2022.10 This, along with slightly higher odds of a potential COVID-19 resurgence, will support gold prices in the near-term. Ags/Softs: Neutral The USDA's Crop Progress report for the week ended 4 July 2021 showed 64% of the US corn crop was in good to excellent condition, down from the 71% reported for the comparable 2020 date. The Department reported 59% of the bean crop was in good to excellent shape vs 71% the year earlier. Chart 11 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN Chart 12 Sentiment Supports Oil Prices Sentiment Supports Oil Prices     Footnotes 1     Please see Are Chinese COVID Vaccines Underperforming? A Dearth of Real-Life Studies Leaves Unanswered Questions, published by Health Policy Watch, June 18, 2021. 2     According to HPW, the World Health Organization's Emergency Use Listing for these two vaccines "were unique in that unlike the Pfizer, AstraZeneca, Moderna, and Jonhson & Johonson vaccines that it had also approved, neither had undergone review and approval by a strict national or regional regulatory authority such as the US Food and Drug Administration or the European Medicines Agency. Nor have Phase 3 results of the Sinopharm and Sinovac trials been published in a peer-reviewed medical journal.  More to the point, post-approval, any large-scale tracking of the efficacy of the Sinovac and Sinopharm vaccine rollouts by WHO or national authorities seems to be missing." 3    Please see A Perfect Energy Storm On The Way, which we published on June 3, 2021 for additional discussion.  It is available at ces.bcaresearch.com. 4    Please refer to The Price of a Fully Renewable US Grid: $4.5 Trillion, published by greentechmedia 28 June 2019. 5    Please refer to the IEA's Net Zero By 2050, published in May 2021. 6    Please refer to USGS Mineral Commodity Summaries, 2021. 7     Please refer to Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition, published by the World Bank. 8    Please refer to Copper supply needs to double by 2050, Glencore CEO says, published by reuters.com on June 22, 2021. 9    Please see the FT's excellent coverage of this trend in A $140bn asset sale: the investors cashing in on Big Oil’s push to net zero published on July 6, 2021. 10   Please refer to Watch Employment, Not Inflation, published by the USBS on June 15, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand.  This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption.  We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year.  This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023.  Chart 3US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong China Refinery Runs Remain Strong China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Markets Remained Balanced Markets Remained Balanced Chart 7Inventories Continue To Draw Inventories Continue To Draw Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 RBOB Gasoline at a High RBOB Gasoline at a High Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices     Footnotes 1     Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Why Are US Health Care Equipment Manufacturers Ripping Higher? Why Are US Health Care Equipment Manufacturers Ripping Higher? The S&P health care equipment (HCE) index is our only overweight within the health care universe, and over the past several weeks the index has been ripping higher. One of the likely catalysts behind the recent rally in US health care equipment manufacturers is the dollar. With exports accounting for a large portion of overall sales, a depreciating US dollar boosts international competitiveness of US manufacturers (middle panel). In turn, HCE stocks enjoy top line growth. On the domestic front the news is also welcoming. Our operating margin proxy, which gauges the difference between the industry’s PPI and wage bill, has made a clear U-turn (bottom panel). The upshot is that earnings will get a boost from this looming margin expansion. Bottom Line: We remain overweight the S&P HCE index. The ticker symbols for the stocks in the index are: BLBG: S5HCEP – ABT, MDT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMD, TFX, HOLX, ABMD, VAR, STE, DXCM.  

Highlights We reiterate our longstanding overweight on healthcare equities for the next 12 months and possibly beyond. The macro environment, as well as underlying demand factors, will continue to drive the sector’s outperformance. Within healthcare equities, we favor biotechnology and healthcare technology over pharmaceuticals. Healthcare corporate bonds, however, are not especially attractive, and therefore warrant no more than a neutral position. Feature Chart 1Healthcare Has Outperformed Over The Past Decade... Healthcare Has Outperformed Over The Past Decade... Healthcare Has Outperformed Over The Past Decade... Over the past decade, global health care stocks have been clear outperformers, alongside information technology and consumer discretionary stocks, rising by almost 50% relative to the broad market (Chart 1). Not only have they benefited from increased demand from an aging population in developed economies and a growing middle class in emerging markets, they have also provided a downside cushion during recessions and bear markets, given their defensive, non- cyclical nature. The COVID-19 pandemic leads us to reiterate our longstanding overweight position on global healthcare equities over the next 12 months and possibly beyond. Favorable tailwinds will continue to drive healthcare outperformance. It is likely that government spending on healthcare will increase over the coming years. Innovative solutions in healthcare technology (healthtech), as well as increased overall research and development (R&D), the shift to value-based healthcare delivery, the focus on preventive medicine, and a low risk of substantial regulatory change and reform (at least in the US, assuming former Vice President Biden is elected president this November) should continue to support the sector’s outperformance. In this Special Report, we analyze whether our long-term overweight position on healthcare equities remains valid. In a later section, we also review healthcare-related investments in bonds and private equity. Why We Like Healthcare BCA Research’s Global Asset Allocation (GAA) service has been positive on global healthcare stocks for over five years. The main reason is that we see demand for healthcare services continuing to rise, as life expectancy increases, populations age – people over 65 will comprise 25% of the developed world’s population by 2040, up from 15% in 2020 – and the middle class in emerging economies becomes richer (Charts 2&3). As people live longer, healthcare spending should rise since, after the age of 65 (retirement), it tends to squeeze out discretionary spending (Chart 4). Chart 2...As The Global Population Grew Older... ...As The Global Population Grew Older... ...As The Global Population Grew Older... Chart 3...And Richer ...And Richer ...And Richer       Healthcare spending everywhere represents a large proportion of GDP, but the percentage varies considerably between countries. In the US for example, healthcare spending comprises 16.9% of GDP, higher than in other advanced economies, where it averages 9.9%, and substantially higher than in emerging economies (average 6.5% of GDP) (Chart 5). It is likely that these figures will increase over the next few years. Chart 4Healthcare Expenditure Dominates Late-Life Spending Healthcare Expenditure Dominates Late-Life Spending Healthcare Expenditure Dominates Late-Life Spending Chart 5Spending On Healthcare Will Rise Spending On Healthcare Will Rise Spending On Healthcare Will Rise   A strong case can be made for serious outbreaks of infectious diseases becoming more common, and therefore governments will have to increase their readiness. The number of countries experiencing a significant outbreak has almost doubled over the past decade, after being on a declining trend during the prior 15 years (Chart 6). The World Health Organization (WHO) warns that, while pandemics are rare, highly disruptive regional and local outbreaks are becoming more frequent and causing more economic damage.1 The non-cyclical nature of healthcare demand makes the industry less vulnerable to economic downturns. In times of below-trend growth, investors rush into defensive-growth stocks. Over the past two recessions, the drawdown of healthcare equities was, respectively, 20% and 27% less than the broad market. Chart 6Number Of Countries Experiencing Serious Outbreak Of Infectious Disease The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight Chart 7The Defensive Side Of Healthcare The Defensive Side Of Healthcare The Defensive Side Of Healthcare   However, the sector is not totally cyclically insensitive, given its capital intensity and reliance on debt. In the US, healthcare sector debt amounts to almost $500 billion (Chart 7). This also leaves it vulnerable to rising interest rates. Nevertheless, the current macro outlook should keep a lid on interest rates for some time. The healthcare industry has lagged in digitalization (Chart 8). This offers wide-ranging opportunities for the sector, particularly in healthtech, biotechnology, and pharmaceuticals. Innovative solutions in robotics, artificial intelligence (AI), and genomics will drive the industry in the years to come. Digitalization will accelerate productivity and improve profitability. Chart 8The Healthcare Sector Is Way Behind In Digitalization The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight Lastly, valuations for healthcare equities in most countries remain attractive, close to their long-run averages. The only exceptions are the UK and Japan, which are two standard deviations above the historical mean relative to their respective markets (Chart 9). The Future Of Healthcare Every crisis provides insights into what went wrong, what needs to be changed, and what areas should be explored. The COVID-19 pandemic is no exception. The pandemic has highlighted supply-chain fragilities, particularly a shortage of some healthcare equipment and drugs, the production of which is outsourced. In the US, for example, according to the Food and Drug Administration (FDA), over 70% of facilities producing essential medicines for the US are located abroad (Chart 10). Chart 9Valuations Remain Reasonable Valuations Remain Reasonable Valuations Remain Reasonable Chart 10Supply Chain Fragilities The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight   Some argue that reshoring healthcare production is essential. Joe Biden, favored to be the next US president, has highlighted this in his plan to rebuild US supply chains.2 This could, however, lead to higher healthcare costs. This would either require increased government spending to subsidize medical expenses, or lead to fewer people being able to afford adequate healthcare. This effect would be pronounced in economies where a large percentage of the population is uninsured, around 10% in the US, and much more so in some emerging economies where healthcare quality is poor. This might be less of a risk for pharmaceutical and biotechnology companies, where the largest cost of bringing a new drug to market is R&D and marketing, rather than manufacturing. In the first months of the outbreak, resources such as ventilators, hospital and ICU beds, and basic personal protective equipment (PPE) quickly became scarce. Inventories of such items and overall hospital capacity will need to increase. This will entail massive investments to boost the public healthcare infrastructure and increase the number of healthcare workers. Chart 11COVID-19 Unveiled Poor Health Standards... The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight The pandemic also underlined weaknesses in social and health standards. The excessive number of deaths from COVID-19 in nursing homes in some developed economies emphasizes the need for investment in this area. For example in Quebec, Canada, a staggering 80% of the province’s deaths occurred in nursing homes and senior residences (both public and private), illustrating the mismanagement and lack of funding (Chart 11). Most notably, care homes run for profit (approximately 70% of the total in the US) have seen almost four times as many COVID-19 infections as those not. The quality ratings of for-profit nursing homes, as measured by the Centers for Medicare and Medicaid Services (CMS), are much lower on average than those of non-profit or government-run facilities (Chart 12). This could imply the mass nationalization of nursing homes. However, this is unlikely. A better option would be to impose higher standards on privately run homes, reducing the sector to a smaller number of high-quality providers. Chart 12...In Most For-Profit Nursing Homes The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight Chart 13The Evolution Of Genome Sequencing Is Illustrated In The Price The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight More positively, there remains a large gap to be filled by a new era of technology-driven, integrated, and online healthcare. Investments in biotechnology – particularly related to genetic information – are also likely to increase, as DNA sequencing becomes cheaper (Chart 13). The way patients interact with physicians will also change. The American Medical Association (AMA) surveyed more than 1000 physicians on the use of digital tools in their practices. Reliance on digital tools for monitoring and clinical support has increased significantly over the past three years. The largest jump however was in the number of practices using telemedicine and virtual visits (Chart 14). Chart 14The Transition To A Digital-Driven Healthcare Model The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight “Contact tracing” is a term that has been widely used during the coronavirus outbreak. The ability to track those infected and monitor their interactions to limit the spread of the virus is seen as a crucial step to mitigate further contagion. This would help not only to eradicate the virus, but might be developed into a long-lasting technology. Similar to how security screening equipment was developed after 9/11, there should be investment opportunities in the medical-screening segment. Breaking Down Healthcare Equities It is important to note that not all healthcare equities are equal: Different regions and industries have performed differently. In this report, we distinguish between the industry groups and subgroups, based on the GICS Level 2 and Level 3 classifications. We also look at the nine largest regions in the MSCI indexes to see if certain regions provide more favorable opportunities. Healthcare equities are broken down into two industry groups, which in turn break down into six industries: Healthcare equipment & services Healthcare equipment & supplies Healthcare providers & services Healthcare technology Pharmaceuticals, biotechnology & life sciences Pharmaceuticals Biotechnology Life sciences tools & services In Table 1, we drill down the constituent weights of the MSCI healthcare indexes. This allows us not only to analyze the size of the sector and its parts, but also to gain multiple insights. For example, a bet on Swiss healthcare stocks is essentially a bet on pharmaceuticals, given the greater-than-80% weighting of that industry. Exposure to the overall Danish equity index is by default a play on healthcare stocks, since they comprise almost 60% of the index. Table 1Global Healthcare Weights The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight Chart 15Healthcare Has Outperformed Broad Indices Globally... Healthcare Has Outperformed Broad Indices Globally... Healthcare Has Outperformed Broad Indices Globally... As noted earlier, global healthcare stocks have outperformed the broad index by almost 50% over the past decade. This is true across all regions. However, several distinctions can be made. US, Swiss, and Danish healthcare equities have outperformed the global healthcare benchmark over the past decade, but their counterparts in the euro area, UK, and Japan have lagged (Chart 15). On a risk-adjusted basis, Danish healthcare equities have been the best performer with a Sharpe-ratio of 0.84 and an annualized return of 18% since 2000 (Table 2).   Table 2...However Not All Healthcare Stocks Are Alike The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight Investment Opportunities Chart 16Within Healthcare Equities, Favor Biotechnology and Healthcare Technology... Within Healthcare Equities, Favor Biotechnology and Healthcare Technology... Within Healthcare Equities, Favor Biotechnology and Healthcare Technology... Viewing healthcare as a set of separate segments, rather than as a single industry, highlights pockets of opportunity.  A selective approach might be preferable for asset allocators in the coming years. As discussed in The Future Of Healthcare section, the sector is likely to shift to a model that relies more on technology, is data-driven, and harnesses the power of digitization, robotics, and AI. The patient will be at the center of the new healthcare model.  We divide our overview of investment opportunities into three categories: equities, corporate bonds, and private investments. Equities: Based on our view of the future of healthcare and the structure of the GICS equity classifications, we favor biotechnology and healthcare technology, and would have only a benchmark allocation to pharmaceuticals. There are insights to be drawn from the fundamentals, historical performance, and valuation metrics. Historically, pharmaceutical equities stand out as the worst performers within the sector. Over the past decade, they have underperformed the global healthcare benchmark by 20%, whereas biotechnology and healthcare technology stocks have outperformed by 59% and 127%, respectively (Chart 16). The outperformance of biotechnology has predominantly been earnings-driven, whereas pharmaceuticals’ and healthcare technology stock prices appear to be detached from earnings (Chart 17). It is worth nothing that despite the fact that valuations for those industries appear expensive relative to the broad market, we remain positive on their outlook. As we drill deeper into Level 3 industries, the small number of constituents within the index makes relying on valuations challenging (Chart 18). Chart 17..Despite A Detachment From Earnings... ..Despite A Detachment From Earnings... ..Despite A Detachment From Earnings... Chart 18...And Elevated Valuations ...And Elevated Valuations ...And Elevated Valuations   Chart 19No Attractive Opportunities Within Healthcare Corporate Bonds No Attractive Opportunities Within Healthcare Corporate Bonds No Attractive Opportunities Within Healthcare Corporate Bonds Corporate Bonds: Within the corporate bond universe, we favor those that qualify for central banks’ purchase programs: Investment-grade bonds and the highest tranche of high-yield. BCA Research’s US fixed-income strategists have an overweight recommendation on US healthcare corporate bonds, though their recommendations are based on a six-to-12 month investment horizon rather than the longer perspective that we are taking in this report.3 Both healthcare and pharmaceuticals bonds, similar to their equity counterparts, trade defensively, outperforming the broad corporate index when spreads widen and underperforming as they tighten (Chart 19). This applies to both investment-grade and high-yield bonds. The credit risk measure favored by our US bond strategists is the duration-times-spread (DTS) ratio. This measure confirms the sector’s defensive nature: A value below 1 implies credit risk lower than the market. However, the recent uptick in the DTS ratio of healthcare investment-grade bonds shows the sector has become riskier and as such may trade more cyclically in the short term. Nevertheless, the macro environment should remain favorable. Pricing power is still strong, with medical care services rising by almost 6.0%, and drug prices rising by 1.4% on a year-over-year basis, outpacing overall consumer prices (Chart 20). Neither segment within the investment-grade space offers an attractive spread advantage over the broad index. However, the risk outlook for healthcare remains better than that for pharmaceuticals, particularly related to political risk (as discussed later in the Risks section). Private Investments: Venture-capital investments in healthtech reached a quarterly record high of $8.2 billion in Q1 2020. The recent pandemic is likely only to push this trend higher. Moreover, large private-equity investments in recent years have been targeted at biopharma.4 According to Bain & Company, global biopharma private-equity deals where value was disclosed, reached $40.7 billion in 2019, up from $16.5 billion the prior year.5  The number of biotech firms going public is also trending up, despite slipping to 48 in 2019 from 58 in 2018 (Chart 21). To date (as of early June), 21 out of 43 US IPOs this year are healthcare-related. Chart 20Pricing Power Remains Favorable Pricing Power Remains Favorable Pricing Power Remains Favorable Chart 21More Biotech IPOs Are Coming To Market The Healthcare Revolution: The Case For Staying Overweight The Healthcare Revolution: The Case For Staying Overweight   Additionally, M&A activity has been increasing, particularly within the biotechnology segment, although the economic shutdown has slowed the deal flow recently. The number of M&A deals peaked in March 2020, when the average premium is 45% (Chart 22). The long-term rising trend is likely to persist. Over the next year, firms with drugs or vaccines related to COVID-19 would be clear targets for acquisitions and should outperform. Over the long term, we also expect to see some industry consolidation. Risks We see the following as the biggest risks to our overall positive outlook for healthcare investments: Quicker-Than-Expected Economic Growth Rebound: As we highlighted, the healthcare sector is defensive – outperforming the broad market during recessions and economic slowdowns. However, if growth rebounds more quickly, driven by further fiscal and monetary stimulus, the upside for healthcare performance could be challenged. Political Risk: Joe Biden might swing to the left in the run-up to the US presidential election to bring on board supporters of Elizabeth Warren and Bernie Sanders. Nevertheless, we see that particular risk for healthcare as relatively small (Chart 23). Biden’s approach is to restore and expand Obamacare (the Affordable Care Act, or ACA), shifting some of the burden of healthcare spending from individuals to the government. Overall, this should be positive for healthcare spending, particularly for insurers and healthcare providers. However, pharmaceutical companies may face headwinds if the administration imposes price caps on drug prices. Chart 22Secondary Market Activity Is Also Strong Secondary Market Activity Is Also Strong Secondary Market Activity Is Also Strong Chart 23Political Risk Has Waned As Biden's Chances Of Election Have Increased Political Risk Has Waned As Biden's Chances Of Election Have Increased Political Risk Has Waned As Biden's Chances Of Election Have Increased Chart 24Reliance On Inorganic Growth Might Prove Unsustainable Reliance On Inorganic Growth Might Prove Unsustainable Reliance On Inorganic Growth Might Prove Unsustainable Lack Of Innovation: Over the past two decades, the healthcare sector has shifted to relying on inorganic growth, driven by takeovers, rather than on research and development. Capital expenditure as a percentage of sales by both pharmaceutical and biotechnology firms fell sharply in the 2000s and has stagnated around 2% and 4%, respectively since (Chart 24). Only A Few Make It: While more IPOs in the healthcare sector is a sign of improving innovation, it is worth noting that only a few newly listed companies are successful. Over the past decade, only 3% of the 349 biotech IPOs had positive earnings at the time of their IPO. This nevertheless is a consequence of the nature of the industry: Companies tend to list while they await a big breakthrough in product development or regulatory approval. Conclusion We continue to recommend investors hold an above-benchmark allocation to healthcare-related investments on a long-term basis. Aging populations, the need to improve the quality of global healthcare, a likely increase in government spending, the shift to digitalized healthcare, and demand which is non-cyclical all support this stance. Healthcare equities in general, and particularly biotechnology and healthcare technology, should perform well over the coming years. For investors with global mandates, allocations to US, Swiss, and Danish healthcare equities should outperform those in the euro area, Japan, and the UK. Corporate bonds do not offer any advantage over the broad corporate US bond index. Political risks for the US healthcare sector should be limited even if the Democrats win the White House. However, the risk is highest for pharmaceuticals, in the event where the government imposes price caps.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1  "World Economic Forum, Outbreak Readiness and Business Impact, Protecting Lives and Livelihoods across the Global Economy," January 2019. 2  For more info please see Joe Biden https://joebiden.com/supplychains/ 3  Please see US Bond Strategy, "Assessing Healthcare & Pharma Bonds In A Pandemic," dated June 9, 2020.available at usbs.bcaresarch.com. 4  Biotech refers to manufactured products that rely on using living systems and organisms. The biopharma industry is backed by biotechnology, the science, which allows products to be manufactured biologically. 5  Bain & Company, Global Healthcare Private Equity and Corporate M&A Report 2020.

Highlights Global shortages of medical equipment – including medicines – are frontloaded until emergency production kicks in. As the crisis abates, political recriminations between the US and China will surge. The US will seek to minimize medical supply exposure to China going forward, a boon for India and Mexico. China has escaped the COVID-19 crisis with minimal impact on food supply. Pork prices are surging due to African Swine Flu, but meat is a luxury. Still, the “Misery Index” is spiking and this will increase social instability. Food insecurity, inflation, and large current account deficits suggest that emerging market currencies will remain under pressure. Turkey and South Africa stand to suffer while we remain overweight Malaysia. Feature Chart 1Collapse In Economic Activity Collapse In Economic Activity Collapse In Economic Activity With a third of the world population under some form of lockdown, general activity in the world’s manufacturing powerhouses has collapsed (Chart 1). The breakdown is a double whammy on market fundamentals. On the supply side, government-mandated containment efforts force workers in non-essential services to stay home while, on the demand side, households confined to their homes are unable to spend. Acute demand for medical supplies is causing shortages, while supply disruptions threaten states that lack food security. While global monetary and fiscal stimulus will soften the blow (Chart 2), the economic shock is estimated to be a 2% contraction in real GDP for every month of strict isolation. If measures are extended beyond April, markets will sell and new stimulus will be applied. Already the US Congress is negotiating the $1-$2 trillion infrastructure package that we discussed in our March 4 report, and cash handouts will be ongoing. When the dust settles the political fallout will be massive. Authoritarian states like China and especially Iran will face greater challenges maintaining domestic stability. Democracies like Italy and the US, which lead the COVID-19 case count, are the most likely to experience a change in leadership (Chart 3). Initially the ruling parties of the democracies are receiving a bump in opinion polling, but this will fade as households will be worse off and will likely vent their grievances at the ballot box. Chart 2 Chart 3 Until a vaccine or treatment is discovered, medical equipment and social distancing are the only weapons against the pandemic. National production is (rightly) being redirected from clothing and cars to masks and ventilators to meet the spike in demand. Will the supply shock cause shortages in food and medicine – essential goods for humankind? In this report we address the impact of COVID-19 on global supply security and assess the market implications. Medical Equipment Shortages Will Spur Protectionism Chart Policymakers are fighting today’s crisis with the tools of the 2008 crisis, but a lasting rebound in financial markets will depend on surmounting the pandemic, which is prerequisite to economic recovery (Table 1). As the US faces the peak of its COVID-19 outbreak, public health officials and doctors are raising the alarm on the shortage of medical supplies. A recent US Conference of Mayors survey reveals that out of the 38% of mayors who say they have received supplies from their state, 84.6% say they are inadequate (Chart 4). Italy serves as a warning: A reported 8% of the COVID-19 cases there are doctors and health professionals, often treating patients without gloves or with compromised protective gear. These workers are irreplaceable and when they succumb the virus cannot be contained. In the US, doctors and nurses are re-using masks and sometimes treating patients behind a mere curtain, highlighting the supply shortage. While the shortages are mainly driven by a surge in demand from both medical institutions and households, they also come from the supply side, particularly China. Factory closures and transportation disruptions in China earlier this year, coupled with Beijing’s government-mandated export curbs, reduced Chinese exports, a major source of US and global supplies (Chart 5). Chart 4 Chart 5 Other countries have imposed restrictions on exports of products used in combating the spread of COVID-19. Following export restrictions by the French, German, and Czech governments in early March, the European Commission intervened on March 15 to ensure intra-EU trade. It also restricted exports of protective medical gear outside of the EU. At least 54 nations have imposed new export restrictions on medical supplies since the beginning of the year.1 Both European and Chinese measures will reduce supplies in the US, the top destination for most of these halted exports (Chart 6). Chart 6 Thus it is no wonder that the Trump administration has rushed to cut import duties and boost domestic production. The administration has released strategic stockpiles and cut tariffs on Chinese medical equipment used to treat COVID-19. With the whole nation mobilized, supply kinks should improve greatly in April. After a debacle in rolling out test kits (Chart 7), the US is rapidly increasing its testing capabilities to manage the crisis, with over a million tests completed as of the end of March (Chart 8). Meanwhile a coalition of companies is taking shape to make face masks. The president has invoked the defense production act to force companies to make ventilators. Chart 7 Chart 8 However, with the pandemic peaking in the US, the hardest-hit regions will continue experiencing shortages in the near term. Shortages are prompting public outcry against the US government for its failure to anticipate and redress supply chain vulnerabilities that were well known and warned against. A report in The New York Times tells how Mike Bowen, owner of Texas-based mask-maker Prestige Ameritech, has advised the past three presidents about the danger in the fact that the US imports 95% of its surgical masks. “Aside from sitting in front of the White House and lighting myself on fire, I feel like I’ve done everything I can,” he said. He is currently inundated with emergency orders from US hospitals. The same report tells of a company called Strong Manufacturers in North Carolina that had to cut production of masks because it depends on raw materials from Wuhan, China, where the virus originated.2 The Trump administration will suffer the initial public uproar, but the US government will also seek to reduce import dependency going forward, and it will likely deflect some of the blame by focusing on the supply risks posed by China. Beijing, for its part, is launching a propaganda campaign against the US to distract from its own failures at home (some officials have even blamed the US for the virus). Meanwhile it is cranking up production and shipping medical supplies to crisis hit areas like Italy to try to repair its global image after having given rise to the virus. In addition, the city of Shenzhen is sending 1.2 million N95 masks to the US on the New England Patriots’ team plane. Even Russia is sending small donations. But these moves work to propagandistic efforts in these countries and will ultimately shame the Americans into taking measures to improve self-sufficiency. Bottom Line: The most important supply shortage amid the global pandemic is that of medical equipment. While these shortages will abate sooner rather than later, the supply chain vulnerabilities they have exposed will trigger new policies of supply redundancy and import substitution. The US in particular will seek to reduce dependency on China. That COVID-19 is aggravating rather than reducing tensions between these states, despite China’s role as a key supplier in a time of need, highlights the secular nature of their rising tensions. The US-China Drug War Shortages of pharmaceuticals are also occurring, despite the fact that the primary pandemic response is necessarily “non-pharmaceutical” (e.g. social distancing). The US Food and Drug Administration (FDA) announced the first COVID-19 related drug shortage in the US on February 27. While the specific drug was not disclosed, the announcement notes that “the shortage is due to an issue with manufacturing of an active pharmaceutical ingredient used in the drug.”3 The FDA is monitoring 20 other (non-critical) drugs potentially at risk of shortages because the sole source is China. The global spread of the pandemic will increase these shortages. On March 3 India announced export restrictions on 26 drugs, including paracetamol and several antibiotics, due to supply disruptions caused by the Chinese shutdown. While Chinese economic activity has since picked up, India is now among the string of countries under a nationwide lockdown. Similar measures enforced across Europe will also hamper the production and transportation of these goods. The implication is that even if Chinese drugs return to market, supplies further down the chain and from alternative suppliers will take a hit. The risk that this will evolve into a drug shortage depends on the intensity of the outbreak. Drug companies generally hold 3-6 months’ worth of inventories. Consequently, while inventories are likely to draw as supplies are disrupted, consumers may not experience an outright shortage immediately. In the US, as with equipment and protective gear, the government’s strategic stockpile will buffer against shortfalls in supplies of critical drugs. COVID-19 is aggravating rather than reducing US-China tensions. Nevertheless the supply chain is getting caught up in the larger US-China strategic conflict. Even before the pandemic, the US-China trade war brought attention to the US’s vulnerabilities to China’s drug exports. This dispute is not limited to illicit drugs, as with China’s production of the opioid fentanyl, but also extends to mainstream medicines, as highlighted in the selection of public statements shown in Table 2. Chart Chart 9 How much does the US rely on China for medicine? According to FDA data, just over half of manufacturing facilities producing regulated drugs in finished dosage form for the US market are located abroad, with China’s share at 7% (Chart 9).4 The figures are higher for manufacturing facilities producing active pharmaceutical ingredients, though still not alarming – 72% of the facilities are located abroad, with 13% in China. Of course, high-level data understate China’s influence. The complex nature of global drug supply chains means that the source of finished dosage forms masks dependencies and dominance higher up the supply chain (Figure 1). Chart For instance, active pharmaceutical ingredients produced in Chinese facilities are used as intermediate goods by finished dosage facilities in India as well as China. The FDA reports that Indian finished dosage facilities rely on China for three-quarters of the active ingredients in their generic drug formulations, which are then exported to the US and the rest of the world. Any supply disruption in China – or any other major drug producer – will lead to shortages further down the supply chain. Chart 10 Chinese influence becomes more apparent when the sample is restricted to generic prescription drugs. These are especially relevant because nearly 70% of Americans are on at least one prescription drug, of which more than 90% are dispensed in the generic form. In this case, 87% of ingredient manufacturers and 60% of finished dosage manufacturers are located outside the US, with 17% of ingredient facilities and 8% of dosage facilities in China (Chart 10). Of all the facilities that manufacture active ingredients that are listed on the World Health Organization’s Essential Medicines List – a compilation of drugs that are considered critical to the health system – 71% are located aboard with 15% located in China (Chart 11). Moreover, manufacturers are relatively inflexible when adapting to market conditions and shortages. Drug manufacturing facilities generally operate at above 80% of their capacity and are thus left with little immediate capacity to ramp up production in reaction to shortages elsewhere. In addition, manufacturers face challenges in changing ingredient suppliers – there is no centralized source of information on them, and additional FDA approvals are required. The US will look to reduce its dependency on China for its drug supplies regardless of 2020 election outcome. China also has overwhelming dominance in specific categories. The Council on Foreign Relations reports that China makes up 97% of the US antibiotics market.5 Other common drugs that are highly dependent on China for supplies include ibuprofen, acetaminophen, hydrocortisone, penicillin, and heparin (Chart 12). Chart 11 Chart 12 Taking it all together, US vulnerability can be overstated. Consider the following: Of the 370 drugs on the Essential Medicines List that are marketed in the US, only three are produced solely in China. None of these three are used to treat top ten causes of death in the United States. Import substitution is uneconomical. Foreign companies, especially Chinese companies, are attractive due to their lower costs and lax regulations. While China’s influence extends higher up the supply chain, this is true for US markets as well as other consumer markets. While China can cut off the US from the finished dosages it supplies, it cannot do the same for the ingredients that are used by facilities in other countries and eventually make their way to the US in finished dosage form. Americans are demanding that drug prices be reduced and an obvious solution is looser controls on imports. The recent activation of the Defense Production Act shows that the US can take action to boost domestic production in emergencies. Nevertheless, China is growing conspicuous to the American public due to general trade tensions and COVID-19. As it moves up the value chain, it also threatens increasing competition for the US and its allies. Hence the US government will have a strategic reason to cap China’s influence that is also supported by corporate interests and popular opinion. This will lead to tense trade negotiations with China and meanwhile the US will seek alternative suppliers. China will not want to lose market share or leverage over the United States, so it may offer trade concessions at some point to keep the US engaged. Ultimately, however, strategic tensions will catalyze US policy moves to reduce the cost differential with China and promote its rivals. Pressure on China over its currency, regulatory standards, and scientific-technological acquisition will continue regardless of which party wins the White House in 2020. The Democrats would increase focus on China’s transparency and adherence to international standards, including labor and environmental standards. Both Republicans and Democrats will try to boost trade with allies. The key beneficiaries will be India, Southeast Asia, and the Americas. Taiwan’s importance will grow as a middle-man, but so will its vulnerability to strategic tensions. Bottom Line: The US and the rest of the world are suffering shortfalls of equipment necessary to combat COVID-19. There is also a risk of drug shortages stemming from supply disruptions and emergency protectionist policies. These shortages look to be manageable, but they have exposed national vulnerabilities that will be reduced in future via interventionist trade policies. While the US and Europe will ultimately manage the outbreak, the political fallout will be immense. The US will look to reduce its dependency on China. This will increase investment in non-China producers of active pharmaceutical ingredients, such as India and Mexico. The US tactics against China will vary according to the election result, but the strategic direction of diversifying away from China is clear and will have popular impetus in the wake of COVID-19. Food Security In addition to the challenges posed by COVID-19 on medical supplies, food – another essential good – also faces risk of shortages. China is a case in point. Food prices there were on the rise well before the COVID-19 outbreak, averaging 17.3% in the final quarter of 2019. However inflation was limited to pork and its substitutes – beef, lamb and poultry – and reflected a reduction in pork supplies on the back of the African Swine Flu outbreak. While year-on-year increases in the prices of pork and beef averaged 102.8% and 21.0%, respectively, grain, fresh vegetable, and fresh fruit prices averaged 0.6%, 1.5%, and -5.0% in Q42019 (Chart 13). Chart 13Chinese Inflation Has (Thus far) Been Contained To Pork Chinese Inflation Has (Thus far) Been Contained To Pork Chinese Inflation Has (Thus far) Been Contained To Pork Chart 14China's Misery Index Is Spiking - A Political Liability China's Misery Index Is Spiking - A Political Liability China's Misery Index Is Spiking - A Political Liability However China’s COVID-19 containment measures had a more broad-based impact on food supplies, threatening to push up China’s Misery Index (Chart 14). Travel restrictions, roadblocks, quarantined farm laborers, and risk-averse truck drivers introduced challenges not only in ensuring supplies were delivered to consumers, but also to daily farm activity and planting. The absence of farm inputs needed for planting such as seeds and fertilizer, and animal feed for livestock, was especially damaging in regions hardest hit by the pandemic. Livestock farmers already struggling with swine flu-related reductions in herd sizes were forced to prematurely cull starving animals, cutting the stock of chicken and hogs. Now as the country transitions out of its COVID-19 containment phase and moves toward normalizing activity (Chart 15), food security is top of the mind. Authorities are emphasizing the need to ensure sufficient food supplies and adopt policies to encourage production.6 This is especially important for crops due to be planted in the spring. Delayed or reduced plantings would weight on the quality and quantity of the crops, pushing prices up. Chart 15 With food estimated to account for 19.9% of China’s CPI basket – 12.8% of which goes towards pork (Chart 16) – a prolonged food shortage, or a full-blown food crisis, would be extremely damaging to Chinese families and their pocketbooks. Chart 16 However, apart from soybeans and to a lesser extent livestock, China’s inventories are well stocked (Chart 17) and are significantly higher than levels amid the 2006-2008 and 2010-2012 food crises. Inventories have been built up specifically to provide ammunition precisely in times of crisis. Corn and rice stocks are capable of covering consumption for nearly three quarters of a year, and wheat stocks exceeding a year’s worth of consumption. Thus, while not completely immune, China today is better able to weather a supply shock. Moreover, with the exception of soybeans, China is not overly dependent on imports for agricultural supplies (Chart 18). Chart 17   Chart 18 As the COVID-19 epicenter shifts to the US and Europe, farmers there are beginning to face the same challenges. Reports of delays in the arrival of shipments of inputs such as fertilizer and seeds have prompted American farmers to prepare for the worst and order these goods ahead of time. Chart 19 While these proactive measures will help reduce risks to supply, farmers in Europe and parts of the US who typically rely on migrant laborers will need to search for alternative laborers as the planting season nears. Just last week France’s agriculture minister asked hairdressers, waiters, florists, and others that find themselves unemployed to take up work in farms to ensure food security. As countries become increasingly aware of the risks to food supplies, some have already introduced protectionist measures, especially in the former Soviet Union: The Russian agriculture ministry proposed setting up a quota for Russian grain exports and has already announced that it is suspending exports of processed grains from March 20 for 10 days. Kazakhstan suspended exports of several agricultural goods including wheat flour and sugar until at least April 15. On March 27, Ukraine’s economy ministry announced that it was monitoring wheat export and would take measures necessary to ensure domestic supplies are adequate. Vietnam temporarily suspended rice contracts until March 28 as it checked if it had sufficient domestic supplies. The challenge is that, unlike China, inventories in the rest of the world are not any higher than during the previous food crisis and do not provide much of a buffer against supply shortfalls (Chart 19). Higher food prices would be especially painful to lower income countries where food makes up a larger share of household spending (Chart 20). In addition to using their strategic food stockpiles, governments will attempt to mitigate the impact of higher food prices by implementing a slew of policies: Chart 20 Trade policies: Producing countries will want to protect domestic supplies by restricting exports – either through complete bans or export quotas. Importing countries will attempt to reduce the burden of higher prices on consumers by cutting tariffs on the affected goods. Consumer-oriented policies: Importing countries will provide direct support to consumers in the form of food subsidies, social safety nets, tax reductions, and price controls. Producer-oriented policies: Governments will provide support to farmers to encourage greater production using measures such as input subsidies, producer price support, or tax exemptions on goods used in production. While these policies will help alleviate the pressure on consumers, they also result in greater government expenditures and lower revenues. Thus, subsidizing the import bill of a food price shock can weigh on public finances, debt levels, and FX reserves. Currencies already facing pressure due to the recessionary environment, such as Turkey, South Africa and Chile will come under even greater downward pressure. Food inventories ex-China are insufficient to protect against supply shortages. Bottom Line: COVID-19’s logistical disruptions are challenging farm output. This is especially true when transporting goods and individuals across borders rather than within countries. This will be especially challenging for food importing countries, as some producers have already started erecting protectionist measures and this will result in an added burden on government budgets that are already extended in efforts to contain the economic repercussions of the pandemic. Investment Implications Chart 21Ag Prices Inversely Correlated With USD Ag Prices Inversely Correlated With USD Ag Prices Inversely Correlated With USD China will continue trying to maximize its market share and move up the value chain in drug production. At the same time, the US is likely to diversify away from China and try to cap China’s market share. This will result in tense trade negotiations regardless of the outcome of the US election. The COVID-19 experience with medical shortages and newfound public awareness of potential medical supply chain vulnerabilities means that another round of the trade war is likely. Stay long USD-CNY. Regarding agriculture, demand for agricultural commodities is relatively inelastic. This inelasticity should prevent a complete collapse in prices even amid a weak demand environment. Thus given the risk on supplies, prices face upward pressure. However, not all crops are facing these same market dynamics. While wheat and rice prices have started to move in line with the dynamics described above, soybeans and to a greater extent corn prices have not reacted as such (Chart 21). In the case of soybeans, we expect demand to be relatively muted. China accounts for a third of the world’s soybean consumption. 80% of Chinese soybeans are crushed to produce meal to feed China’s massive pork industry. However, the 21% y/y decline in pork output in 2019 on the back of the African Swine Flu outbreak will weigh on demand and mute upward pressures on supplies. Demand for corn will also likely come in weak. The COVID-19 containment measures and the resulting halt in economic activity reduce demand for gasoline and, as a consequence, reduce demand for corn-based ethanol, which is blended with gasoline. In addition to the above fundamentals, ag prices have been weighed down by a strong USD which makes ex-US exporters relatively better off, incentivizing them to raise exports and increase global supplies. A weaker USD – which we do not see in the near term – would help support ag prices. It is worth noting that if there is broad enforcement of protectionist measures, then producers will not be able to benefit from a stronger dollar. In that case we may witness a breakdown in the relationship between ag prices and the dollar. In light of these supply/demand dynamics, we expect rice and wheat prices to be well supported going forward and to outperform corn and soybeans.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 See "Tackling COVID-19 Together: The Trade Policy Dimension," Global Trade Alert, University of St. Gallen, Switzerland, March 23, 2020. 2 See Rachel Abrams et al, "Governments and Companies Race to Make Masks Vital to Virus Fight," The New York Times, March 21, 2020. 3 The announcement also notes that there are other alternatives that can be used by patients. See "Coronavirus (COVID-19) Supply Chain Update," US FDA, February 27, 2020. 4 All regulated drugs include prescription (brand and generic), over the counter, and compounded drugs. 5 Please see Huang, Yanzhong, "The Coronavirus Outbreak Could Disrupt The US Drug Supply," Council on Foreign Relations, March 5, 2020. 6 The central government ordered local authorities to allow animal feed to pass through checkpoints amid the lockdowns. In addition, Beijing has relaxed import restrictions by lifting a ban on US poultry products and announcing that importers could apply for waivers on goods tariffed during the trade war such as pork and soybeans. The lifting of these restrictions also serves to help China meet its phase one trade deal commitments. Please see "Coronavirus hits China’s farms and food supply chain, with further spike in meat prices ahead," South China Morning Post, dated February 21, 2020.

Overweight Stick With Health Care Equipment Stick With Health Care Equipment While our overweight S&P health care equipment (HCE) call has given up some of its gains since inception, profit fundamentals have not changed and we continue to recommend an above benchmark allocation in this defensive sector. US medical equipment manufacturers are world leaders in supplying hospitals with quality equipment, and given that BCA’s house view for 2020 calls for a weaker dollar, HCE exporters have a bright future (middle panel, real trade-weighted dollar shown inverted). Further, the industry also showcases some of its defensive characteristics that are similar to its parent GICS1 health care sector, and in light of the recent disappointing ISM manufacturing PMI print, the path of least resistance is higher for relative share prices (bottom panel, ISM manufacturing index shown inverted). Bottom Line: We stand by our overweight S&P health care equipment call. The ticker symbols for the stocks in the index are: BLBG: S5HCEP – ABT, MDT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMD, TFX, HOLX, ABMD, VAR, STE.   ​​​​​​​