Industrials

Highlights Portfolio Strategy We recommend investors participate in the equity market rotation during the ongoing correction and position portfolios for next year’s bull market resumption by preferring unloved and undervalued deep cyclical laggards. Ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.    Recent Changes Our trailing stop got triggered and we downgraded the S&P internet retail index to neutral for a gain of 20% since the mid-April inception. This move also pushed our S&P consumer discretionary sector weighting to a benchmark allocation for a gain of 15% since inception. Table 1 Riot Point Looms Riot Point Looms Feature The S&P 500 broke below the important 50-day moving average last week, but managed to bounce off the early-June 3233 level – also a level where the SPX started the year – that could serve as temporary support (Chart 1). We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Chart 1Critical Support Levels Riot Point Looms Riot Point Looms The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated last week. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    Figure 1The Fiscal Policy Loop Riot Point Looms Riot Point Looms It is no surprise that the Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry (Chart 2). Chart 2In Dire Need Of Fiscal Stimulus In Dire Need Of Fiscal Stimulus In Dire Need Of Fiscal Stimulus If Congress fails to pass a new fiscal package by October 16, the latest now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse despite households drawing down their replenished savings (middle panel, Chart 3). This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. With regard to equity market specifics during the current FPL iteration, banks are most at risk as they are levered to the economic recovery, and commercial real estate ails remain a big headache. Absent a fiscal package bank executives will have to further provision for loan losses when they kick off Q3 earnings season in late-October as CEOs will err on the side of caution. Tack on the recent news on laundering money – including by US banks – and the Fed’s new stringent stress tests, and the risk/reward tradeoff remains poor for the banking sector (bottom panel, Chart 3).  Odds are high that volatility will remain elevated heading into the election, therefore this phase represents an opportunity for investors to reshuffle portfolios and prepare for an eventual resumption of the bull market in early-2021. We continue to recommend investors avoid our “COVID-19 winners” basket and prefer our “back-to work” equity basket that we initiated on September 8. Similarly, this pullback is serving as a catalyst to shift some capital out of the fully valued tech titans and into other beaten down parts of the deep cyclical universe. Chart 3Show Me The Money Show Me The Money Show Me The Money We doubt this correction is over as positioning in the NASDAQ 100 derivative markets is still lopsided; stale bulls are caught net long as NQ futures are deflating, thus a flush out looms (Chart 4).  Chart 4Flush Out Flush Out Flush Out The easy money has likely been made in the tech titans that near the peak on September 2, AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out.  Using a concrete rebalancing example to illustrate such a rotation is instructive.2 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift (Chart 5). As a reminder our portfolio has an above benchmark allocation in all three deep cyclical sectors, and this week we reiterate our overweight stance on both the industrials sector and on a key subgroup. Chart 5Rotation Rotation Rotation Rotation Rotation Rotation Rotation Rotation Rotation Buy The Machinery Breakout Were we not already overweight the S&P machinery index, would we upgrade today? The short answer is yes. Aggressive loosening in Chinese financial conditions have underpinned the economic recovery (second & third panels, Chart 6). Infrastructure projects are making a comeback and absorbing the slack in machinery demand caused by COVID-19. As a result, Chinese excavator sales have soared in the past quarter which bodes well for US machinery profit prospects (bottom panel, Chart 6). Beyond China, emerging markets demand for machinery equipment is robust as the commodity complex is recovering smartly (second panel Chart 7). The US dollar bear market is also bolstering global trade growth, despite the greenback’s recent technical bounce, and should continue to underpin machinery net export growth and therefore profit growth for US machinery manufacturers (third & bottom panels, Chart 7).   Chart 6Enticing Chinese Backdrop Enticing Chinese Backdrop Enticing Chinese Backdrop Chart 7Dollar The Great Reflator Dollar The Great Reflator Dollar The Great Reflator The domestic machinery demand backdrop is also conducive to a renormalization of top line growth to a higher run-rate. The ISM manufacturing new orders sub-component is shooting the lights out, heralding a jump in machinery orders in the coming months (second panel, Chart 8). Simultaneously, a quick inventory check is revealing: both in the manufacturing and wholesale channels cupboards are bare which means that the risk of a liquidation phase in non-existent (third panel, Chart 8). Encouragingly, an inventory buildup phase is looming in order to satisfy firming demand. The tick up in machinery industrial production growth, the V-shaped recovery in the utilization rate and newly expanding backlog orders, all suggest that domestic demand conditions are on the mend (Chart 9). Tack on still prudent payrolls management that is keeping the machinery industry’s wage bill at bay (bottom panel, Chart 8), and a profit margin expansion phase is a high probability outcome. Chart 8What’s Not… What’s Not… What’s Not… Chart 9…To Like …To Like …To Like Our resurgent S&P machinery revenue growth model and climbing profit growth model do an excellent job in encapsulating all the industry’s moving parts and suggest that the path of least resistance is higher for relative share prices in the New Year (Chart 10). Finally, relative valuations have also recovered from the depth of the recession, but are only back to the neutral zone leaving enough room for a multiple expansion phase (Chart 11). Chart 10Models Say Buy Models Say Buy Models Say Buy Chart 11Compelling Entry Point Compelling Entry Point Compelling Entry Point In sum, ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Industrials Are Jumpstarting Their Engines We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Industrials equities have been on the selling block and suffered a wholesale liquidation during the dark days of the COVID-19 pandemic, and have yet to regain their footing (top panel, Chart 12). The GE and Boeing sagas have dealt a big blow to this deep cyclical sector, but now this market cap weighted sector has filtered these stocks out as neither of these “fallen angels” is occupying a spot in the top 5 weight ranks. Relative valuations are washed out, and relative technicals are still deep in oversold territory (second & third panels Chart 12). Sell-side analysts are the most pessimistic they have been on record with regard to the long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 12)! All this bearishness is contrarily positive as a little bit of good news can go a long way. Already, relative EPS breadth is stealthily coming back, and net earnings revisions are rocketing higher (Chart 13).  Chart 12Liquidation Phase… Liquidation Phase… Liquidation Phase… Chart 13…Is Over …Is Over …Is Over One reason behind this optimism rests with the domestic recovery. Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (Chart 14). Emerging markets (EM) and China represent another source of industrials sector buoyancy. The EM manufacturing PMI clocking in at 52.5 hit an all-time high. China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 300 points from -240 to above +60 over the past six months. The upshot is that US industrials stocks should outperform when China and the EM are vibrant (Chart 15). Chart 14Domestic And … Domestic And … Domestic And … Chart 15… EM Green Shoots Are Bullish … EM Green Shoots Are Bullish … EM Green Shoots Are Bullish Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve (third panel, Chart 16). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel, Chart 16). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel, Chart 16). The US Equity Strategy’s macro based EPS growth model captures all the different earnings drivers and signals that an earnings-led recovery is in the offing (Chart 17). Chart 16The Greenback Holds The Key The Greenback Holds The Key The Greenback Holds The Key Chart 17Models Flashing Green Models Flashing Green Models Flashing Green Adding it all up, vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.   Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. 2     Our example assumes benchmark allocation in all sectors for illustrative purposes.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Even after the COVID-19 pandemic is over, likely within 18 months, many behavioral changes that were forced on society by social distancing will remain. Individuals who have gotten used to working from home, shopping online, and using the internet for socializing and entertainment will continue to do so. Amid any large structural shift, it is easier to spot losers than winners. The biggest losers are likely to be: (1) Parts of the real estate industry, as companies shed expensive city-center office space and office workers move away from big cities; and (2) the travel industry, since business travel will decline. The winners will include: Health care (as governments spend to strengthen medical services); capital-goods producers (with US manufacturers increasingly reshoring production but automating more); and the broadly-defined IT sector which, while expensively valued, is nowhere near its 2000 level and has several years of strong growth ahead.   “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” –  Bill Gates “There are decades where nothing happens, and there are weeks where decades happen.” –  Lenin Introduction The world has been turned upside down since February by the coronavirus pandemic. Households all around the globe have been forced to stay indoors; companies have been forced to drastically change working practices; some industries, such as online shopping or videoconferencing software, have seen a surge in demand. But once the pandemic is over, how many of these changes will stick? What will be the long-term impact on society, the workplace, consumer attitudes, and companies’ strategic planning? How should investors position themselves to take advantage of secular changes in the sectors that will be most affected, ranging from health care and technology, to real estate, retailing, and travel? In this Special Report (which should be read in conjunction with two other recent BCA Research Special Reports on the macro-economic and geopolitical consequences, respectively, of COVID-191), we look at the social and industry implications of the coronavirus pandemic. We assume that, within the next 12-to-18 months, the pandemic will be a thing of the past, either because a vaccine has been developed, or because enough people have caught it for herd immunity to develop. This does not mean that people will be unconcerned about a reoccurrence, or about a new virus triggering another epidemic. Pandemics are not rare, even in modern history (Table 1). And COVID-19 may return as an annual mild seasonal flu (as the 1968 Asian flu did), but which is not serious enough to alter behavior. But the assumption in this report is that, within a couple of years, people will feel comfortable again about being in crowded spaces and traveling, without a need for social distancing or periodic lockdowns. Table 1Estimated Mortality And Infection Rates Of Pandemics During The Past Century The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But that doesn’t mean that everything will return to the status quo ante. At least some individuals who have gotten used to working from home, video conferencing, and shopping online will continue these practices. Companies will, therefore, need to rethink their employment policies, as well as how they manage their office space, global supply chains, and just-in-time inventories. Government policies towards health care and education will need to be rethought. None of these changes are new. Indeed, the result of an exogenous shock is often simply to accelerate trends that were already in place. E-commerce, telecommuting, and “reshoring” have already been growing steadily for years. COVID-19 is, however, likely to accelerate these shifts. Not every individual or company will change their behavior, but even small changes at the margin can have a significant impact. Ultimately, what these changes amount to is a liberalization of space and time. Employees do not need to be in the same physical space to work together. Students can choose when to listen to a lecture. Music lovers based in a small city can have the same access to a live (streamed) concert as those in London or New York. This Special Report is divided into two sections. In the first section, we examine the meta-changes in consumer and corporate behavior that could result from the pandemic. How widely will the shift from office-based work to “working from home” stick? How much will shopping, entertainment, and education stay online? Will companies really bring back a large chunk of manufacturing from overseas? In the second section, we analyze the impact on specific industries, such as real estate, health care, technology, and retailing, and make some suggestions as to how investors should tilt their portfolios over the longer term to take advantage of these trends. In summary, we identify the winners as health care, technology, and capital-goods producers. The clear losers are in real estate and travel. Retailing and consumer goods will see a significant shakeout, with both winners and losers, but the overall impact on these industries will be neutral. Social Impacts Working From Home Teleworking, or working from home, is hardly new. Craftsmen before the industrial revolution did so as a matter of course. But the development of computers and telecommunications in the 1980s made it feasible for white-collar workers to work from home too. As Peter Drucker wrote as long ago as 1993: "...commuting to office work is obsolete. It is now infinitely easier, cheaper and faster to do what the nineteenth century could not do: move information, and with it office work, to where the people are."2  Until now, however, teleworking has been rare. But the requirements imposed by the pandemic could cause that to change. Technically, it is possible for workers in many job categories to telework effectively. A recent study by Jonathan Dingel and Brent Neiman3 estimated, based on job characteristics, that it is feasible for 37% of all jobs in the US to be done entirely from home (46% if weighted by wages). The vast majority of jobs in sectors such as education, professional services, and company management could be done from home (Table 2). Extending the analysis to other countries, they find that more than 35% of jobs in most developing countries can be done from home, but less than 25% in manufacturing-heavy emerging economies such as Turkey and Mexico (Chart 1). Table 2Share Of Jobs That Can Be Done At Home, By Industry The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 1Share Of Jobs That Can Be Done At Home, By Country The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But, in practice, before the coronavirus pandemic, many fewer people than this worked from home. Partly this was simply because many companies did not allow it. A survey by OWL Labs in 2018 found that 44% of companies around the world required employees to work from an office, with no option to work remotely.4 The percentage was even higher, 53%, in both Asia and Latin America. By contrast, OWL did find that 52% of employees globally worked from home at least occasionally, and that as many as 18% of respondents reported working from home always. The pandemic forced many white-collar workers to telework for the first time. The Pew Research Center found that 40% of US adults – and as many as 62% of those with at least a bachelor’s degree – worked from home during the crisis.5  How white-collar workers found the experience, and whether they plan to continue to work from home some of the time even if not required to do so, vary widely. Employers are generally positive about the idea. A survey of hiring managers by Upwork found that 56% believed that remote working functioned better than expected during the crisis (Chart 2). They cited reduced meetings, fewer distractions, increased productivity, and greater autonomy as reasons for this. The major drawbacks were technological issues, reduced team cohesion, and communication difficulties. Another survey, by realtor Redfin, found that 76% of US office workers had worked from home during the crisis (compared to only 36% who worked from home at least some of the time beforehand) and that 33% of respondents who had not worked remotely pre-shutdown expect to work remotely after shutdowns end (with another 39% unsure) (Chart 3). Chart 2Employers Found That Teleworking Worked Well The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 3Many Employees Expect To Continue Working Remotely After The Pandemic Ends The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But there are problems too. Research published in the Journal of Applied Psychology found that, while teleworking has some clear advantages, such as improved work-family interface, greater job satisfaction, and enhanced autonomy, it also has drawbacks. Most notably, if workers aren’t in the office at least half the week, relationships with fellow workers suffer, as does collaboration.6 There are also developed countries where backward technology has made the experience of working from home difficult. This is particularly the case in Japan. A survey by the Japan Productivity Center found that 66% of office workers said their productivity fell when working from home; 43% were dissatisfied with the experience. The reasons cited for the dissatisfaction were “lack of access to documents when not in the office” (49%), “a poor telecommunications environment” (44%), and a difficult working environment, such as lack of desk space (44%). Japanese companies remain rather paper-based, and household living space tends to be small. Research carried out on employees at Chinese online travel company Ctrip before the pandemic concluded that home working led to a 13% performance increase but, crucially, there were four requirements for working from home to succeed: Children must be in school or daycare; employees must have a home office that is not a bedroom; complete privacy in that room is essential; and employees must have a choice of whether to work from home.7  After the pandemic, a significant shift in the pattern of office work is likely. Many workers will work remotely part or most of the time. But they will also benefit from coming to an office a certain number of days a month to work together, bond with co-workers, exchange ideas, etc. Online Shopping E-commerce has been growing steadily for years. In the US, it increased by 15% year-on-year in 2019, to reach $602 bn, or 16% of total retail sales (Charts 4 and 5). The share is even higher in some other countries: For example, 25% in China and 22% in the UK. The pandemic caused a big acceleration in e-commerce the first few months of this year, as consumers in most countries around the world were either not allowed to go outside, or felt unsafe doing so. Chart 4The Share Of E-commerce Has Been Steadily Expanding For Years… The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Data from Mastercard show that, in the worst period of lockdowns in April, e-commerce grew by 63% in the US, and 64% in the UK year-on-year, compared to a decline of 15% and 8%, respectively, in overall retail sales (Chart 6). The growth was particularly apparent in products such as home improvement, footwear, and apparel (Chart 7). Chart 5…With Growth Of Around 15% A Year The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 6In April, Online Sales Soared… The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not?   Chart 7…Especially In Certain Categories The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Moreover, many consumers in advanced economies bought goods such as clothing, medicine, and books online for the first time, and used services such as online grocery delivery, and apps to order food from restaurants (Chart 8). Note, however, that few consumers bought financial services, magazines, music, and videos online for the first time. Presumably these are products that the vast majority of households had already been consuming online. Chart 8Consumers Shifted Purchases Of Many Items Online The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? It is hard to know how sticky these trends will be. Once shops permanently reopen without restrictions, will consumers simply return to their old habits of going to supermarkets, restaurants, and clothing stores? Perhaps many enjoy the experience of browsing. It seems likely, however, that the newly acquired habit of shopping online will at least accelerate the trend towards e-commerce. Many of those who ordered, for example, supermarket deliveries online for the first time will continue to do so at least occasionally in the future. Other changes are likely too: Many smaller retailers were forced to close their physical stores during the pandemic and so had no choice but to set up an online delivery service. Some struggled with this, but others were aided by companies such as Shopify, which simplify the process of setting up a website, processing payments, and arranging delivery. Shopify now works with over a million merchants. These smaller retailers are now better able to compete with giants such as Amazon. During the lockdown, US consumers notably diversified their online product searches away from Amazon and Google to smaller retailers (Chart 9). Chart 9Search Diversified Away From Amazon And Google The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? We might see a trend towards smaller-scale, local shops benefiting as consumers stick to shopping in smaller stores closer to their homes. Many stores during the pandemic refused to accept cash; this might accelerate the shift towards contactless payments. Consumers may be less focused in future on conspicuous consumption. The trend towards wellness, home-cooking, gardening, crafts, and self-investment might continue. Other Uses Of Technology It is not only work and shopping habits that changed during lockdowns. Individuals also got used to a range of technologies for socializing, entertainment, education, and medical consultation. Consumer surveys by the Pew Research Center show that a third of American adults have socialized online using services such as Zoom, and a quarter have used online systems for work or conferences (Chart 10). But these percentages are much higher for certain demographics. For example, 48% of 18-to-29 year-olds have socialized online, and 30% of this age group have taken online fitness classes. The percentage using video systems for work is as high as 48% for people with a college degree. And, unsurprisingly, with many university courses moving online since the spring, 38% of 18-to-29 year-olds say they have taken an online class. Chart 10Individuals Have Been Socializing And Communicating More Online The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? How sticky these trends will be once the pandemic is over is not easy to forecast. But further research by Pew showed that 27% of US adults believed that online and telephone contacts are “just as good as in-person contact,” and only 8% thought of them as not much help at all, although a rather larger 64% answered that online socializing is “useful but will not be a replacement for in-person contact.” The responses differed little between gender, race, and political views, although fewer people under the age of 30 thought online contacts were as good as in-person ones (Table 3). Table 3How Do Online Interactions Compare To In-Person Ones? The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Another survey in Japan by Ipsos suggests that people’s values have changed as a result of the pandemic and quarantines, with a greater focus on wellbeing, home-based activities such as cooking, and self-improvement. When questioned, a large percentage of people believe they will persist with these habits even when lockdowns end. For example, 51% of Japanese respondents believe they will continue to enjoy themselves as much as possible at home in their spare time, compared to only 20% who favored entertainment at home before the pandemic (Chart 11).  Chart 11Pandemic Brought A Greater Focus On Wellbeing And Home-Based Activities The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Other areas that have moved online en masse include education, health care, the judiciary, concerts, and sports (e-sports, and popular sports such as soccer and baseball that are now being played in empty venues). Education at the tertiary level in advanced economies was already partly online before the pandemic. In the US, out of 19.7 million tertiary students in 2017, 2.2 million (13.3%) were enrolled in exclusively online/distance learning courses, and another 3.2 million (19.5%) took at least one course online.8 Of course, everything changed during the pandemic, with 98% of US institutions moving the majority of in-person courses online, and many planning to continue this through the Fall 2020 semester. At the elementary and secondary school level, online education was much more limited pre-pandemic. According to the National Center for Educational Statistics, 21% of US schools offered some courses entirely online in 2016 but, of this 21%, only 6% offered all their courses online and only another 6% the majority of courses. Many of these schools were forced to shift entirely online during lockdowns: According to UNESCO data, at the peak of the pandemic 1.6 billion children (90% of the total in school) in 191 countries attended schools that had closed physically. It seems likely that, while in-person teaching will remain the central method of education, distance and online learning solutions, even at the high school level, will become more prevalent in the future. The health care sector has lagged in technology, in terms of using AI for diagnosis, digitalizing patient records, and offering online doctor-patient consultation. But the use of digital tools had started to increase in recent years, particularly in the number of practices using telemedicine and virtual visits (Chart 12). At the peak of the pandemic in April, the number of telehealth visits in the US rose by 14% year-on-year, compared to a 69% decline in in-person visits to a doctor.9 It seems likely that this trend will continue, as medical practitioners find viritual consultations more efficient and effective for many simple initial diagnoses, and as sick or elderly patients prefer to avoid a physical visit to a surgery.10 Chart 12The Transition To A Digital-Driven Health Care Model The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Travel Travelers have been very reluctant to get back on airplanes and stay in hotels again, even in countries and regions where the pandemic has eased over the past couple of months (Chart 13). Based on our assumption that the pandemic will be completely over within 18 months, it seems likely that people will eventually resume travelling, at least for leisure and to see family and friends. After previous disruptions to global travel, such as 9/11 and SARS, it took only two-to-three years for air travel to resumed its pre-crisis trend (Chart 14). Chart 13Travelers Remained Reluctant Even When Pandemic Eased The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 14 Business travel might be very different, however. Salespeople who have become used to making sales calls over Zoom may not feel the need to travel to see clients so much. Conferences, exhibitions, and other events will be increasingly (at least partly) online. Travel budgets are a large expense for many companies. According to estimates by Certify, a travel software provider, spending on business trips in 2019 totalled $1.5 trillion (including $315 billion by US businesses). The availability of a technological alternative to at least some business trips will provide a good excuse for many companies to meaningfully reduce the number of trips and their travel budget. In the future, business travel may become more of a privilege than a necessity. It is easy to imagine a significant decline in overall business travel. Manufacturing Supply Chains Corporate behavior could also change as a result of the disruptions caused by the coronavirus. Companies in the US and Europe realized how vulnerable their complex supply chains are. Popular and political pressure is pushing firms to reshore at least some of their overseas production. Firms will need to build in more “operational resilience,” with higher levels of inventory, less debt, and greater redundancy in their systems. Developed economies such as the US have been deindustrializing for 40 years – since reforms in China in the late 1970s, followed by Mexico and central Europe in the 1990s,  made these countries appealing locations for cheap manufacturing. US manufacturing employment has almost halved since 1980, falling to only 27% of the workforce (Chart 15). Manufacturing output, especially outside of the computer sector, has substantially lagged that of the overall private sector (Chart 16). The US has also fallen behind in automation, with a much lower number of robots per manufacturing worker than in countries such as Germany and Japan (Chart 17). Chart 15US Manufacturing Employment Has Halved Since 1980 US Manufacturing Employment Has Halved Since 1980 US Manufacturing Employment Has Halved Since 1980   Chart 16Manufacturing Output Outside The Computer Sector Has Lagged The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 17The US Has Relatively Few Robots The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? The pandemic highlighted how vulnerable widely distributed supply chains are. This was clearest in the health care sector. The US is far away the biggest spender on health care research and development (Chart 18). And yet it was unable to provide critical medical equipment such as face masks, testing kits, and ventilators to its population at an adequate rate, mainly because almost 70% of the facilities which manufacture essential medicines are based abroad (Chart 19). During the pandemic, countries such as China and India prioritized their own citizens, forcing the US government to strike emergency deals to avoid drug shortages. Chart 18The US Spends A Lot On R&D In Health Care… The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 19…But Drug Production Is Mostly Done Overseas The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Once the crisis subsides, CEOs of American companies (as well as the US government) will have to decide if they are comfortable with the fact that, while they possess a vast store of intellectual capital, the manufacturing of their products happens halfway around the world. What happens if there is another pandemic? What about a global disaster caused by climate change? Finally, and perhaps more worryingly, what happens if tensions between the US and China escalate seriously? This shift will not happen overnight: China still has much cheaper labor, an enormous manufacturing base of factories and parts suppliers, and formidable transportation infrastructure. Many aspects of supply chains are too deep-rooted and the economics too compelling for them to be unwound quickly. Some production will shift from China to other emerging economies. A Biden administration might be less confrontational with China, and could lower some of the Trump tariffs. But, at the margin, companies will choose to build new factories in the US (and in western Europe and Japan), with highly automated systems. Government policy (via both subsidies and tariffs) will encourage these trends. Manufacturers which have lived “on the edge” in recent years, with dispersed supply chains, just-in-time processes, minimal inventories, the fewest possible workers, and the maximum amount of debt compatible with their targeted credit rating (often BBB) now understand the need to build redundancy into their systems. Corporate debt levels are high by historical standards in many countries (Chart 20). Companies may want to build up a buffer of net cash in the future, as Japanese companies did for decades after the bubble there burst in 1990. Inventories have risen a little relative to sales since the Global Financial Crisis but will probably rise further (Chart 21). These trends are likely to be negative for profit margins. Chart 20In The Future, Will Companies Be Happy With This Much Debt... In The Future, Will Companies Be Happy With This Much Debt... In The Future, Will Companies Be Happy With This Much Debt... Chart 21...And Such Low Level Of Inventories? ...And Such Low Level Of Inventories? ...And Such Low Level Of Inventories? Implications For Industries In light of the social changes described above, how will various industries be reshaped over the coming years? Which sectors should investors tilt towards because they are likely to emerge as winners from post-COVID structural shifts? And which are the sectors that investors should avoid since they will suffer from the creative destruction? In the midst of major social and technological change, it is often easier to spot losers than winners. Think of the arrival of the internet in the 1990s. How many investors would have correctly picked Google, Amazon, Apple, and only a handful of others as the winners? It would have been easier to correctly identify industries that were likely to lose out to disruption, such as book retailers, travel agents, newspaper publishers, and TV broadcasters. We start, therefore, with the industries likely to lose out from post-COVID changes. The Losers Real Estate Over the next few years, prime real estate seems the most likely loser. It is not clear how many white-collar workers will choose to work from home in the future, or how many days a month they will want to come into an office to meet with fellow workers. But it seems likely there will be a strong continued trend in the direction of remote working. As a result, demand for prime central-business-district property will fall, given that it is very expensive. In Manhattan, for example, the average workspace for each of the 1.5 million office workers is around 310 square feet. At pre-COVID rental costs, that amounts to an average of $20,000 per employee – and more than $30,000 for A+ grade buildings. And rent is only part of what a company pays: There are also costs for cleaning, utilities, technology, security, coffee machines, and cafeterias on top of that. Employees working at home pay for their own space, utilities, food (and often even computer equipment). The size, location, and layout of offices will need to be rethought. Maybe companies will choose to build a campus in the suburbs, with a range of different working spaces (for meetings, quiet work, or collaboration). They may prefer to rent shared co-working spaces by the day or week. Some real estate developers and builders would be beneficiaries of this. Companies would save money in real estate costs. But they may need to pay a stipend to employees who work at home to cover the extra space they will require, and to upgrade their technology (computer equipment, internet speed, and so on). On the other hand, companies may pay lower salaries for workers who move out of high-cost locations such as Manhattan or London to places where it is cheaper to live. Many office spaces are leased on a long-term basis, so some companies will not be able to move out of big cities immediately. But residential property is more liquid. The trends in work practices might accelerate a shift to the suburbs which has already been emerging over the past few years (Chart 22). Workers will not need to live so close to the company’s office if they will visit it for only a few days a month. Small towns with a lively community and pleasant environment (and decent transportation links to a big city) could grow in popularity. This would be bad news for developers which are specialized in developing residential property in cities such as London, Sydney, Toronto, and Vancouver, and for the owners of those properties. But it might be positive for builders who will develop the new houses and out-of-town office campuses. Chart 22The Shift To The Suburbs Was Already Taking Place The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? This does not mean that cities will wither away. After previous epidemics and crises in history (think the Great Plague of London in the 17th century, or 9/11), they have always bounced back. “Casual collisions” – chance meetings with interesting people which lead to collaborative relationships – are crucial in creative industries, and happen online only with difficulty. Buildings will be repurposed: Retail space will be turned into warehouses or apartments, for example. A fall in rents would allow cities to “degentrify” and attract back young people, making the city more dynamic again. But the period of transition could be painful for some segments of the real estate industry. Travel A permanent decline in business travel would be a significant blow to airlines and hotel chains. Business travelers account for only about 12% of the number of air tickets purchased, but they generate 70%-75% of airlines’ profits. Even discount leisure airlines such as Southwest have in recent years started to target business travelers. And it will not just be airlines that are affected. Data from the US Travel Association show that 26% of the $2.5 trillion in travel-related revenues in the US in 2018 came from business travelers. Of that, 17% goes to air travel, 13% to accommodation, and 5% to car rental. An even larger portion goes to food (21%). Around 40% of hotel rooms are occupied by business travelers. Conference organizers and venues could also suffer: 62% of US business trips are to attend conferences. “Sharing economy” companies would be affected too. In 2018, 700,000 business travelers booked accommodation through AirBnB, and 78% of business travelers use Uber and other ride-sharing services. Furthermore, a slowdown in business travel would have knock-on effects on the leisure travel sector. Surveys suggest that almost 40% of business trips in the US are extended to include leisure activities (“bleisure” in the travel industry parlance). The Winners Health Care A recent report by BCA Research’s Global Asset Allocation service argued in detail that the macro environment for global health care equities will remain very positive in the coming years.11 An aging population in the world, and a growing middle class in emerging countries will steadily raise demand for health care services (Charts 23 and 24). China, in particular, has underinvested in health care: It spends only 5% of GDP, barely higher than it did 20 years ago, and well behind other emerging economies such as Brazil and South Africa (Chart 25). Chart 23Positives For Health Care Include An Aging Population… Positives For Health Care Include An Ageing Population... Positives For Health Care Include An Ageing Population... Chart 24…And A Growing Emerging Market Middle Class ...And A Growing Emerging Market Middle Class ...And A Growing Emerging Market Middle Class As a result of the COVID-19 pandemic, governments everywhere will need to spend more money on health care (or, in the case of the US, perhaps spend it more effectively). In the US, before the pandemic, intensive-care beds were sufficient to cope only with the peak of a normal seasonal influenza breakout. The World Health Organization warns that, while pandemics are rare, highly disruptive regional and local outbreaks of infectious diseases are becoming more common (Chart 26). More money will need to be spent, in particular, on developing health care technology (online consultations, digitalized patient records, track-and-trace systems), on improving senior care homes (80% of COVID-19 deaths in the Canadian province of Quebec were in such facilities), and on biotech (such as gene-related therapies). Chart 25Expenditures On Health Care Will Have To Grow Expenditures On Health Care Will Have To Grow Expenditures On Health Care Will Have To Grow Chart 26Number Of Countries Experiencing Serious Outbreak Of Infectious Disease The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not?   The health care equity sector is not expensive, trading in line with its long-run average valuation (Chart 27). Within the sector, biotech and health care technology look more attractive than pharmaceuticals, which are expensive and vulnerable to the price caps proposed by Joe Biden if he is elected US president this November. Chart 27Health Care Stocks Are Not Expensive Health Care Stocks Are Not Expensive Health Care Stocks Are Not Expensive Technology In a plethora of ways, the pandemic has propelled the use of technology: For working at home, communication, online shopping, entertainment, etc. Companies such as Zoom have moved from niche players to mainstream business providers: Zoom’s peak daily users rose from 10 million in December 2019 to 300 million in April. Chart 28Tech Stocks Are Nowhere Close To Previous Peaks Tech Stocks Are Nowhere Close To Previous Peaks Tech Stocks Are Nowhere Close To Previous Peaks Assuming that at least some of these developments remain in place once the pandemic is over, it is easy to see how technology stocks (broadly defined to include any company that uses information technology as a central part of its business) will continue to prosper. These stocks will not be just in the IT sector, but also in communications and consumer discretionary. Picking the individual winners will be hard: Will Microsoft overtake Amazon in cloud computing? Will Zoom’s much-discussed privacy issues undermine it? Will competitors emerge to Shopify in merchant services? Can Spotify compete with Apple in online music streaming? But the broadly-defined sector seems likely to have improving fundamentals for some years to come. The only question is whether the good news is already priced in, after the huge run-up in stock prices over the past few years. We do not believe it is fully. The valuations of these sectors are still nowhere close to the level they reached at the peak of the TMT Bubble in 1999-2000 (Chart 28), they have strong balance-sheets, and considerable earnings power. For their outperformance to end, it will take one of two things. The first trigger could be a significant shift down in growth. Over the past three years, Amazon has grown EPS at a compound rate of 47%, and Netflix at 76% (Chart 29). Over the next three years (2020-2023), analysts forecast compound EPS growth of 32% for Netflix, 30% for Amazon, 15% for Facebook (compared to 24% in 2016-2019), and 12% for Microsoft (compared to 16%). Those are still impressive growth numbers, and should be achievable as long as these companies can continue to grow market share. Chart 29Can The Big Tech Stocks Keep Growing Earnings At This Rate? The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? The second set of risks would be regulatory: A move to break up companies such as Google and Amazon, the US introducing data privacy legislation similar to that in the European Union, or a move to a digital tax or minimum global taxation. None of these seems likely in the immediate future. Automation/Robotics/Capital Goods The return, at the margin, of some manufacturing to the United States (and other developed economies) will bring about economic changes. Unable to tap into the pool of cheap international labor as easily as before, companies will have to invest significantly in this sector. This will result in the following: A resurgence of manufacturing productivity, thanks to increased investment. An intensification of automation. The US will need to boost the number of robots per capita to compete with Korea, Germany, and Japan. This will further improve productivity. The development of a high-tech manufacturing sector. Analogous to the FAANG stocks during the 2010s, a new group of innovative manufacturing companies could emerge. New infrastructure, roads, factories, and machinery will be needed to replace what is now an outdated capital stock in the US (Chart 30). These trends should all be positive for the capital-goods sector. Such a project would also need large amounts of raw materials. This might push up the prices of commodities such as industrial metals, and benefit materials producers. As mentioned above, it could boost the price of real estate outside of the major cities, where the new manufacturers would be likely to set up. Chart 30The US Capital Stock Is Becoming Outdated The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Mixed Retailing / Consumer Goods Retailing is likely to see a significant shakeout over the next few years. The cracks have been apparent for some years: Decreasing footfall, and empty units on many high streets and shopping malls, amid the shift to online shopping. A shift to the suburbs and further growth in online shopping will change retailing further. Rents in the highest end Manhattan shopping districts have already fallen noticeably since the start of the year, especially Lower Fifth Avenue (between 42nd and 49th Streets) which is dominated by large chain stores (Chart 31). Shopping malls, particularly undistinguished ones in poorer areas, will continue to suffer. Overall, the US in particular has an excess of retailing space, almost five times as much per capita as the major European economies (Chart 32). Chart 31Manhattan Retail Store Rents Already Falling Sharply The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? Chart 32The US Has Far Too Much Retail Space The World After COVID-19: What Will Change, What Will Not? The World After COVID-19: What Will Change, What Will Not? But it is hard to predict the winners from this shake-out. Overall spending by consumers is unlikely to be significantly affected, so it is a matter of forecasting which companies and formats will emerge victorious. Will Walmart and Target and other large retail chains improve their online offering to fight back against Amazon? Facebook, Shopify, and others have set up new services to compete with Amazon on price – will they be successful? Will small stores start to win back market share? Will supermarkets figure out how to make profits from their order-online-and-deliver services (which are now very costly because most often a human has to run around the store picking out the items ordered), or will new, fully automated competitors emerge? Will new technologies materialize to make it easier to buy clothes online (for example, digitized body measuring systems)? These changes will also affect producers of consumer products. They will have to understand the new channels, and adapt their offerings and positioning strategies accordingly. These changes will make the sector a tricky one. A skilled fund manager might be able to predict which companies’ strategies will be successful. But it could be a problematic area for investors owning individual stocks within the sector who do not have detailed expertise. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "Beyond The Virus," dated May 22, 2020 and Geopolitical Strategy, "Nationalism And Globalization After COVID-19," dated June 26, 2020. 2 Peter E. Drucker, "The Ecological Vision: Reflections on the American Condition," 1993, p.340. 3 Jonathan I. Dingel and Brent Neiman, "How Many Jobs Can Be Done At Home?" NBER Working Paper No. 26948, April 2020. 4 OWL Labs, “The State of Remote Work Report,” available at www.owllabs.com. 5 Pew Research Center survey conducted March 19-24 2020. Please see https://www.pewsocialtrends.org/2020/03/30/most-americans-say-coronavirus-outbreak-has-impacted-their-lives/psdt_03-30-20_covid-impact-00-4/ 6 Gajendran, R.S., & Harrison, D.A., “The Good, the Bad, and the Unknown about Telecommuting”,  Journal of Applied Psychology 92(6), 2007. 7 Nicholas Bloom, James Liang, John Roberts & Zhichun Jenny Ying, “Does Working from Home Work? Evidence From a Chinese Experiment,” The Quarterly Journal of Economics (2015), 165-218. 8 Please see educationdata.org. 9 Ateev Mehrotra, Michael Chernew, David Linetsky, Hilary Hatch, and David Cutler, "The Impact of the COVID-19 Pandemic on Outpatient Visits: A Rebound Emerges," The Commonwealth Fund, dated May 19, 2020.  10For more on the long-term outlook for the health care sector, Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight," dated July 24, 2020, available at gaa.bcaresearch.com. 11Please see Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight,"dated July 24, 2020, available at gaa.bcaresearch.com.

The Fed’s efforts to jawbone the US dollar are paying off as investors have been shedding their greenback exposure over the past several weeks. In recent research,1 we have also been highlighting that although Powell would never admit it, the Fed is trying to devalue the greenback and reflate the global economy. The knock-on effect of a depreciating USD is to rekindle S&P sales. According to S&P Dow Jones Indices,2 the SPX derives approximately 43% of its sales from abroad making the US dollar among the key macro profitability drivers (Chart 1, middle panel, US dollar shown advanced and inverted). One of the mechanisms to undermine the greenback is to flood the market with dollars. Ample US dollar based liquidity has historically served as a catalyst to reignite global growth and consequently S&P earnings (Chart 1, bottom panel). Chart 1US Dollar - The Key Driver US Dollar - The Key Driver US Dollar - The Key Driver Chart 2Bearish Across All Timeframes Bearish Across All Timeframes Bearish Across All Timeframes The Dollar: A Bearish Case The fate of the US dollar is yet to be sealed, but piling evidence suggests that the path of least resistance will be lower. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (Chart 2, top panel, dotted red line), but now the US Congressional Budget Office (CBO) estimates3 that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (Chart 2, middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 induced recession and resulting money printing will likely exert extreme downward pressure on the US dollar (Chart 2, bottom panel). Summarizing, when looking across three different time horizons, the evidence is pointing toward a weakening US dollar for the foreseeable future. SPX Sectors And US Dollar Correlations With a rising probability of a US dollar bear market on the horizon, it pays to look back in time and examine which S&P GICS1 sectors benefited from a depreciating US dollar. The purpose of this Special Report is to shed light on the empirical evidence of SPX sectors and USD correlations and serve as a roadmap of sector winners and losers during USD bear markets. Table 1 provides foreign sales exposure for each of the sectors. All else equal, a falling greenback should be synonymous with technology, materials, and energy sectors outperforming as they are the most internationally exposed sectors. In contrast, should the USD change its course and head north, financials, telecom, REITs, and utilities will be the key beneficiaries. Why? Because most of these industries are landlocked in the US and thus in a relative sense should benefit when the US dollar roars. Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell To confirm the above hypothesis, we have identified three previous US dollar bear markets (Chart 3) and computed GICS1-level sector relative returns (Table 2). Chart 3US Dollar Bear Markets US Dollar Bear Markets US Dollar Bear Markets Table 2S&P 500 Gics1 Returns* During US Dollar Bear Markets US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell Looking at median return profile reveals that our hypothesis held as all three: technology, materials, and energy decisively outperformed the market when the US dollar headed south. Similarly, domestically focused and predominately defensive industries such as utilities and telecoms underperformed the market with the consumer staples sector being a notable outlier – something that we address in the consumer staples section of the report. What follows next is a detailed discussion on each of the GICS1 sectors historical relationship with the US dollar, ranked in order of foreign sales exposure from highest to lowest. For completion purposes, we also provided S&P 500 GICS1 relative sector performance against the US dollar charts since 1970 in the Appendix.     Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Technology (Neutral)  Technology sits atop the foreign sales exposure table garnering 58% of revenues from abroad, which is a full 15% percentage points higher than S&P 500 (Table 1). In two out of the three periods of USD bear markets that we examined, tech stocks bested the broad market and the median outperformance sat over 9%. Nevertheless, the correlation between the US dollar and relative share prices is muted over a longer-term horizon (see Appendix Chart A1 below). Likely, one reason for the inconclusive long-term correlation between tech and the greenback is that the majority of tech gadgets are manufactured overseas (Chart 4, third panel). Therefore, an appreciating currency boosts margins via deflating input costs. Tack on the resilient nature of demand for tech hardware goods and especially software and services which preserves high selling prices and offsets and negative P&L losses from a rising greenback. We are currently neutral the S&P technology sector and employ a barbell portfolio approach preferring software and services and avoiding hardware and equipment. Chart 4Technology Technology Technology Materials (Neutral) The materials sector behaves similarly to its brother the energy sector as both move in the opposite direction of the greenback (Chart 5, top panel). Consequently, materials stocks have outperformed the market during periods of US dollar weakness that we analyzed. The third panel of Chart 5 shows that our materials exports proxy is the flip image of the greenback. This tight inverse relationship is exacerbated by the negative impact of a firming dollar on underlying metals commodity prices (Chart 5, second panel). As a result, materials profit margins widen when the dollar falls and narrow when it rises. Ultimately, S&P materials earnings reflect this USD-commodity dynamic (Chart 5, bottom panel) We are currently neutral the S&P materials index. Chart 5Materials Materials Materials Energy (Overweight) The energy sector enjoys a tight inverse correlation with the US dollar (Chart 6, top panel) as it is the third most globally exposed sector as shown in Table 1 with 51% of sales coming from abroad. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (Chart 6, second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (Chart 6, third panel). Finally, the S&P energy companies enjoy a boost to their income statements (Chart 6, bottom panel), which explains the sizable median sector outperformance of 43% during dollar bear markets as highlighted in Table 2. We are currently overweight the S&P energy sector and have recently capitalized on 40%+ combined gains in the long XOP/short GDX pair trades.4 Chart 6Energy Energy Energy Industrials (Overweight) US industrials stocks’ foreign sales exposure is on a par with the S&P 500, which explains why the sector only barely outperformed the broad market during periods of dollar weakness. Still, the correlation between this manufacturing-heavy sector and the greenback is negative (Chart 7, top & second panels). Similar to its deep cyclical brethren (materials and energy), the link comes via the commodity channel. A softening dollar boosts global growth, which in turn supports higher commodity prices. Not only do US capital goods producers benefit from overall rising demand (i.e. infrastructure spending), but also via market share gains in global markets as the falling greenback results in a comparative input cost advantage (Chart 7, third panel). Finally, P&L translation gain effects act as another fillip to industrials stocks profits when dollar heads south. We are currently overweight the S&P industrials index. Chart 7Industrials Industrials Industrials Health Care (Overweight) The defensive health care sector is positively correlated with the dollar as its foreign sales revenues are below the ones of the SPX (Chart 8, top panel). Moreover, empirical evidence suggests that the relationship between the sector’s exports and the USD has been mostly positive, which is counterintuitive (Chart 8, middle panel). Keep in mind that pharma and biotech represent roughly half the index and derive 75%+ of their profits domestically as they dictate pricing terms to the US government (it is written into law). This is not the case in Europe where the NHS and the German government for example, have a big say on what pharmaceuticals can charge for their drugs. The bottom panel of Chart 8 summarizes the domestic nature of the health care sector, highlighting the tight positive relationship between the sector’s earnings and the greenback. We are currently modestly overweight the S&P health care sector. Chart 8Health Care Health Care Health Care Consumer Discretionary (Overweight) While the impact of the US dollar on the consumer discretionary sector varied over time switching from a positive to a negative and vice versa, today the sector enjoys a positive correlation with the currency (Chart 9, top panel). The 33% foreign sales exposure may appear as a significant proportion, but it is still a full 10% percentage points below the SPX (Table 1). The implication is that even though the exports benefit from a falling dollar (Chart 9, middle panel), this bump is not enough to drive sector outperformance. Likely, the key reason why consumer discretionary stocks currently enjoy a positive correlation with the dollar is the US large trade deficit. In other words, the US imports the lion’s share of its consumer goods. As the dollar grinds higher, the cost of imports decreases for the US consumer, which provides a boost to companies’ earnings (Chart 9, bottom panel). Tack on the heavy weight AMZN has in the sector (comprising 40% of consumer discretionary sector market cap) and the positive correlation with the currency is explained away. We are currently overweight the S&P consumer discretionary index. Chart 9Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer Staples (Neutral) While a softening US dollar generally favors cyclical industries as it reignites global trade, the defensive S&P consumer staples sector outperformed the overall market on a median basis during USD bear markets (Table 2). Granted, the results are likely skewed as staples stocks rallied more than 300% in the last two decades of the 20th century. Nevertheless, there is a key differentiating factor at play that helped the consumer staples sector trounce other defensive industries during US dollar bear markets. Staples stocks derive 33% (Table 1) of their sales from abroad, whereas other traditional defensive industries (utilities, telecom services) have virtually no export exposure. In other words, given that staples companies are mostly manufacturers, a depreciating currency acts as a tonic to sales via the export relief valve (Chart 10, bottom panel). We are currently neutral the S&P consumer staples sector. Chart 10Consumer Staples Consumer Staples Consumer Staples Financials (Overweight) Financials sit at the bottom half of our Table 1 in terms of their foreign sales exposure, which underpins the sector’s positive correlation with the greenback (Chart 11, top panel), and explains why the sector underperforms the market during dollar bear markets. One of the transmission channels between this sector’s performance and the currency is via increased credit demand. Currency appreciation suppresses inflation and supports purchasing power, and thus loan demand, in addition to keeping bond yields low (Chart 11, middle panel). The process reverses as the US dollar stars to depreciate. We are currently overweight the S&P financials index. Chart 11Financials Financials Financials Utilities (Underweight) Utilities underperformed in all three dollar bear markets we analyzed. As we highlighted in the energy section of the report, a softening dollar is synonymous with higher crude oil prices, which in turn raise inflation expectations. The ensuing selloff in the 10-year Treasury, compels investors to shed this bond proxy equity sector (Chart 12, middle panel). With virtually no exports, utilities also miss on the positive currency translation effects that other GICS1 sectors enjoy. In fact, utilities underperformed by the widest margin on a median basis across all GICS1 sectors (Table 2). This defensive sector typically attracts safe haven flows when the dollar spikes and investors run for cover. This positive correlation with the dollar is clearly reflected in industry earnings, which rise and fall in lockstep with momentum in the greenback (Chart 12, bottom panel). We are currently underweight the S&P utilities sector. Chart 12Utilities Utilities Utilities Telecommunication Services (Neutral) Telecom services relative performance is positively correlated with the dollar, similarly to its defensive sibling, the utilities sector. In fact, telecom carriers go neck-in-neck with utilities as the former is the second worst performing sector during dollar bear markets (Table 2). A softening dollar has proven to be fatal to the industry’s relative pricing power beyond intra industry competition. In fact, industry selling prices are slated to head south anew if history at least rhymes (Chart 13, middle panel). Importantly, this defensive sector is in a structural downtrend and is trying to stay relevant and avoid becoming a “dumb pipeline” with the eventual proliferation of 5G. Worrisomely, telecoms only manage to claw back some of their severe losses during recessions. But, the latest iteration is an aberration as this safe haven sector has failed to stand up to its defensive stature likely owing to the heavy debt load. We are currently neutral the niche S&P telecom services index that now hides underneath the S&P communication services sector. Chart 13Telecom Services Telecom Services Telecom Services REITs (Underweight) Surprisingly, US REITs enjoy an overall negative correlation with the dollar, especially since 1993, and in fact lead the greenback by about 18 months (Chart 14). Our hypothesis would have been a positive correlation courtesy of the landlocked nature of this sector i.e. no export exposure. Granted, in the three periods of dollar bear markets we examined, REITs slightly outperformed the market by 2.5% on a median basis. While the causal link (if any) is yet to be established and the correlation may be spurious, our sense is that forward interest rate differentials are at work and more than offset the domestic nature of this index. REITs have a high dividend yield and thus outperform when the competing risk free asset the 10-year Treasury yield is falling and vice versa (except during recessions). As a result, REITs outperformance is more often than not synonymous with a depreciating currency as lower Treasury yields would exert downward pressure on the USD ceteris paribus.  We are currently underweight the S&P REITs index. Chart 14REITs REITs REITs   Appendix Chart A1Appendix: Technology Appendix: Technology Appendix: Technology Chart A2Appendix: Materials Appendix: Materials Appendix: Materials Chart A3Appendix: Energy Appendix: Energy Appendix: Energy Chart A4Appendix: Industrials Appendix: Industrials Appendix: Industrials Chart A5Appendix: Health Care Appendix: Health Care Appendix: Health Care Chart A6Appendix: Consumer Discretionary Appendix: Consumer Discretionary Appendix: Consumer Discretionary Chart A7Appendix: Consumer Staples Appendix: Consumer Staples Appendix: Consumer Staples Chart A8Appendix: Financials Appendix: Financials Appendix: Financials Chart A9Appendix: Utilities Appendix: Utilities Appendix: Utilities Chart A10Appendix: Telecommunication Services Appendix: Telecommunication Services Appendix: Telecommunication Services Chart A11 landscapeAppendix: REITs Appendix: REITs Appendix: REITs   Footnotes 1    Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2    https://us.spindices.com/indexology/djia-and-sp-500/sp-500-global-sales 3    https://www.cbo.gov/system/files/2020-05/56351-CBO-interim-projections.pdf 4    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.  

What Are Trucks Telling Us? What Are Trucks Telling Us? While the S&P transports index has neither made new all-time highs nor outperformed the SPX year-to-date, one economically hypersensitive sub-group, trucking, has been revving its engines and is sending a bullish signal for the broad market (top panel). The S&P 1500 trucking index has stealthily joined the “new all-time highs” club, similar to the biotech index that we mentioned two weeks ago. Likely, as large parts of the economy are on the verge of reopening, this index has priced in a full recovery and a return to normal in the back half of the year. True, the jury is still out on the economic recovery shape and the risk of a second wave is significant along with the recent spike in uncertainty regarding the US election. But stocks continue to climb the proverbial "wall of worry". Bottom Line: Historically, the highly fragmented trucking industry has an excellent track record in leading the SPX and the current message is that the path of least resistance remains higher for the SPX in the coming 9-12 months (bottom panel).  

The COVID-19 induced recession has accelerated several paradigm shifts that were already afoot. Populism, anti-immigrant sentiment, deglobalization, and fiscal profligacy were replete – particularly in the US – even before the pandemic. For the first time since WWII, the US budget deficit significantly expanded for three years running at a time when the unemployment rate was declining, late in the cycle. We fear that the Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus, as our geopolitical strategists have posited in the past. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. The most important long-term consequence of the Buenos Aires Consensus will be higher inflation. And we are not talking just the asset price kind – which investors have enjoyed over the past decade – but of the more traditional flavor: consumer price inflation (Chart 1). Chart 1Inflation Is Coming Inflation Is Coming Inflation Is Coming A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (Chart 2). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium (Chart 3). Chart 2Only A Whiff Of Inflation Is Good For Stocks Only A Whiff Of Inflation Is Good For Stocks Only A Whiff Of Inflation Is Good For Stocks Importantly, the magnitude of the economic damage, the likelihood that a “second wave” requires renewed lockdowns, and a new steady state of the apparent “square root” type of recovery remain unknown. This means that “deflationistas” may continue to have an upper hand on the “inflationistas”, as witnessed by the subdued inflation expectations (Chart 3). Chart 3In The Near-Term Disinflation Looms In The Near-Term Disinflation Looms In The Near-Term Disinflation Looms The Federal Reserve’s Function As The Lender Of Last Resort What is certain is the Fed’s resolve to keep things gelled together and allow businesses and the economy enough time to heal and overcome the coronavirus shock. Simply put, there are high odds that the Fed will remain accommodative and take inflation risk “sitting down” for quite some time, certainly for the next year, and likely longer (Chart 4). While early on, the Powell-led Fed had been ambivalent, the FOMC’s swift and immense response to the coronavirus calamity with unorthodox monetary policies has been appropriate and unprecedented (Chart 5). Clearly, the sloshing liquidity cannot cure the coronavirus, but providing the credit needed in parts of the financial markets and select business sectors that had completely dried up was the proper policy response. The Fed acted promptly as a lender of last resort. Unlike the difficulty in defeating deflation – look no further than Japan – ending inflation is easy. The great Paul Volcker has taught the Fed and the world how to break the back of inflation. The Fed, therefore, has the credible tools to deal with a possible inflationary impulse. Chart 4Do Not Fight The Mighty Fed Do Not Fight The Mighty Fed Do Not Fight The Mighty Fed Chart 5Joined At The Hip Joined At The Hip Joined At The Hip Until economic growth regains its footing and climbs to its post-GFC steady 2-2.5% real GDP growth profile, the probability is high that the Fed will take some inflation risk (Chart 6). Chart 6The Fed Can Afford To Take Inflation Risk The Fed Can Afford To Take Inflation Risk The Fed Can Afford To Take Inflation Risk This is especially the case given that political risk in the US is tilted to the downside. With income inequality at nose bleeds levels, US policymakers (both fiscal and monetary authorities) will hesitate to act on the inflation mandate with gusto and objectivity (Chart 7). Chart 7The Apex Of Globalization And Income Inequality The Apex Of Globalization And Income Inequality The Apex Of Globalization And Income Inequality The Fed will therefore not rush to abruptly tighten monetary policy, a view confirmed by the bond market: fed funds futures are penciling a negative fed funds rate in mid-2021 and ZIRP as far as the eye can see (Chart 8). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside, which would compel the Fed to aggressively raise the fed funds rate. But that is not on the immediate horizon especially given the recent coronavirus-related blow to unit labor costs (please see Appendix below). Even if there were an inflationary backup in longer term Treasury yields, yield curve control is a tool the Fed is considering, something it first tried on the Treasury’s orders during and following WWII for a nine year period. Chart 8ZIRP As Far As The Eye Can See ZIRP As Far As The Eye Can See ZIRP As Far As The Eye Can See Dollar And The Inflationary Valve Importantly, the US dollar’s direction will be critical in determining whether any lasting inflation acceleration occurs. The top panel of Chart 9 shows that inflation accelerates during U.S. dollar bear markets. A depreciating greenback greases the wheels of the global financial system and also serves as a global growth locomotive given that trade is largely conducted in US dollars (bottom panel, Chart 9). Thus, the Fed’s recent US dollar swap lines to other Central Banks, along with its FIMA facility, were instrumental in unclogging the global financial system. Sloshing US dollar liquidity restored a semblance of normality to asset prices (Chart 10). Chart 9Inversely Correlated Inversely Correlated Inversely Correlated Chart 10Ample Liquidity To Debase The Greenback Ample Liquidity To Debase The Greenback Ample Liquidity To Debase The Greenback As we highlighted in our December 16 Special Report titled “Top US Sector Investment Ideas For The Next Decade” ,1 there are rising odds that a US dollar bear market takes root this decade. Eventually, the steeper the greenback’s fall, the higher the chance of a longer lasting inflationary spurt as US import price inflation will rear its ugly head (Chart 11). Chart 11US Dollar Bear Markets Are Synonymous With Inflation US Dollar Bear Markets Are Synonymous With Inflation US Dollar Bear Markets Are Synonymous With Inflation So What? While, in the near-term, accelerating inflation is a negligible risk owing to excess economic slack, in the intermediate-term, it is a rising probability outcome. BCA’s long-held de-globalization theme,2 the US/Sino trade war that is here to stay irrespective of the next electoral outcome and excessive US government fiscal largesse will likely, in the next two-to-three years, swing the global deflation/inflation pendulum toward sustained inflation (Chart 12). For investors that are worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap, especially if inflationary pressures become more acute sooner than we anticipate. Chart 12Deglobalization Will Result In Inflation Deglobalization Will Result In Inflation Deglobalization Will Result In Inflation Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be the primary beneficiaries. Table 1 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. On the flip side, utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. Table 1S&P 500 Sector Performance During Inflationary Periods Revisiting Equity Sector Winners And Losers When Inflation Climbs Revisiting Equity Sector Winners And Losers When Inflation Climbs With the exception of real estate, our portfolio will benefit from an accelerating inflationary backdrop. However, our early- and late-cyclical preference to defensives is a consequence of the current stage of the cycle: when in recession it pays to have a cyclical portfolio bent (please see Charts 6 and 7 from our mid-April Weekly Report).3 Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to further shift our portfolio in order to benefit from accelerating inflation. What follows is a one page per sector analysis of the impact of inflation on pricing power and performance. Sectors are ranked by their average returns (largest to smallest) in the six inflationary cycles we studied as shown on Table 1.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Health Care Health care stocks have consistently outperformed during the six inflationary periods we examined. Over the long haul, it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is on a secular rise around the globe most recently further catalyzed by the COVID-19 pandemic: in the developed markets driven largely by the aging population and in the emerging markets by the accelerating adoption of health care safety nets and higher standards. Chart 13Health Care Health Care Health Care Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector’s pricing power prospects that suffered from a constant derating. Now that political uncertainty has lifted as Biden is a more moderate Democratic President candidate than either Sanders or Warren, a rerating looms. Finally, demand for health care goods and services will not only remain robust, but also get a boost from the recent coronavirus pandemic as governments around the globe beef up their health care response systems. Chart 14Health Care Health Care Health Care Energy The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 above). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge. Chart 15Energy Energy Energy Relative energy pricing power collapsed during the COVID-19 accelerated recession plumbing multi-decade lows. Saudi Arabia’s decision in early-2020 to refrain from balancing the oil market triggered a plunge in WTI crude oil prices to negative $40/bbl. While global demand remains deficient, this breakdown in oil prices has brought some much needed supply discipline in global oil producers including US shale. As the reopening of economies takes hold oil demand will recover and absorb excess oil inventories. While base effects will push crude oil inflation to the stratosphere in Q1/2021, eventually a more balanced global oil market will pave the way to a sustainable rebound in oil prices. Chart 16Energy Energy Energy Real Estate REITs have outperformed the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (Table 1 above). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation. Chart 17Real Estate Real Estate Real Estate Following the GFC trough, REITs pricing power has outpaced the overall CPI. CRE selling prices had been on a tear since the GFC, but the ongoing recession has short-circuited this hard asset’s near uninterrupted price appreciation; according to Green Street Advisors, average CRE prices contracted by roughly 10% in April. Worrisomely the persistent multi-family construction boom and the “amazonification” of the economy will act as a restraint to the apartment REIT and shopping center REIT segments, respectively. Tack on the longer-term knock-on effects of the work-from-home wave that has staying power and even office REITs may suffer a demand-related deflationary shock. Chart 18Real Estate Real Estate Real Estate Materials Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind. Chart 19Materials Materials Materials Our relative materials pricing power gauge is currently contracting, but encouragingly it is showing some signs of stabilization. The drubbing in Chinese GDP in Q1 has dealt a blow to commodities-related demand and thus prices as infrastructure projects ground to a halt. As the Chinese economy has restarted slightly ahead of developed markets a return to normalcy is a high probability outcome in the back half of the year. Keep in mind that the delayed effect of stimulus spending should also hit in Q3 and Q4 likely further tightening commodity markets. Chart 20Materials Materials Materials Consumer Discretionary While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power. Chart 21Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, and are on a trajectory to hit double digit growth. Deflating energy prices, ultra-loose monetary conditions and the $3tn fiscal stimulus have kept the US consumer afloat. As Washington and the Fed are providing a lifeline to the economy during the recession, the reopening of the economy has the potential to turbo-charge consumer discretionary spending as pent up demand will get unleashed. Chart 22Consumer Discretionary Consumer Discretionary Consumer Discretionary Financials Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Chart 23Financials Financials Financials Financials sector pricing power has jumped by about 450bps since the 2019 trough and have exited deflation. Given the recent steepening of the yield curve that is typical at the depths of the recession, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop even temporary could also provide a fillip to margins and offset the large precautionary provisioning that banks are taking to combat the looming recession-related losses. Chart 24Financials Financials Financials Industrials The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges. Chart 25Industrials Industrials Industrials Following a three-year period in the deflation zone, industrials relative pricing power is steadily rising, likely as a consequence of decreasing supplies, CEO discipline and the ongoing US/Sino trade war. The previously expansionary mindset has given way to retrenchment, as the scars from the late-2015/early 2016 manufacturing recession remain fresh. However, infrastructure spending is slated to increase at some point in late-2020 as China revs its economic engine and bolster the demand prospects for this deep cyclical sector. Chart 26Industrials Industrials Industrials Consumer Staples Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector’s track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign. Chart 27Consumer Staples Consumer Staples Consumer Staples Relative consumer staples pricing power has slingshot higher and is flirting with the upper bound of the past three decade range near the 10% mark. The current recession has augmented the status of consumer staples. While the lockdowns has dealt a blow to select discretionary purchases, demand for staples has actually increased according to recent retail sales and inflation data releases. Tack on falling commodity input costs and the implication is that consumer staples manufacturers will likely continue to enjoy widening profit margins. Chart 28Consumer Staples Consumer Staples Consumer Staples Tech Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than is typically perceived, generating enormous amounts of free cash flow. Cash flow growth is also steadier than in the past and has served as a catalyst to embark on shareholder friendly activities. Chart 29Tech Tech Tech Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2016, it has recently soared as tech companies preserved their pricing power, but overall wholesale inflation has suffered a sizable setback. Importantly, demand for tech goods and services has remained resilient during the current recession, further adding to the allure of the tech sector. Chart 30Tech Tech Tech Utilities Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis (Table 1 above). In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry’s lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times. Chart 31Utilities Utilities Utilities Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry’s marginal price setter, have risen 18% since the early-April trough, signaling that recent utility pricing power gains have more upside. Nevertheless, as the economy is gradually reopening, soft data will stage a V-shaped recovery bolstering the odds of a selloff in the bond market. Such a backdrop will dampen the demand for high-yielding defensive equities, including pricey utilities. Chart 32Utilities Utilities Utilities Telecom Services Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 above. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa. Chart 33Telecom Services Telecom Services Telecom Services Telecom services pricing power has been on a recovery mode since February 2017 when Verizon surprised investors and embarked on a price war by reinstating its unlimited plans in order to defend its market share. Importantly, earlier in the year telecom carriers relative selling prices exited deflation coinciding with the completion of the T-Mobile/Sprint deal. Intra-industry M&A is over as now only three major wireless providers are left raising the threat of monopolistic power. Nevertheless, the ongoing 5G deployment is of the utmost importance for telecom carriers and a foray further into cable/media/content services is inevitable so that the telecom incumbents move beyond being “dumb pipelines”. Chart 34Telecom Services Telecom Services Telecom Services Appendix Chart A1 CHART A1 CHART A1 Chart A2 CHART A2 CHART A2 Chart A3 CHART A3 CHART A3 Chart A4 CHART A4 CHART A4 Chart A5 CHART A5 CHART A5 Chart A6 CHART A6 CHART A6     Footnotes 1     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com 2     Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization - All Downhill From Here” dated November 12, 2014, available at gps.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.

Highlights Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control A Swift Policy Response Has Brought Spreads Under Control A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 3US IG: More Value In The Lower Tiers US IG: More Value In The Lower Tiers US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 5Euro Area IG: All Credit Buckets Are Attractive Euro Area IG: All Credit Buckets Are Attractive Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 7UK IG: Value In All Tiers Except Aaa UK IG: Value In All Tiers Except Aaa UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 9Canada IG: Great Value Across Tiers Canada IG: Great Value Across Tiers Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Australia IG: Favor A-Rated and Baa-Rated Credit Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hunting For Alpha In The Global Corporate Bond Jungle Hunting For Alpha In The Global Corporate Bond Jungle Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report on China from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt will discuss whether China’s President Xi Jinping is losing his political mandate. Best regards, Peter Berezin, Chief Global Strategist Highlights The pandemic is likely to have a more severe impact on Main Street than Wall Street, which helps explain why stocks have rallied off their lows even as bond yields have remained depressed. Equity investors are hoping that central banks will keep rates lower for longer, while fiscal easing will revive demand. The end result could be lower bond yields within the context of a full employment economy – a win-win for stocks.  In the near term, these hopes could be dashed, given bleak economic data, falling earnings estimates, and rising worries about a second wave of the pandemic. Longer term, an elevated equity risk premium and the likelihood that the pandemic will not have a significantly negative effect on the supply side of the economy argue for overweighting stocks over bonds. Negative real rates will continue to support gold prices. A weaker dollar later this year will also help. Divergent Signals Chart 1Conflicting Signals Conflicting Signals Conflicting Signals Global equities have rallied 24% off their March lows. The S&P 500 is down only 12% year-to-date and is trading close to where it was last August. In contrast, bond yields have barely risen since March. The US 10-year note currently yields 0.63%, down from 1.92% at the start of the year. The yield on the 30-year bond stands at a mere 1.3%. While crude oil and industrial metal prices have generally tracked bond yields, gold prices have rallied alongside equities (Chart 1). It would be easy to throw up one’s hands and exclaim that markets are behaving schizophrenically. Yet, we think it is possible to reconcile these seemingly divergent price patterns in a way that sheds light on where the major asset classes are likely to go in the months ahead. Two important points should be kept in mind: Bonds and industrial commodities tend to reflect the outlook for the real economy (i.e., Main Street) whereas stocks reflect the outlook for corporate earnings (i.e., Wall Street). The two often move together but can occasionally diverge in important ways. Stock prices and bond yields will tend to move in tandem when deflationary pressures are intensifying; however, the two often move in opposite directions when monetary policy is becoming more accommodative. The former prevailed in early March whereas the latter has been the dominant force since central banks have opened up the monetary spigots. The Real Economy Is Suffering The current economic downturn will go down as the deepest since the Great Depression. The IMF expects global GDP to contract by 3% this year, compared with a flat reading in 2009. GDP in advanced economies is projected to fall by 6%, twice as bad as in 2009 (Chart 2). Chart 2Severe Damage To The Global Economy This Year Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Unemployment rates are also likely to reach the highest levels since the 1930s. The US unemployment rate spiked to 14.7% in April. Even that understates the true increase in joblessness. The labor force has shrunk by 8 million workers since February. If everyone who had left the labor force had been considered unemployed, the unemployment rate would have jumped to nearly 19% (Chart 3). Unemployment among less-skilled workers rose more than among the skilled. Joblessness also increased more among women than men (Chart 4). Chart 3Increase In Joblessness Is Understated Increase In Joblessness Is Understated Increase In Joblessness Is Understated Chart 4Unemployment Has Risen More For Less Skilled Workers And Women Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? The one silver lining is that unlike in past recessions, temporary layoffs have accounted for the vast majority of job losses (Chart 5). This suggests that the links between firms and workers have yet to be severed. As businesses reopen, the hope is that most of these workers will be able to return to their jobs, fueling a rebound in spending. Chart 5Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Risks Of A Second Wave Will that hope be realized? As we discussed last week, the virus that causes COVID-19 is highly contagious – probably twice as contagious as the one that caused the Spanish flu.1 While some social distancing measures will persist even if governments relax lockdown orders, the risk is high that we will see a second wave of infections. Even if a second wave ensues, we do not expect stocks to take out their March lows. In many places, the second wave could come on top of a first wave that has barely abated. This is precisely what happened during the Spanish flu pandemic (Chart 6). Stock prices and credit spreads have closely tracked the number of Google queries about the coronavirus (Chart 7). If the number of new infections begins to trend higher, concern about the pandemic will deepen. This makes us somewhat wary about the near-term direction of risk assets. Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Chart 7Joined At The Hip Joined At The Hip Joined At The Hip   March Was The Bottom In Equities Nevertheless, even if a second wave ensues, we do not expect stocks to take out their March lows. This is partly because the cone of uncertainty around the virus has narrowed. We now know that the fatality rate from the virus is around 1%-to-1.5%, which makes COVID-19 ten times more deadly than the common flu, but still less lethal than SARS or MERS, let alone some avian flu strains which have mortality rates upwards of 50%. A few treatments for the virus are on the horizon. Gilead’s remdesivir appears to be effective in treating COVID-19. Blood plasma injections also look promising. A vaccine developed by researchers at the University of Oxford has been shown to be safe on humans and effective against COVID-19 on rhesus monkeys. Production of the vaccine has already begun, and if it works well on humans, the Oxford scientists expect it to be widely available by September.2 The Stock Market Is Not The Economy Then there is the issue of Main Street versus Wall Street. US equities account for over half of global stock market capitalization. Tech and health care are the two largest sectors in the S&P 500. The former has benefited from the shift towards digital commerce in the wake of the pandemic, while the latter is a highly defensive sector that has gained from the flurry of interest in new treatments for the disease (Chart 8). Chart 8AUS Equity Sectors: Winners And Losers From The Pandemic (I) US Equity Sectors: Winners And Losers From The Pandemic US Equity Sectors: Winners And Losers From The Pandemic Chart 8BUS Equity Sectors: Winners And Losers From The Pandemic (II) US Equity Sectors: Winners And Losers From The Pandemic US Equity Sectors: Winners And Losers From The Pandemic Even within individual sectors, the impact on Wall Street has been more muted than on Main Street. For example, spending on consumer discretionary goods and services has plummeted across the real economy over the past few months. Yet, this has not hurt equity investors as much as one might have expected. Amazon accounts for 55% of the retail sector’s market capitalization. Home Depot is in second place by market cap. Home Depot’s stock is trading near an all-time high, buoyed by increased spending on home improvement projects by people stuck at home. McDonald's, which is benefiting from the shift to take-out ordering, is the largest stock in the consumer services sector (followed by Starbucks). Contrary to the claim that the stock market is blissfully ignorant of the mounting economic damage, those sectors that one would expect to suffer from a pandemic-induced downturn have, in fact, suffered. Airline stocks, which account for less than 2% of the industrials sector, have plunged. The same is true for cruise ship stocks. Bank stocks have also been beaten down, reflecting fears of heightened loan losses. Likewise, lower oil prices have undercut the stocks of energy exploration and production companies (Chart 9). At the regional level, non-US stocks, with their heavy weighting in deep cyclicals and financials, have underperformed their US peers. Small caps have also lagged their large cap brethren, while value stocks have trailed growth stocks (Chart 10). Chart 9Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Chart 10Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Tech stocks are overrepresented in growth indices, which helps explain why growth has outperformed value. Tech companies also tend to carry little debt while sporting large cash holdings. Companies with strong balance sheets have greatly outperformed companies with weak ones since the start of the year (Chart 11). Chart 11Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Chart 12Real Rates Have Come Down This Year Real Rates Have Come Down This Year Real Rates Have Come Down This Year In addition, growth companies have disproportionately benefited from the dramatic decline in real interest rates (Chart 12). A drop in the discount rate raises the present value of a stream of cash flows more the further out in time those cash flows are expected to be realized.   What Low Bond Yields Are Telling Us Doesn’t the decline in real long-term interest rates signal that future economic growth will be considerably weaker? If so, doesn’t this nullify the benefit to growth companies in particular, and the stock market in general, from a lower discount rate? Not necessarily! While lockdowns have led to a temporary drop in aggregate supply, they have not severely undermined the long-term productive capacity of the economy. Unlike during a war, no factories have been destroyed. And while heightened unemployment could lead to some atrophying of skills, the human capital base has remained largely intact. Chart 13 shows that output-per-worker eventually returned to its long-term trend following the Great Depression. Chart 13No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth What the pandemic has done is made some forms of capital obsolete. We probably will not need as many cruise ships or airplanes as we once thought. But these items are not a huge part of the capital stock. And while some brick and mortar stores will disappear, this was part of a long-term shift toward a digital economy – a shift that has been raising productivity levels, rather than lowering them. Demand Is The Bigger Issue So why have long-term real interest rates fallen so much? The answer has more to do with demand than supply. Investors are betting that the pandemic will force central banks to keep interest rates at ultra-low levels for a very long period of time. All things equal, such an extended period of low rates might be necessary if the pandemic causes households to increase precautionary savings and prompts businesses to cut back on investment spending for an extended period of time. All things are not equal, however. As discussed in greater detail in Box 1, if real interest rates fall by enough, aggregate demand could still return to levels consistent with full employment since lower interest rates would discourage savings while encouraging capital expenditures. What if interest rates cannot fall by enough because of the zero-lower bound? In that case, fiscal policy would have to pick up the slack. Either taxes would need to be cut so that the private sector becomes more eager to spend, or the government would need to undertake more spending directly on goods and services. When interest rates are close to zero, worries about debt sustainability diminish since debt can be rolled over at little cost. In the end, the economy could end up in a new post-pandemic equilibrium where real interest rates are lower and fiscal deficits are larger. Applying Theory To Practice Framed in this light, we can make sense of what has happened over the past few months. The drop in long-term bond yields in February and early March was driven by falling inflationary expectations and rising financial stress. Yields then briefly jumped in mid-March as panicky investors dumped bonds in a mad scramble to raise cash. Not surprisingly, stocks suffered during this period. The Federal Reserve reacted to this turmoil by cutting rates to zero. It also initiated large-scale asset purchases, which injected much needed cash into the markets. In addition, the Fed dusted off the alphabet soup of programs created during the financial crisis, while launching a few new ones in an effort to increase the availability of credit and reduce funding costs. Other central banks also eased aggressively. As Chart 14 illustrates with a set of simple examples, even a modest decline in long-term interest rates has the power to significantly raise the present value of future cash flows. To compliment the easing in monetary policy, governments loosened fiscal policy (Chart 15). The point of the stimulus was not to raise GDP. After all, governments wanted most non-essential workers to remain at home. What fiscal easing did do was allow many struggling households and businesses to meet their financial obligations, while hopefully having enough income left over to generate some pent-up demand for when businesses did reopen their doors. Chart 14What Happens To Earnings During A Recessionary Shock? Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Chart 15Will It Be Enough? Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Ultimately, equity investors are hoping for an outcome where fiscal policy is eased by enough to eventually restore full employment while interest rates stay low well beyond that point in order to induce the private sector to keep spending: A win-win combination for stocks. Chart 16Gold Prices Move In The Opposite Direction To Real Rates Gold Prices Move In The Opposite Direction To Real Rates Gold Prices Move In The Opposite Direction To Real Rates The discussion above can also explain the divergent moves in commodity prices. Most industrial metals are consumed not long after they are produced. This makes industrial metal prices highly sensitive to the state of the global business cycle. In contrast, almost all of the gold that has ever been unearthed is still around. This makes gold an anticipatory asset whose price reflects expectations about future demand. Since owning gold does not generate any income, the opportunity cost of holding gold is simply the interest rate (Chart 16). When real interest rates rise, as they did briefly in early March when deflationary fears intensified, gold prices tend to fall. When real interest rates decline, as they did after central banks slashed rates and restarted large-scale QE programs, gold prices tend to rise. Investment Conclusions The current environment bears a passing resemblance to the one that prevailed in late 2008. Following the stock market crash in the wake of Lehman’s bankruptcy, the S&P 500 rallied by 24% between November 20, 2008 and January 6, 2009 to reach a level of 935. Had you bought stocks on that day in January, you still would have made good money over a 12-month horizon. However, you would have lost money over a 3-month horizon since the S&P 500 ultimately dropped to as low as 667 on March 6. During that painful first quarter of 2009, the economic surprise index remained firmly below zero, while earnings estimates continued to drift lower, just like today (Chart 17). As noted above, we do not expect stocks to take out their March 2020 lows, but a temporary sell-off would not surprise us, especially against a backdrop where a second wave of the pandemic looks increasingly likely. Chart 17Is Today A Replay Of Late 2008/Early 2009? Is Today A Replay Of Late 2008/Early 2009? Is Today A Replay Of Late 2008/Early 2009? Chart 18Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Despite our near-term concerns, we continue to think that stocks will outperform bonds over a 12-month horizon. The equity risk premium remains elevated, particularly outside the US (Chart 18). While non-US stocks do not have as much exposure to tech and health care, they do benefit from very cheap valuations. European banks are trading at washed out levels (Chart 19). The cyclically-adjusted PE ratio for EM stocks is near record lows (Chart 20). Investors should consider increasing exposure to non-US equities if global growth begins to reaccelerate this summer. Chart 19European Banks Are Trading At Washed Out Levels European Banks Are Trading At Washed Out Levels European Banks Are Trading At Washed Out Levels Chart 20EM Stocks Are Very Cheap Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Given our view that central banks want real rates to stay low and will refrain from tightening monetary policy even if inflation eventually begins to rise, investors should maintain above-average exposure to gold. A weaker US dollar later this year will also help bullion. Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2  Charlie D’Agata, “Oxford scientists say a vaccine may be widely available by September,” cbsnews (April 30, 2020). Global Investment Strategy View Matrix Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages? Current MacroQuant Model Scores Are Stocks And Bonds Sending Mixed Messages? Are Stocks And Bonds Sending Mixed Messages?