Homebuilding

Buy Homebuilders Sell Home Improvement Retailers Buy Homebuilders Sell Home Improvement Retailers While we reiterate our recent overweight call on the S&P homebuilding index1 and the high-conviction underweight call on the S&P home improvement retail (HIR) group,2 it also makes sense to initiate a market neutral trade: long homebuilders/short HIR. Keep in mind that housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (top & middle panels). Beyond these macro tailwinds for this intra-sector trade, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (change in lumber prices  shown inverted and advanced in bottom panel). Bottom Line: We initiated a new long S&P homebuilding/short S&P home improvement retail pair trade yesterday; please see yesterday’s Weekly Report for more details. The ticker symbols for the stocks in these indexes are: BLBG: S5HOME – DHI, LEN and PHM, and BLBG: S5HOMI – HD and LOW, respectively.   1      Please see BCA U.S. Equity Strategy Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com 2      Please see BCA U.S. Equity Strategy Report, “2019 Key Views: High-Conviction Calls” dated December 3, 2018, available at uses.bcaresearch.com    

Highlights Portfolio Strategy Vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Recent Changes Initiate a long S&P homebuilding/short S&P home improvement retail pair trade today. Table 1 Dissecting 2019 Earnings Dissecting 2019 Earnings Feature Equities have retraced 50% of the peak-to-trough losses, and are still consolidating the post December Fed meeting tremor. Chart 1 shows that the VIX has been cut in half and the high-yield corporate bond option-adjusted spread has dropped 105bps. Retrenching volatility and deflating junk spreads suggest that the equity risk premium (ERP) remains uncharacteristically high. The path of least resistance is for the ERP to narrow in the coming months as we do not foresee recession in 2019. As a reminder, the ERP and the economy are inversely correlated. Chart 1Risk Premia Renormalization Risk Premia Renormalization Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A positive U.S./China trade resolution A continuation of the earnings juggernaut With regard to the macro related catalysts, an update to our reflation gauge (RG) is in order. The trade-weighted U.S. dollar has been depreciating since early November, the 10-year U.S. Treasury yield has come undone since the early November peak and oil prices are 33% lower than the early-October peak. These three variables comprise our RG and the signal is unambiguously bullish. In other words, a reflationary impulse looms in the months ahead which should pave the way for a rebound in both plunging investor sentiment and the gloomy economic surprise index (RG shown advanced, Chart 2). Chart 2Reflating Away Reflating Away Reflating Away On the earnings front, last week we trimmed our end-2020 SPX EPS forecast to $181 while we sustained the multiple at 16.5 times which resulted in a 3,000 SPX target.1 Drilling beneath the surface and analyzing the composition of SPX profits is revealing. Table 2 highlights sell side analysts’ profit levels and growth projections on a per GICS1 sector basis and also their contribution to overall earnings along with each sector’s projected earnings weight and most recent market capitalization weight. Table 2S&P 500 Earnings Analysis Dissecting 2019 Earnings Dissecting 2019 Earnings Chart 3 shows that financials, health care and industrials are responsible for 61% of the SPX’s profit growth in 2019. Interestingly, technology’s contribution has fallen to a mere 7.2% and even if we add the new communication services sector’s 9.6% contribution it still falls well shy of the tech sector’s market cap and earnings weight. Another worthwhile observation is that energy profits are no longer off the charts, as base effects since the early-2016 $25/bbl oil trough have filtered out of the dataset. Chart 3 While the risk of disappointment surrounds financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 4 & 5). In addition, if our Commodity & Energy Strategy service’s bullish oil forecast pans out this year, the negative energy sector contribution to SPX profit growth will get a sizable upward revision (please look forward to our GICS1 sector EPS growth models updates and profit margin analysis in next week’s report). Chart 4Earnings Revisions... Earnings Revisions... Earnings Revisions... Chart 5...Really Weigh On Tech ...Really Weigh On Tech ...Really Weigh On Tech ​​​​​​​ In sum, if the Fed pauses its hiking cycle through at least the first half of the year, we see a positive U.S./China trade resolution and SPX profits sustain their upward trajectory, then the SPX budding recovery will morph into a durable rally. This week we are updating an interest rate sensitive index that is highly levered to the surging U.S. credit impulse (Chart 6) and are initiating an early cyclical intra-sector and intra-industry pair trade. Chart 6Heed The U.S. Credit Impulse Signal Heed The U.S. Credit Impulse Signal Heed The U.S. Credit Impulse Signal Stick With Banks While our overweight call in the S&P banks index suffered a setback last month, since inception it has moved laterally, and we continue to recommend an above benchmark allocation to this key financials sub group. Not only are the odds of recession low for this year, but narrowing credit spreads and a reversal in financial conditions are also waving the green flag (junk spread shown inverted & advanced, bottom panel, Chart 7). Chart 7Bank On Banks Bank On Banks Bank On Banks Unlike the previous three reporting seasons when banks revealed blowout numbers and stocks subsequently fell, this season some profit and top line growth misses have been greeted with rising bank stocks prices. Such a reaction suggests that the worst is behind this sector and a sustainable recovery looms. Importantly, on the loan growth front, our credit impulse diffusion index is reaccelerating (Chart 6) and the overall credit impulse is expanding (middle panel, Chart 7). Our total loans & leases growth model and BCA’s C&I loan growth model both corroborate this encouraging credit backdrop (second & bottom panels, Chart 8). The latter is significant given that C&I loans are the single biggest credit category in bank loan books (Chart 9). Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Chart 8Credit Models Flashing Green Credit Models Flashing Green Credit Models Flashing Green Chart 9Credit Models Flashing Green C&I Loans Leading The Pack C&I Loans Leading The Pack Multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 8). The outlook for the second largest credit category, residential real estate, remains upbeat in spite of last quarter’s soft housing related data releases. The recent easing in monetary conditions has breathed life back into the mortgage purchase applications index and also house prices continue to expand at a healthy pace (Chart 10). The upshot is that first-time home buyers will show up this spring selling season. Chart 10Residential Loans Also On Solid Footing Residential Loans Also On Solid Footing Residential Loans Also On Solid Footing Beyond positive credit growth prospects, credit quality remains pristine. BCA’s no recession in 2019 view remains intact, thus NPLs and chargeoffs should stay muted. As a reminder, U.S. banks are the best capitalized banks in the world,2 and their reserve coverage ratio has returned to 124%, a level last seen in 2007 (Chart 11). Chart 11Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Another important source of support is equity retirement. Banks have been late to the buyback game as the GFC along with the new strict bank regulatory body, the Fed, really tied their hands with regard to shareholder friendly activities. In fact, according to flow of funds data, the financial sector is still a net equity issuer, albeit at a steeply decelerating pace especially relative to the non-financial corporate sector (Chart 12). Pent up financial sector buyback demand is a boon for bank EPS growth. Chart 12Pent Up Buyback Demand Getting Unleashed Pent Up Buyback Demand Getting Unleashed Pent Up Buyback Demand Getting Unleashed This is significant at a time when analysts have been swiftly downgrading EPS growth figures for the SPX. Encouragingly, our bank EPS growth model captures all these positive forces and while it is decelerating it still suggests that profit growth will be stellar in 2019 and easily outpace the overall market (Chart 13). Chart 13Banks EPS Growth Will Outpace The Market Banks EPS Growth Will Outpace The Market Banks EPS Growth Will Outpace The Market Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that a re-rating phase looms (Chart 14). Chart 14Rerating In Still In The Early Innings Rerating In Still In The Early Innings Rerating In Still In The Early Innings Nevertheless, there is one headwind banks face as the business cycle is long in the tooth and on track to become the longest expansion on record: the price of credit. One reason for the deflating relative stock price ratio since the January 2018 peak has been the yield curve slope flattening (Chart 15), as it suppresses bank net interest margins. Banks have been fighting this off partly by keeping their source of funding ultra-low judging by still anemic CD rates, according to Bankrate’s national average (bottom panel, Chart 15). Chart 15One Minor Headwind One Minor Headwind One Minor Headwind While yield curve inversions have widened all the way out to the 7/1 slope, the key 10/2 slope has yet to invert. Were the 10-year U.S. treasury to resume its selloff, even a mild yield curve steepening will go a long way, as BCA’s bond strategists expect. Clearly a flattening curve is a risk to our sanguine bank view, but the rest of the positives we outlined above more than offset the yield curve blues. Adding it all up, vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of the 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Bottom Line: Maintain the overweight stance in the S&P banks index. 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, . Buy Homebuilders/Sell Home Improvement Retailers While we reiterate our recent overweight call on the S&P homebuilding index3 and the high-conviction underweight call on the S&P home improvement retail (HIR) group,4 it also makes sense to initiate a market neutral trade: long homebuilders/short HIR. This pair trade is levered on the swings of residential construction compared with residential investment. Currently the former is significantly outpacing the latter and suggests that relative share prices have ample room to run (top panel, Chart 16). Chart 16A Play On Residential Construction Vs. Investment A Play On Residential Construction Vs. Investment A Play On Residential Construction Vs. Investment Put differently, this share price ratio moves in tandem with homebuilders breaking new ground versus home owners renovating their existing house. Chart 17 shows the NAHB’s homebuilder sales expectations survey compared with the remodeling expectations survey. This relative sentiment gauge has ticked up recently, confirming the message from national accounts that residential construction has the upper hand over residential investment. The upshot is that the bull market in relative share prices is in the early innings. Chart 17Relative Survey Expectations... Relative Survey Expectations... Relative Survey Expectations... Keep in mind that housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (middle & bottom panels, Chart 16). More specifically on the interest rate front, while both groups move with the oscillation of lending rates, new home sales are more sensitive than HIR sales to the price of credit. Our proxy of mortgage application purchase to refinance index does an excellent job in capturing this relative interest rate sensitivity and the recent jump signals that a catch up phase looms in the relative share price ratio (top panel, Chart 18). Chart 18...Easing Interest Rates... ...Easing Interest Rates... ...Easing Interest Rates... Relative loan growth activity also corroborates that demand for residential real estate is outpacing demand for home renovation (bottom panel, Chart 18). Beyond these macro tailwinds for this intra-sector trade, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. In other words, rising lumber prices are a boon for HIR and a bane to homebuilders and vice versa. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (Chart 19). Chart 19...And Cheapened Lumber Prices Favor Homebuilders Over HIR ...And Cheapened Lumber Prices Favor Homebuilders Over HIR ...And Cheapened Lumber Prices Favor Homebuilders Over HIR Finally, oversold relative technicals, depressed valuations and extreme sell side analysts’ relative profit pessimism, offer a very compelling entry point in the pair trade for fresh capital (Chart 20). Chart 20Oversold And Unloved Oversold And Unloved Oversold And Unloved Netting it all out, rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and relative alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Bottom Line: Initiate a new long S&P homebuilding/short S&P home improvement retail pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: S5HOME – DHI, LEN and PHM, and BLBG: S5HOMI – HD and LOW, respectively.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com footnotes 1 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, “Top 10 Reasons We Still Like Banks” dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “2019 Key Views: High-Conviction Calls” dated December 3, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Rebuilding From The Basement Rebuilding From The Basement Overweight After reaching their post-GFC highs in the middle of 2017, the S&P homebuilders index put in a seven-year bottom in October, though has since recovered to roughly the level where we upgraded to overweight.1 The fall came as homebuilder sentiment gave up some of its optimism (second panel), driven largely by higher mortgage rates and the resulting lower affordability (third panel). However, we believe the market priced in faltering homebuilder optimism well before the industry itself. Anecdotally, Toll Brothers (TOL, notably not a member of the S&P homebuilders index but a major homebuilder nonetheless) recently delivered quarterly results where new orders fell for the first time in four years, including a precipitous 39% decline in California, their biggest market, and offered guidance below analyst expectations. This glum news was met by a market that took the stock higher that day. Our inference is that negativity is fully priced in to this index and with the overall housing market index squarely above the 50 boom/bust line (second panel) and earnings growth expectations coming back to reality (bottom panel), the S&P homebuilders index is set to continue its recovery. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.   1      Please see BCA U.S. Equity Strategy Weekly Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com.

Highlights U.S. housing's immediate past will not repeat, ... : It is understandable that investors who lived through the financial crisis are acutely sensitive to any sign of trouble in housing, but none of the factors that helped precipitate the crisis are in place now. ... and its older history will only rhyme: Home construction slowdowns have a good record of signaling recessions, but residential investment's steadily waning share of GDP has chipped away at its influence. The current housing soft patch is not over, but it's unlikely to get much worse, ... : The rapid rise in mortgage rates sharply reduced affordability, but it still remains at a very comfortable level relative to history. Inventories of new and existing homes are very low, and the pace of new construction continues to run slightly behind household formation. Most importantly for the expansion, there were no construction excesses in this cycle that need to be worked off. ... so we don't think it's sending any broader signal about the economy: A tiny contraction in residential investment is not a harbinger of recession, nor is it an indication that monetary policy is already tight. Feature Desynchronization has been the name of the game in 2018. The U.S. economy, already ahead of its peers in putting the crisis in its rear-view mirror, has gotten an additional fillip from the fiscal stimulus package. Global growth, on the other hand, has been slipping. As Fed chair Jay Powell put it last week, the rest of the world is "gradual[ly] chipping away" at the U.S., but there "is not a terrible slowdown" in the global ex-U.S. economy. Global conditions have not slowed enough to get the Fed to interrupt its tightening campaign, but signs of softness outside of the U.S.'s borders have been popping up like mushrooms after the rain. With disappointments having been few and far between in the U.S., any pockets of weakness that do appear attract immediate attention. Against this backdrop, the slowing in housing - residential investment has now contracted for three consecutive quarters - is making some investors a little uneasy. We have spent a good deal of time within BCA debating housing's recent softness, its outlook, and its implications for financial assets and the economy, and clients are increasingly inquiring about our views. Housing's Recent Past Housing is top of mind for many investors because it was at the center of the financial crisis. Residential mortgages were ground zero of the credit bubble that systemically threatened the banking system. Wobbles in housing bring back unpleasant memories of the searing trauma that unfolded just ten years ago. With the dot-com mania and the financial crisis having occurred just a decade apart, the financial media, and many strategists, analysts and investors are on high alert for the next crash. The concerns are understandable, but conditions today are nearly the polar opposite of conditions in 2005 and 2006. There is nothing even remotely bubble-like about the current housing market. The critical weakness back then was the shunning of time-tested underwriting standards, as revealed by the homeownership rate. An average of just over 64% of households owned their own homes for the first three decades of the ownership series in a remarkably steady pattern,1 but a steady debauching of standards pushed the rate to above 69% at its peak (Chart 1, top panel). Chart 1Too-Easy Lending Standards ... Too-Easy Lending Standards ... Too-Easy Lending Standards ... The homeownership rate was built on a foundation of increasingly unserviceable mortgages (Chart 1, bottom panel). Prices surged (Chart 2, top panel), flippers flooded the market, and homebuilders ramped up production to meet the ensuing demand (Chart 2, second panel). When the music stopped, the housing market was left with unprecedentedly large inventories of unsold homes (Chart 2, third panel); the banking system's primary source of collateral was poised to suffer a body blow; and a hiring surge that played out over a decade and a half was unwound in just two years (Chart 2, bottom panel). Chart 2... Made Housing Unstable ... Made Housing Unstable ... Made Housing Unstable Housing In The Current Cycle Current conditions are much more stable. The homeownership rate is back to its time-tested levels. New housing supply has generally undershot the smoothed trend in household formations ever since the crisis ended (Chart 3, top panel). Inventories are strikingly low when adjusted for the overall size of the housing stock (Chart 3, middle panel). The vacancy rate is low (Chart 3, bottom panel), and there is no construction employment cliff. Most importantly from a stability perspective, the Basel III/Dodd-Frank regulatory framework makes it very difficult to replicate the reckless credit conditions that enabled the housing bubble. This cycle has been devoid of housing excesses. Chart 3Plenty Of Room For More Homes Plenty Of Room For More Homes Plenty Of Room For More Homes A broader historical context reveals that housing has been exerting steadily less influence on the economy across the entire postwar era. We have a good deal of sympathy for the argument that the postwar business cycle has been a consumption cycle, largely led by housing,2 but it's possible that the crisis marked housing's last hurrah as a driver of recessions. Residential investment's share of GDP exploded when pent-up demand was released upon the return of servicemen and women needing homes for their burgeoning families (Chart 4). The construction of the interstate system, and the network of subsidiary roads that sprang up to connect to it, facilitated the creation of the suburbs, and Levittown-style tract housing communities had to be built from scratch to meet the demand. Chart 4The Incredible Shrinking Impact Of Housing Activity The Incredible Shrinking Impact Of Housing Activity The Incredible Shrinking Impact Of Housing Activity The baby boom kept demand for more, and larger, houses going strong. Once grown themselves, the baby boomers helped keep household formation growth flush. The baby boomers are now net sellers, however, and will be at an increasing rate across the next couple of decades. The time trend of residential investment's share of GDP is stark, and demographics are poised to keep it going as long as the baby boomers are divesting their holdings. The bottom line is that we do not think housing is the business cycle this time around. It is a highly cyclical part of the economy, and its fluctuations will still be felt, but its influence on the overall economy has been steadily waning for 70 years, and it is not currently in a position to exert a powerful drag. It would be overstating matters to say that housing booms cause recessions, but they've been observed at the scene of the crime in every recession of the last 60 years except for the dot-com bust. In this cycle, the barely visible white area above the trend line in Chart 4 is nowhere near large enough to give rise to a big swing below the trend line, and inspire a patch of gray shading on its own. The ratio of housing starts to the existing stock of homes (Chart 5) reinforces the message of residential investment's declining contribution to overall output. The United States has been augmenting and/or replacing the existing stock of homes at a steadily diminishing rate for 60 years. Assuming that the rate of obsolescence has remained roughly constant, it seems that there has simply been less to build once the suburban frontier was settled. Even against the declining time trend, however, residential construction activity in this cycle has not revived enough to require a correction. Chart 5Tinkering Around The Edges Tinkering Around The Edges Tinkering Around The Edges We attribute the current softness to the backup in mortgage rates over the last twelve months. 100 basis points may not seem like the end of the world, but the rise in interest rates has been sudden, and it is entirely plausible to think that it has sent some marginal first-time buyers to the sidelines. The Housing Affordability Index is way below its 2013 peak, but remains quite high relative to its pre-ZIRP history (Chart 6, top panel). The sudden drop in the index has been a function of mortgage payments (Chart 6, second panel) as sudden moves almost always are - the median home price (Chart 6, third panel) and the median income series (Chart 6, bottom panel) are much less variable. Chart 6Mortgage Rates Drive Affordability Mortgage Rates Drive Affordability Mortgage Rates Drive Affordability We expect that rates will go still higher, but our bond strategists don't think it will happen any time soon. They see rates consolidating for a while as the economy digests the sharp move higher, and favorable year-over-year comparisons cool off inflation's upward momentum over the coming months. Our above-consensus view on the terminal fed funds rate is not housing friendly. Housing will have to contend with ongoing bond-market headwinds, but we don't expect another move of this magnitude will recur in such a concentrated time frame. Bottom Line: Housing may face a headwind from higher rates for at least another year, but a big drop-off in activity is not in the cards. There are no current cycle excesses that need to be unwound, and housing has become too small a part of the economy to induce a recession on its own. Housing Demand And The Fed Funds Rate Cycle The notion that mortgage rates are to blame for the housing soft patch raises some questions about our assessment of the monetary policy backdrop. Is it possible that a funds rate that's proximally related to a slowdown in housing demand is not impacting consumer demand for other goods or services, or corporate demand? Could there be multiple equilibrium fed funds rates? If not, is the housing soft patch a sign that the economy is actually in Phase II of the cycle, and not Phase I? We are unperturbed by the three-quarter contraction in residential investment, which one has to squint to see (Chart 7). We do not believe that housing demand has reached an inflection point; we simply think that prospective monthly mortgage payments have moved so fast that some buyers have temporarily stepped aside. Given that buying a home still looks quite inviting by the historical standards of the affordability index, conditions are not yet restrictive. Ex-the ZIRP era, the index had not exceeded 140 for more than three decades (Chart 6, top panel). If homes are still affordable relative to history, then housing would seem to support our equilibrium fed funds rate model's assessment that monetary policy remains accommodative. Chart 7Not Much Of A Downturn Yet Not Much Of A Downturn Yet Not Much Of A Downturn Yet We view the state of policy as binary for the economy as a whole, even if some activity is necessarily more rate-sensitive. While some marginal investment projects cease to generate positive prospective net present value any time interest rates rise, encouraging or discouraging activity is a universal condition. The broader investment-relevant question is whether or not our assessment that the fed funds rate cycle has not yet transited from Phase I to Phase II is correct (Chart 8). If the economy is still in Phase I, and will remain there for a year, our constructive take on the economy and financial markets still applies. If it's shifted to Phase II, however, the empirical record says investors should be paring back risk. Chart 8The Fed Funds Rate Cycle Housing: Past, Present And (Near) Future Housing: Past, Present And (Near) Future The preponderance of evidence supports the idea that we remain in Phase I. Real-time measures of activity remain robust. Credit performance remains very good, so banks are still eager lenders. Employment is surging, and a follow-up dose of fiscal stimulus in 2019 should keep all the plates spinning for another year. As macro investors, and students of cycles, we are as eager as anyone to recognize the inflection point as swiftly as possible, but the data series we follow do not indicate that it is approaching. We continue to abide by our equilibrium fed funds rate model's benign conclusion. Investment Implications Although housing's direct impact on GDP has steadily waned, it remains an important part of the economy, given how it feeds into several other elements of consumer demand. Three consecutive quarters of contraction in residential investment are worthy of notice, but such a run has occurred before without provoking a recession, and the contraction to date has been awfully modest in any event. We do not view the slowdown as the beginning of the end for the expansion. We also do not view it as a sign that monetary policy is tighter than we originally judged. We expect that the ongoing surprise over the rest of this cycle will be that the neutral fed funds rate is considerably higher than the market consensus expects. We therefore think that investors should continue to maintain benchmark exposure to risk assets while remaining underweight Treasuries and holding all bond exposure below benchmark duration. Since we think the expansion remains in place, supported by accommodative monetary policy, we view the recurring mini-scares provoked by data points like housing's soft patch as potential opportunities to put our cash overweight to work. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Over the 120 quarters through the end of 1994, a mean 64.3% of households owned a home, with a standard deviation of 0.6%. Only 22% of the quarterly observations were more than a standard deviation away from the mean, as opposed to the 32% predicted by the normal distribution. 2 Leamer, Edward E., "Housing IS the Business Cycle," NBER Working Paper No. 13428, September 2007. http://www.nber.org/papers/w13428

Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year Housing Has Been A Drag On The U.S. Economy This Year Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... No Mystery Why U.S. Housing Has Been Weak... No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) ...But Fundamentals Are Still In Good Shape (I) ...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) ...But Fundamentals Are Still In Good Shape (II) ...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Lending Standards Have Been Tight, But Are Starting To Loosen Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High Interest Coverage Looks Relatively High Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards U.S. Corporate Debt Is Not That High By Global Standards U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy The 2015 Debt Scare Did Not Topple The Economy The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The U.S. Private Sector Is A Net Saver The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Fighting The Last War Fighting The Last War Chart 11Brazil Is Fiscally Challenged Brazil Is Fiscally Challenged Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted Fighting The Last War Fighting The Last War The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Overweight While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates but as long as job certainty remains intact and wage growth picks up steam as we expect, we doubt that the U.S. housing market will suffer a relapse. In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel). In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels). Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight and see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Look Through The Housing Soft Patch Look Through The Housing Soft Patch