Homebuilding

Highlights Portfolio Strategy Interest rates are one of the most important macro drivers of overall equity returns via valuations. BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as BCA predicts, will have significant knock on effects on sector selection. Recent Changes There are no changes to our portfolio this week. Table 1 2020 Key Views: High-Conviction Calls 2020 Key Views: High-Conviction Calls Feature As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. We remain perplexed by the market’s euphoric rise and near total neglect of weak profit growth fundamentals. This “hope rally”, as we have characterized it in the recent past, may have some more legs with the traditional Santa Rally around the corner, but the set up for stocks could not be more treacherous for 2020. Importantly, we deem the risk of not getting a Sino-American trade deal to be significantly greater than a relief rally in case of a successful deal. Most of the positive trade-related news is already reflected into equities. This complacent backdrop is reminiscent of the early 2018 SPX catapult to 2,870 as back then the fresh fiscal easing package was all priced into stocks in the first 20 trading days of that year. Chart 1 vividly depicts this euphoric melt-up in stocks with the longest dated VIX future trouncing the squashed front month VIX future. While this ratio is not at the stratospheric level hit in late-December 2017, it hit a wall recently forewarning that equities are skating on thin ice. Chart 1VOL... VOL... VOL... Similarly, speculators are net short vol, but a snap can occur at any time. This is eerily reminiscent of February 2018. Since 2017, this vol positioning measure has consistently troughed prior to the SPX peak on three occasions and a “four-peat” likely looms (vol net spec positions shown inverted, bottom panel, Chart 2).   On the profit front, sector earnings breadth is sinking like a stone confirming the negatively anchored S&P 500 net EPS revisions ratio (Chart 3). We doubt that 10% EPS growth for calendar 2020 is even plausible, especially given the looming steep deceleration in equity retirement that we highlighted recently.1 Tack on the mighty US dollar, and profit headwinds abound. Chart 2...A Coiled Spring ...A Coiled Spring ...A Coiled Spring Chart 3No Earnings Pulse No Earnings Pulse No Earnings Pulse Market internals are also screaming that something is off in the equity markets. Small caps are trailing large caps, transports are at stall speed, weak balance sheet stocks are underperforming strong balance sheet stocks, the median stock as per the Value Line Geometric Index is far from all-time highs and high yield bonds (especially CCC rated) are also not confirming the SPX breakout (Chart 4). Importantly, the CBOE’s S&P 500 implied correlation index, which gauges “the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX”,2 is rising again over the 40% mark, underscoring that stocks are more and more beginning to move in tandem. Historically this has been a negative omen (implied correlation index shown inverted, top panel, Chart 5). Chart 4Watch Market Internals Watch Market Internals Watch Market Internals Chart 5Reflation No More? Reflation No More? Reflation No More? Downtrodden M&A activity is also firing a warning shot. A steep divergence of M&A deals from stock prices is atypical at this late stage of the business cycle (middle panel, Chart 5). In fact, out Reflation Gauge comprising the greenback, oil prices and the 10-year Treasury yield has taken a turn for the worse, signaling that economic surprises will likely suffer the same fate (bottom panel, Chart 5). All of this, warns that the risks of a significant pullback in the SPX are rising. What follows is four high-conviction overweight and four underweight calls. Similar to last year, we are using BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls.3 While last year this was offside, the collapse in the 10-year US Treasury yield from 3% last December to 1.75% currently offers a better backdrop for this view to pan out. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as our BCA house view predicts, will have significant knock on effects on sector selection.4 As a reminder, interest rates are one of the most important macro drivers of overall equity returns via valuations (10-year Treasury yield shown inverted, Chart 6). Moreover on a sector basis, the ebbs and flows of the risk free asset directly influence utilities, real estate, financials, consumer discretionary and tech growth stocks or more than half of the S&P 500’s market capitalization. Chart 6Priced To Perfection Priced To Perfection Priced To Perfection What follows is four high-conviction overweight and four underweight calls.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   S&P Managed Health Care (Overweight) We upgraded the S&P managed health care group to overweight in April shortly after Bernie Sanders re-introduced his revamped “Medicare For All” bill. Despite the recent explosive run up in relative share prices – partly owing to the drop in Elizabeth Warren’s odds of winning the Democratic candidacy and partly given her watering down of her “Medicare For All” take up plan – we are adding this health care sub-group to our high-conviction overweight call list. HMOs are finally raising prices at the steepest rate of the past fifteen years and while such breakneck pace is unsustainable, profit margins are set to expand smartly (Chart 7). The profit margin backdrop is enticing for health insurers for another reason: labor cost containment. CEOs have been extremely prudent refraining from adding to headcount. One final profit margin booster is the rising 10-year Treasury yield, as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves. Thus, if BCA’s bond view materializes, it will prove a tonic to both margins and profits. With regard to technicals, relative share prices are not as oversold as they were mid-year, but remain below the neutral zone still offering investors a compelling entry point to this position (bottom panel, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG.  Chart 7S&P Managed Health Care S&P Managed Health Care S&P Managed Health Care S&P Machinery (Overweight) A tentative up-tick in EM data in general and China in particular along with improving operating metrics signal that the US/China trade war wounded machinery stocks deserve a high-conviction overweight status for 2020. In more detail, the budding recoveries in the EM and Chinese manufacturing PMIs herald a brighter outlook for relative share prices. China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can reclaim the early-2018 highs. On the operating front, the new orders-to-inventories momentum has traced a bottom. Assuming that the Chinese manufacturing PMI reading stays on an upward trajectory, machinery demand will make a durable comeback. None of these green shoots are reflected in sell-side analysts’ bombed out relative profit and sales growth expectations (bottom panel, Chart 8). The ticker symbols for the stocks in this index are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS.  Chart 8S&P Machinery S&P Machinery S&P Machinery S&P Banks (Overweight) The expected price of credit, still pristine credit quality, and a looming reacceleration in credit growth all argue for including the S&P banks index in our high-conviction overweight list. Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. As the bond sell-off gained steam, the bank outperformance phase also caught on fire. BCA’s view for next year calls for a 50-75bps selloff in the 10-year Treasury yield, further boosting the allure of bank equities (top panel, Chart 9). Beyond the rising price of credit, credit growth is another key industry profit driver. Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher. The upshot is that bank credit growth will likely reaccelerate in the first half of 2020 (third panel, Chart 9). Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine. Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that there is a long runway ahead for relative bank valuations (bottom panel, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.  Chart 9S&P Banks S&P Banks S&P Banks Long Large Caps/Short Small Caps (Overweight) The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. Today we recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence (Chart 10). Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late (Chart 10). Chart 10Long Large Caps/Short Small Caps Long Large Caps/Short Small Caps Long Large Caps/Short Small Caps S&P Homebuilding (Underweight) We downgraded homebuilders to underweight in late-October, and today we are adding it to our high-conviction underweight call list. Most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drubbing in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Now that interest rates are moving in reverse, more pain lies ahead for the S&P homebuilding index (Chart 11). Worrisomely, consumers’ expectations to purchase a new home plunged anew last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 11). Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 11). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR.  Chart 11S&P Homebuilding S&P Homebuilding S&P Homebuilding S&P Semi Equipment (Underweight) While year-to-date chip equipment stocks are the best performing index in the SPX, we deem them a mania, and include them in our high-conviction underweight basket for 2020. The top panel of Chart 12 shows this irrational exuberance that has permeated the semi equipment universe is similar to the dotcom era excesses. Back in the late-1990s relative profit growth was sky high, but today it is flirting with the zero line, warning that gravity will pull these stocks back down to earth (second panel, Chart 12). The contracting ISM manufacturing survey signals that relative share price momentum running at a breakneck pace is unwarranted. The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (middle panel, Chart 12). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (bottom panel, Chart 12). In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the mania in the S&P chip equipment index will likely turn into a panic next year. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Chart 12S&P Semi Equipment S&P Semi Equipment S&P Semi Equipment S&P Utilities (Underweight) Heavily indebted utilities are a high-conviction underweight call for next year. · Relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (Chart 13). Utilities command a 19.4 forward P/E multiple representing roughly a 10% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 400bps. Our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession (Chart 13). On the operating front, natural gas prices are contracting at the steepest pace of the past four years, and electricity capacity utilization is in a multi-decade downtrend, warning that the relative profitability will remain under pressure in 2020. The implication is that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES.  Chart 13S&P Utilities S&P Utilities S&P Utilities S&P Real Estate (Underweight) We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 14). Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 14). Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA expects. (Chart 14). The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. Chart 14S&P Real Estate S&P Real Estate S&P Real Estate Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Gasping For Air” dated November 18, 2019, available at uses.bcaresearch.com. 2    https://www.cboe.com/micro/impliedcorrelation/impliedcorrelationindicator.pdf 3    Please see BCA The Bank Credit Analyst Monthly Report, “OUTLOOK 2020: Heading Into The End Game” dated November 22, 2019, available at bca.bcaresearch.com. 4    Ibid. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Underweight The downward oscillation in the S&P homebuilders index is slowly taking shape as the index lost more than 4% versus the SPX since inception a mere eight trading days ago. While still early we are surprised by the ferocity of the fall which likely signals that homebuilders have been a crowded trade. Now that interest rates are rising we reckon there is staying power in the recent down move as this niche index unwinds overbought conditions. At the margin, a hawkish Fed cut later today could put additional pressure on this interest rate-sensitive index. Finally, earnings prospects face stiff headwinds as not only lumber costs are galloping higher, but also new home prices are deflating as we highlighted in our recent Weekly Report. Bottom Line: We reiterate our recent downgrade to underweight in the S&P homebuilding index. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Downward Homebuilding Oscillation Downward Homebuilding Oscillation

Cracking Homebuilding Foundations Cracking Homebuilding Foundations Underweight In yesterday’s Weekly Report1 we recommended downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. The drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders and is no longer a positive catalyst. For instance, the mortgage application purchase index (MAPI) initially benefited from the plunge in interest rates, but the recent 30bps rise in the 10-year Treasury signals that the MAPI has tentatively crested (second panel). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel). Bottom Line: Downgrade the S&P homebuilding index to underweight. For additional details on the rationale behind this move please refer to the most recent Weekly Report.1 The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR.   1  Please See U.S. Equity Strategy, "Is This It?," dated October 21, 2019.

Highlights Portfolio Strategy Soft housing demand, the trough in interest rates, new home price deflation and weak industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index.      Firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Recent Changes Downgrade the S&P homebuilding index to underweight, today. Table 1 Is This It? Is This It? Feature Equities made a run for fresh all-time highs last week, continuing to cheer the trade war “phase one” deal and breathing a big sigh of relief on better-than-expected bank earnings. We doubt a real deal will materialize which would include Intellectual Property and the tech sector. Instead all we got was a trade truce, at best. Larry Kudlow’s recent football analogy is worth repeating: “It's like being on the seven-yard line at a football game…And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone…When you get down to the last 10 percent, seven-yard line, it's tough". As a reminder, steep tariffs remain in place and there are high odds that the damage already done to global trade is severe enough that it will be months before the emergence of any green shoots. Meanwhile, following up on our “chart of the year candidate” we published two weeks ago, we drilled deeper and discovered two additional economically sensitive indexes that have consistently peaked prior to the SPX in the past three cycles (Chart 1). They now comprise the U.S. Equity Strategy’s Equity Leading Indicator – an equally weighted composite of the S&P Banks index, the Russell 2000 index and the Value Line Geometric index – which signals that the easy money has already been made this cycle in the SPX (Chart 2). Chart 1Three Bulletproof Signals... Three Bulletproof Signals... Three Bulletproof Signals... Chart 2...Combined Into One Leading Equity Indicator ...Combined Into One Leading Equity Indicator ...Combined Into One Leading Equity Indicator Importantly, absent profit growth, it remains extremely difficult for equities to embark on a sustainable fresh leg up by solely relying on multiple expansion. Chart 3 shows our updated Corporate Pricing Power Indicator (CPPI) and it continues to deflate. In fact the steep fall in our CPPI more than offsets the fall in wage growth warning that the margin contraction in the S&P 500 has staying power1 (bottom panel, Chart 3). Drilling beneath the surface, our CPPI is waving a red flag. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Only 42% of the industries we cover are lifting selling prices by more than 1%, and 33% are outright deflating. Worrisomely, only 26% of sectors are raising prices at a faster clip than overall inflation. With regard to pricing power trends, two thirds of the industries we cover are either flat or in a downtrend (Table 2). Chart 3Nil Corporate Pricing Power Nil Corporate Pricing Power Nil Corporate Pricing Power Table 2Industry Group Pricing Power Is This It? Is This It? Gold has jumped to the top of our table galloping at a 26%/annum rate (keep in mind it was deflating in our early July update), and only three additional commodity-related industries made it to the top twenty (Table 2). The disappearance of the commodity complex from the top ranks is consistent with global PPI ills and U.S. dollar strength. This week we update two groups, one early and one deep cyclical. Interestingly, defensive sectors have a healthy showing in the top ten spots with five entries. On the flip side, commodities in general and energy-related industries in particular occupy the bottom of the ranks as WTI crude oil is steeply deflating from the October 2018 peak. Adding it up, corporate sector selling price inflation is sinking in line with depressed inflation expectations. As we posited in our recent profit margin Special Report, profit margins have already peaked for the cycle. We reiterate our cautious overall equity market view on a cyclical 9-to-12 month time horizon. This week we update two groups, one early and one deep cyclical. Cracking Homebuilding Foundations We recommend downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Since the Great Recession, homebuilders have been in clearly defined mini up-and-down cycles, and there are high odds we will soon enter a down oscillation (bottom panel, Chart 4). Interest rates bottomed in early September and there is little additional push they can exert to relative share prices (10-year Treasury yield shown inverted, top panel, Chart 4). Chart 4Relative Gains Are Exhausted Relative Gains Are Exhausted Relative Gains Are Exhausted Worrisomely, consumers’ expectations to purchase a new home nosedived last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 5). Chart 5Cracks Forming Cracks Forming Cracks Forming Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled recently. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 6). While the mortgage application purchase index (MAPI) has been rising on the back of the plunge in interest rates, the 30bps rise in the 10-year Treasury yield since September 1 signals that the MAPI has tentatively crested (second panel, Chart 7). Chart 6Contracting Sales Contracting Sales Contracting Sales Chart 7Margin Trouble Margin Trouble Margin Trouble Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels, Chart 7). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel, Chart 7). Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. On the operating front, the labor market is also emitting a distress signal. Job openings in the construction industry are sinking like a stone and residential construction employment growth is flirting with the contraction zone. Historically, the ebbs and flows in construction jobs have moved in lockstep with relative share price performance and the current message is to expect a drawdown in the latter (Chart 8). Most of the indicators we track underscore a challenging homebuilding backdrop in the coming months. However, there is a key risk to our view: interest rates. Were the 30-year fixed mortgage rate to fall further from current levels, it would entice first time home buyers and cushion the blow to homebuilding demand (mortgage rates shown inverted, top panel, Chart 9). Similarly, bankers are willing extenders of mortgage credit and are reporting rising demand for residential real estate loans as a lagged consequence of falling rates. But, our sense is that the easy gains are exhausted and a reversal is in the offing in most of these measures (Chart 9). Chart 8Heed The Labor Market's Message Heed The Labor Market's Message Heed The Labor Market's Message Chart 9Potentially Lower Rates Are A Key Risk Potentially Lower Rates Are A Key Risk Potentially Lower Rates Are A Key Risk Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Bottom Line: Downgrade the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Stick With Refiners While our bullish take on refiners got to a slippery start, it has recovered all the losses and this position is now in the black. Factors are falling into place for additional gains in the coming months and we recommend investors stick with this overweight recommendation in pure-play downstream stocks. Encouragingly, refining stocks have been trouncing the overall energy index of late and have resumed their multi-year relative uptrend (top panel, Chart 10). With regard to the export relief valve, U.S. net exports of refined products are on a secular uptrend and surprisingly unaffected by the greenback’s moves (bottom panel, Chart 10). Tack on the soon to be adopted International Maritime Organization (IMO) Sulfur 2020 regulations in maritime transportation fuel, and U.S. refiners that produce lower-sulfur fuel oil are well positioned to outearn the SPX. Chart 10Resumed Uptrend Resumed Uptrend Resumed Uptrend Domestic refined product consumption remains upbeat and should serve as a catalyst to unlock excellent value in this niche energy subgroup (middle panel, Chart 11). In fact, gasoline consumption is expanding anew on the back of rising vehicle miles travelled (bottom panel, Chart 11). Chart 11Solid Demand... Solid Demand... Solid Demand... Refining product supply dynamics are also moving in the right direction. Gasoline inventories are getting whittled down and should boost beaten down refining relative profit expectations (inventories shown inverted, bottom panel, Chart 12). Importantly, this firming demand/supply backdrop has been a boon to refining margins and should continue to underpin relative share price momentum (middle panel, Chart 12). In terms of what is baked in the cake for this industry, the expected profit growth bar is extremely low and falling and relative value has been fully restored. First in terms of relative valuations, the relative trailing price-to-sales ratio has corrected 35% from the mid-2018 peak (middle panel, Chart 11). On a forward PE ratio basis refiners are extremely appealing compared with the SPX following a near halving in the relative forward PE in the past fifteen months (second panel, Chart 13). Chart 12...Supply Backdrop Is Boosting Crack Spreads  ...Supply Backdrop Is Boosting Crack Spreads  ...Supply Backdrop Is Boosting Crack Spreads  Chart 13Profit Hurdle Is Uncharacteristically Low Profit Hurdle Is Uncharacteristically Low Profit Hurdle Is Uncharacteristically Low Second, relative EPS growth has sunk below the zero line both twelve months and five years forward. Such pessimism is overdone and we would lean against sell-side bearishness (bottom panel, Chart 13). Even the refining industry’s net earnings revisions ratio has collapsed, which is contrarily positive (third panel, Chart 13). Adding it all up, firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Bottom Line: Stay overweight the S&P oil & gas refining & marking index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Special Report, “Peak Margins” dated October 7, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term.  Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland   Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits:   Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union.   Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD.  For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System*  Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 NZD VS. JPY NZD VS. JPY For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate 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  

Energy Stocks Are Heading North Energy stocks are heading north Energy stocks are heading north Banks Clamoring For Higher Rates And A More Hawkish Fed Banks clamoring for higher rates and a more hawkish Fed Banks clamoring for higher rates and a more hawkish Fed Homebuilding Stocks Are Catching Up To Housing Starts Homebuilding stocks are catching up to housing starts. Homebuilding stocks are catching up to housing starts. Will Global Trade Get “Fed-Exed”? Will Global Trade Get "Fed-Exed"? Will Global Trade Get "Fed-Exed"? Do Not Try To Bottom Fish… ... in cyclicals vs. defensives. ... in cyclicals vs. defensives. ... In Cyclicals Vs. Defensives ... in cyclicals vs. defensives. ... in cyclicals vs. defensives. ​​​​​​​

Highlights Markets expressed disappointment over last week’s FOMC meeting, … : Equities sold off, Treasury yields slid, and the curve flattened. … but we didn’t think there was all that much to get excited about, … : Data dependence remains the Fed’s mantra, and it was never likely that the FOMC would signal that policy through September has been pre-programmed. … though the specter of escalating trade tensions was a bummer: We have followed our repeated exogenous-shock caveat with an acknowledgement of the gravity of trade barriers. Our geopolitical strategists don’t expect a resolution any time soon, though, and White House tweets are here to stay. Marginally easier monetary policy is not likely to have all that much of an effect on the economy: A reduction in the fed funds rate from 2.5% to 2% isn’t likely to turbo-charge housing or corporate investment, but we do expect that the major central banks’ easing bias will support risk assets. Feature The FOMC delivered the result we expected at the conclusion of its meeting last week: a 25-basis-point cut and a dovish adjustment to its balance sheet runoff plans. Markets acted as if they’d been blindsided. Apparently it really isn’t what you say, it’s how you say it. Or maybe, as our colleague Martin Barnes has long contended, press conferences and all the other assorted communications strategies do more harm than good. We have nearly reached the point of Fed fatigue ourselves, but there’s no ignoring the elephant in the room. The Fed is squarely in the center of every investor’s mind and may well remain there for the rest of what was shaping up as a slow-news month before the latest tariff move. American and Chinese negotiators have called it quits until September; lawmakers have left the building in London and Brussels; the ECB’s Governing Council will be idle until mid-September; and the winnowing of the Democratic field is so far off that even Bill de Blasio remains a presidential candidate. We devote this week’s report to an examination of increased accommodation’s implications for financial markets and the U.S. economy. What did the FOMC do on Wednesday? Chart 1An Adjustment, Not A New Direction An Adjustment, Not A New Direction An Adjustment, Not A New Direction The FOMC cut the fed funds rate by 25 basis points, to a range of 2-2.25%, and terminated its modest balance sheet reduction effort two months ahead of time. It studiously kept its options open with regard to future policy rate adjustments, with Chair Powell describing the cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. The mid-cycle reference kiboshed hopes that the cut was meant to bring the curtain down on the tightening cycle that began at the end of 2015 (Chart 1). The hawkish surprise concerning the future direction of the fed funds rate overwhelmed the modestly dovish news that the Fed is immediately ending small-scale quantitative tightening. How did markets take the developments? Not so well, especially over the two hours of Wednesday afternoon trading following the decision. The S&P 500 sold off by close to 2% during the press conference, the dollar surged against the euro, and the yield curve flattened as long-dated Treasuries surged while the 2-year note sold off sharply. Equities recovered their losses in Thursday morning’s trading, though bonds and the dollar held much of their gains, before the latest salvo in the U.S.-China dispute sent investors in all markets scurrying for cover. Overall, financial markets were disappointed that they didn’t get a clearer signal that additional accommodation is on the way. Did markets overreact? In retrospect, it looks like they’d gotten their hopes up too high. The Fed wants to avoid surprises by keeping markets apprised of future developments, but it’s hard to envision it deliberately boxing itself in. It wants to preserve the flexibility to act as it sees fit, so data dependence remains the order of the day, just as it has for the last several years. We continue to take the Fed at its word that policy is not on a pre-set course. Markets seemed to be looking for a little more solicitousness from the Fed. Central bankers will presumably always attempt to guard their discretion, but the monetary policy path is far from clear, given elevated economic uncertainty. Between the stop-and-start trade hostilities with China and the Whack-a-Mole emergence of tariff threats against long-standing allies and trade partners, global manufacturing is reeling and corporate managers have every reason to hold back on capex. The differences of opinion within BCA reflect the lack of an obvious economic direction. Dissention within the Fed – Boston’s Rosengren and Kansas City’s George voted against last week’s cut, while Minneapolis’ Kashkari surely wanted it to be larger – shows that the way forward is not so clear-cut. So is it a good thing or a bad thing that the Fed cut rates? We view easier policy as a market positive over the one-year timeframe that drives most investors. There will come a point of diminishing returns, when risk assets no longer respond to incremental accommodation, but we don’t think we’re there yet. Equity multiples have room to expand before they become silly and the ECB is apparently preparing a new round of asset purchases. Given that it’s exhausted the supply of Eurozone sovereigns, it will have to proceed to evicting incumbent holders from their positions somewhat further out the risk curve, prodding them to venture out still further to redeploy the proceeds, putting downward pressure on spreads globally. How will a lower fed funds rate impact the economy? How much time do you have? The textbook answer is that a lower fed funds rate directly reduces the cost of financing big-ticket consumer purchases and corporate initiatives while indirectly nudging households and corporate managers to make them by boosting their confidence. Unconventional measures like asset purchases (QE) push investors further out the risk curve, lifting the prices of risky assets, lowering lending spreads and increasing asset holders’ wealth. They also promote a broader sense of well-being (the CNBC screen is framed in green, print headlines are cheerful, and jobs are increasingly easier to find), fueling confidence that helps reinforce the direct effects of easier policy. As Chair Powell put it in January, “Our policy works through changing financial conditions[,] … it’s … the essence of what we do.” The logic behind the textbook answer is undeniably sound, and it’s displayed in the simple six-channel model in Figure 1. People respond to incentives, and when the cost of consumption and investment falls, they are likely to save less and consume and invest more (Interest Rates/Substitution Effect). Increasing numbers of observers are becoming restless, however, as events on the ground don’t seem to jibe with the theory. Ten years of a negative real fed funds rate has failed to generate much oomph, and markets sputtered on cue once it tiptoed into positive territory (Chart 2), coinciding with the current global economic softness. Chart Chart 2Real Rates Are Still Low Relative To History Real Rates Are Still Low Relative To History Real Rates Are Still Low Relative To History Martin Barnes, our resident grumpy economist, scoffs at how little extraordinary accommodation has been able to achieve. (Don’t get him started on the communication strategies.) Even after adjusting for how a half-century of Scotland and Montreal weather has colored his perspective, he has a point. “Do you really want to buy equities and riskier bonds in an economy that needs this much help just to grow at 2%?” he might ask. For the time being, yes, we still do. Although the channels promoting economic activity are not functioning as reliably as they have in the past, the channels boosting asset prices – Portfolio Balance, Confidence/Risk Taking, and Interest Rates/Substitution – are still A-Okay (Figure 1). The initial reaction to the FOMC meeting suggests that it will be very hard for the Fed to surprise dovishly in a relative sense, blocking the Currency channel for the time being. The Credit channel is still hindered by post-crisis regulations from Basel to Capitol Hill, at least in terms of the official banking system. Trade tensions have roiled net exports via retaliatory tariffs and suppressed global aggregate demand.1 Shouldn’t housing be at the forefront of any pickup in activity? Chart 3Lower Rates Haven't Helped Much Yet Lower Rates Haven't Helped Much Yet Lower Rates Haven't Helped Much Yet Housing is the classic proxy for tracing the effects of easier policy on the domestic economy, since nearly all of its end consumers finance their purchases, and its domestic concentration insulates it from trade effects. It has failed to respond much to the monetary policy shifts that have brought 30-year fixed mortgage rates down nearly 100 basis points year to date (Chart 3). Fed skeptics suggest that the muted response is evidence of the declining efficacy of easy policy, though we have been inclined to read the data as an indication that homebuilders aren’t building enough starter and move-up homes to bring homeownership within reach of first-time homebuyers and median-income households. Housing should exhibit a high sensitivity to changes in monetary policy, but an abundance of other debt burdens and a lack of affordable supply may be holding it back.   One should have expected that the housing pickup would be muted, and slower to take hold in this expansion, given the severity of the recession and its mortgage-lending roots. Adjusted for inflation, private residential investment, which has declined slightly for four straight quarters, is just over two-thirds of its 2005 peak (Chart 4, middle panel). In the past, residential investment has been more sensitive to the level of the fed funds rate than its direction. Since 1961, the Fed has hiked rates in as many quarters as it has cut them, and the difference in annualized growth has been relatively modest: 2.8% when the Fed has been cutting rates, and 1.6% when it’s been raising them. Chart 4Residential Investment Responds To The Monetary Policy Backdrop... Residential Investment Responds To The Monetary Policy Backdrop... Residential Investment Responds To The Monetary Policy Backdrop... Per our equilibrium fed funds rate framework, we deem monetary policy to be accommodative when the fed funds rate is below our estimate of equilibrium, and restrictive when the funds rate exceeds it (Chart 4, top panel). Despite the fact that the Fed has hiked as often as it has cut since 1961, we estimate that policy has been easy for two-thirds of the time, and the difference in residential investment growth in the two policy states has been dramatic: 6.8% when policy is easy and -6.6% when policy is tight (Chart 4, bottom panel). With the Fed keeping policy easy for longer, housing will have the wind at its back, though it isn’t much more than a breeze at the moment. The same goes for construction employment, which has grown more rapidly under accommodative monetary policy (2.1% versus 0.7% when policy is tight), but has merely treaded water over the last 11 years of easy policy (Chart 5). Chart 5... And So Does Construction Employment ... And So Does Construction Employment ... And So Does Construction Employment The bottom line is that the jury is still out on housing activity. Low mortgage rates will help renters buy homes (and fill them with furniture and appliances), and put more cash in the pockets of homeowners who refinance their existing loans, but the market remains soft. Though it can’t be captured by the aggregate data, it does seem possible that median-income households may be burdened by too much student loan, automobile and/or credit card debt to save the required down payment.2 Disparities between households may well be holding the economy back, but they have a silver lining if they encourage the Fed to pursue accommodative policies for longer than it otherwise would. Will rate cuts give the economy a tangible lift? We don’t know for sure, but no one else does, either. We are convinced that easier monetary conditions will help the economy at the margin. Ten years into the expansion, though, it is not clear if the economy has pent-up demand that easier conditions will help release. Externally, worsening trade tensions could exacerbate the global manufacturing slowdown, further squeezing global aggregate demand, and exporting recession pressures to the U.S. Our mandate is not to forecast the economy in itself, though. We and our clients are investors, not government officials or public-policy professors, and we focus on the economy only to the extent that it impacts financial markets. In the near term, incremental accommodation should boost risk asset prices, provided that trade tensions don’t ratchet up enough to undermine investor, consumer and business confidence. Animal spirits matter, and if they shift decisively from greed and toward fear, they can become a self-fulfilling prophecy that sweeps monetary policy efforts before them. Ex-a significantly negative exogenous event, we remain constructive on the U.S. economy, and continue to look for a global revival outside of the U.S. Investment Implications The incremental information received this week – an FOMC meeting that mostly went off as we expected, a modest escalation in U.S. pressure on China in line with our geopolitical strategists’ warnings that a final deal is not at hand, mixed global manufacturing PMIs, a surge in U.S. consumer confidence, a straight-down-the-middle employment situation report, and an upward inflection in S&P 500 earnings growth that has 2Q EPS now tracking to a 2.7% year-over-year gain – did not change our perspective. We see U.S. economic growth decelerating from its 2018 pace, but remaining above trend, and an absence of imbalances that would make the economy more vulnerable. We have made our peace with recurring flare-ups of hostilities between the U.S. and China, and trade tensions will only change our investment outlook if they worsen materially. The Fed is not magic, but it is doing the best it can to keep the expansion going for the purpose of spreading its gains as broadly as possible, and the easing bias among major central banks is gathering force. On balance, the new information received last week didn’t do anything to change our overall take. We remain constructive, and think investment portfolios should as well. We recognize that the climate is uncertain, and that we should accordingly dial back our conviction. Part of the reason the agency mortgage REITs appeal to us at this juncture is that they offer the opportunity to reduce equity beta and enhance a balanced portfolio’s capacity to absorb shocks. We watched the flattening in the yield curve with dismay, but we continue to expect that incremental monetary accommodation will promote a steeper curve. Easier monetary conditions promote growth, boosting the real component of interest rates, and can stoke inflation pressures when an economy is operating at or above capacity, as the U.S. has been for over a year. We remain vigilant, but our base-case constructive take is unchanged.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were preparing to go to press on Thursday, the U.S. announced the imposition of new tariff levies on the subset of Chinese imports that hadn’t yet been subjected to tariffs. The move supported our geopolitical strategists’ view that the trade war is unlikely to be settled soon. 2 Andriotis, AnnaMaria; Brown, Ken; and Shifflett, Shane, “Families Go Deep in Debt to Stay in the Middle Class,” Wall Street Journal, August 1, 2019.

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

Since early March, when we first turned tactically cautious on the prospects of the broad equity market, we started applying risk metrics to our portfolio in order to protect profits. In recent weeks as our cautiousness morphed from a tactical into a cyclical time horizon, we have both added more stops and also tightened existing trailing stops to our portfolio. As a result, our long S&P homebuilding/short S&P home improvement retail market- and sector-neutral trade got stopped out last week at the 10% return mark since the January 22nd, 2019 inception. Bottom Line: We have been increasingly using risk management metrics to protect gains in our U.S. equity portfolio and we are obeying the trailing stop on the long S&P homebuilders/short S&P home improvement retailers pair trade for a gain of 10% since inception.  Long Homebuilding/Short Home Improvement Retail Update: Move To The Sidelines Long Homebuilding/Short Home Improvement Retail Update: Move To The Sidelines