Pharmaceuticals

In our Beta report, we focus on our decade view. Many of our global allocator clients are scrambling to incorporate geopolitics into their strategic asset allocation. For most, this means thinking about war… or about future end-states. This is a mistake. We consider the next five years (maybe a decade) as the transition to the new era, a transition away from American unipolarity. And the transition itself is investment relevant. A transition to a multipolar world – which we think is occurring – will crush the USD and favor non-US assets. A transition to a bipolar world – not our base case, but still possible – would do the opposite. 

We recommend overweight in Pharma over a tactical and strategic investment horizon, as challenges, that have recently hampered the industry group’s performance, are dissipating. Likely election outcomes are positive for the industry, while major trends like generative AI applied to drug development and an aging population are long-term tailwinds.

Executive Summary Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 2Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 7Democrats’ Odds Will Improve On Margin Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Market Responds To Drug Price Caps Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Market Responds To China Competition Bill Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A3US Political Capital Index Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5BPolitical Capital: Household And Business Sentiment Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5CPolitical Capital: The Economy And Markets Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake

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

Upgrade Pharma Equities To Neutral Upgrade Pharma Equities To Neutral This Monday we closed both our cyclical and high-conviction S&P pharmaceuticals underweights for a combined gain of 23%, since inception. We did not wish to overstay our welcome in this defensive industry as not only is the bearish story well-known and fully reflected in bombed out technicals (bottom panel) and valuations (not shown), but our short-term cautious outlook is also forcing us to add some defensive exposure to our portfolio. Encouragingly, our macro EPS growth models signal that pharma profits have a strong pulse and will outshine the overall market in the coming year, meaning that an underweight stance is no longer warranted and instead investors should augment exposure back up to a benchmark allocation (middle panel). Bottom Line: We crystalized 23% in combined gains (cyclical and high-conviction list) in the S&P pharma index and lifted exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5PHARX– JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, VTRS, PRGO. Please refer to this past Monday’s Strategy Report for additional details. ​​​​​​​

Highlights Portfolio Strategy Firming operating metrics, a capex upcycle, rock bottom valuations and deeply oversold conditions all suggest that it no longer pays to be bearish Big Pharma. Upgrade to neutral, today. A looming M&A boom, excess liquidity leaking into biotech stocks, extremely pessimistic Wall Street analysts’ forecasts and severe undervaluation, all suggest that now is the time to go against the grain and overweight biotech equities. Recent Changes Lift the S&P pharmaceuticals index to neutral and remove it from the high-conviction underweight list cementing gains of 12.6% and 10.3% respectively. Boost the S&P biotech index to overweight today. Both of these moves also lift the S&P health care sector to an above benchmark allocation. Table 1 Sell In May And Go Away Or Hold And Pray? Sell In May And Go Away Or Hold And Pray? Feature The bulls have taken full control of the equity market and propelled almost every index to fresh all-time highs despite a muted earnings season. Not only are the SPX, the DOW industrials and transports, the NASDAQ composite and the NASDAQ 100 all flirting with uncharted territory, but also more obscure indexes like the Value Line Arithmetic (gauging the average US stock) and Geometric (gauging the median US stock) indexes have also cleared the all-time high bar (Chart 1). On a stock level, bellwether AAPL – the largest stock in the world – has yet to make the leap to new highs despite a blowout profit report and gargantuan buyback announcement, which is cause for near-term concern. Given that the Fed orchestrated this once in a lifetime bonanza, it is also the Fed that can spoil this party, at least temporarily, by removing the proverbial punchbowl. Peering toward the back half of the year, our view remains that the Fed will have to relent and taper asset purchases as inflation will be rearing its ugly head not in a transitory, but more on a semi-permanent fashion. Importantly, the USD can further fan this inflationary impulse. Chart 2 shows that US real GDP expectations are trouncing the rest of the world (ROW) as we first showed in early March. Similarly the ISM manufacturing dichotomy compared with the ROW PMIs is as good as it gets. While this would typically call for a surge in the greenback, counterintuitively we think the path of least resistance is lower for the US dollar as the US economy reaches an inflection point versus the ROW mid-year. Crudely put, if the USD merely ticked up on such a wide economic differential, once Europe and Japan play catch up as the vaccine rollouts and economic reopening smoothen up, then investors will likely flee the US dollar. Chart 1All Time Highs Everywhere All Time Highs Everywhere All Time Highs Everywhere Chart 2Relative Growth Expectations At A Zenith Relative Growth Expectations At A Zenith Relative Growth Expectations At A Zenith With regard to stock market dynamics, this is welcome news for revenue growth, especially for internationally sourced SPX sales that garner a 40% share of total revenues. Since the US dollar floated in the early 1970s, the inverse correlation has increased between top line S&P 500 growth and the greenback (Chart 3). The implication is that a US dollar debasing from current levels will further boost the allure of companies that can raise selling prices. On that front our Corporate Pricing Power Indicator (CPPI) that we recently updated has been on a tear, underscoring that sales growth will soon follow suit (Chart 4). Chart 3Depreciating USD A Boon For SPX Sales Depreciating USD A Boon For SPX Sales Depreciating USD A Boon For SPX Sales Chart 4Rising Inflation Will Boost Revenues Rising Inflation Will Boost Revenues Rising Inflation Will Boost Revenues Tack on optimistic Chief Executives, and the picture brightens further for SPX revenue prospects. Inflation breakevens also corroborate the messages from our soaring CPPI and surging business confidence (Chart 4). One level down to the SPX GICS1 sector level, Charts 5, 6 & 7 highlight sales growth expectations, with deep cyclicals reigning supreme –especially the energy complex– and defensives the clear laggards (all sectors are compared with the broad market). On the early cyclical front, consumer discretionary equities are forecast to grow sales by 500bps more than the SPX, while financials are slated to trail the overall market by 500bps. Chart 5Consumer Discretionary… Consumer Discretionary… Consumer Discretionary… Chart 6…And Deep Cyclicals… …And Deep Cyclicals… …And Deep Cyclicals… Chart 7…Have The Upper Hand …Have The Upper Hand …Have The Upper Hand With regard to the contribution to SPX sales growth for calendar 2021, Table 2 details sector sales growth, sector sales weight, all ranked by sector contribution to SPX sales growth. Chart 8 highlights that consumer discretionary, energy and health care comprise roughly half of the increase in overall revenue growth for 2021. Adding industrials and tech to the mix and these five sectors explain 80% of this year’s projected top line growth contribution to the SPX. Table 2SPX GICS1 Sector Sales Analysis Sell In May And Go Away Or Hold And Pray? Sell In May And Go Away Or Hold And Pray? Chart 8Sector Contribution To 2021 SPX Sales Growth Sell In May And Go Away Or Hold And Pray? Sell In May And Go Away Or Hold And Pray? Drilling further into industry sub-groups and for inclusion purposes, Table 3 shows our universe of coverage, ranking GICS1 sectors by 12-month forward sales growth and then re-ranking by sub-groups always from highest-to-lowest. Table 3Identifying S&P 500 Sector Sales Growth Leaders And Laggards Sell In May And Go Away Or Hold And Pray? Sell In May And Go Away Or Hold And Pray? Circling back to investment implications and gelling everything together, what should investors do given this backdrop? If portfolio managers can stomach volatility and sail through the seasonally weak month of May, then holding the line and sitting tight is the appropriate strategy. However, if investors cannot stomach the bout of volatility that is likely looming, then playing some defense would make sense. We stand closer to the latter camp, and this week we take profits on a defensive group and lift exposure to neutral and boost another beaten down health care sub-group to overweight. These two moves also lift the S&P health care sector to an above benchmark allocation. Exiting The ER The bearish undertones haunting the S&P pharmaceuticals index are well ingrained in investors’ minds and our portfolio has also handsomely benefited from avoiding this key health care industry group. However, it no longer pays to be negative Big Pharma and today we book gains of 12.6% and lift exposure to neutral, and also take this index out of our high-conviction underweight list locking in gains of 10.3% since the early December inception. Chart 9 shows that likely all the adverse news is priced in rock bottom valuations and extremely oversold technical conditions. In fact, the pharma forward P/E ratio is trading at a 40% discount to the SPX and all time low since the GICS reclassification of sectors took place in the early 1990s! While such drubbing is warranted, as this defensive index has to contend an economy exiting recession and also a near unanimous outcry against industry pricing power gains, the easy money has been made on the short/underweight side. This de-rating has coincided with a collapse in relative forward profit growth, on a 12-month and five-year basis, both of which are probing all-time lows (Chart 10). The implication is that the EPS bar is so low it is nearly guaranteed that Big Pharma will surpass it. Such extreme pessimism is contrarily positive and if there is even a whiff of positive profit news, an explosive rally will take root. Chart 9Unloved And Under-owned Unloved And Under-owned Unloved And Under-owned Chart 10Analysts Have Given Up On Pharma Analysts Have Given Up On Pharma Analysts Have Given Up On Pharma Encouragingly, our macro EPS growth models signal that pharma profits have a strong pulse and will outshine the overall market in the coming year (Chart 11). We recently highlighted the near perfect inverse correlation of the relative share price ratio with the US leading economic indicator and the US ZEW. Similarly, we have shown in the recent past that a number of subcomponents of the ISM manufacturing survey also move inversely with pharma relative profitability. Now that the ISM is at a zenith, staying bearish pharmaceutical stocks will likely prove offside. Meanwhile, Chart 12 shows that the fed funds rate impulse is neither contracting nor weighing on relative share prices. Similarly, the bond market has already priced in two hikes in two years, warning that the relative share price ratio risk/reward tradeoff is slowly shifting to the overweight column. Chart 11Out Of The Ward Out Of The Ward Out Of The Ward On the operating front, Big Pharma is investing anew with capex gone parabolic (bottom panel, Chart 13). The last time pharma capital outlays rose over 20%/annum was in the early 1990s! Chart 12There Is A Pulse There Is A Pulse There Is A Pulse Chart 13Capex To The Rescue? Capex To The Rescue? Capex To The Rescue? Industry shipments are climbing roughly at a double digit clip and pharma output is also expanding smartly, underscoring that soon industry productivity will also ascend, which is a boon for profits (Chart 14). Tack on the export relief valve pharma manufacturers are enjoying of late, and factors are falling into place for an earnings led rebound in pharma equities (second panel, Chart 14). Finally, the top panel of Chart 15 highlights that demand for pharmaceuticals in as upbeat as ever and has been significantly diverging from relative share prices. The implication is that this steep gulf will narrow via a catch up phase in the latter. Chart 14Glimmers Of Hope Glimmers Of Hope Glimmers Of Hope Chart 15Upbeat Demand, But Deflation Is A Tough Pill To Swallow Upbeat Demand, But Deflation Is A Tough Pill To Swallow Upbeat Demand, But Deflation Is A Tough Pill To Swallow Nevertheless, before getting outright bullish this heavyweight health care sub-group, there are two significant (and related) offsets. Industry pricing power is under attack and will remain in duress until it reaches a new equilibrium (middle panel, Chart 15). As a result, pharmaceutical profit margins have been in an almost uninterrupted multi year squeeze, warranting only a neutral allocation to Big Pharma manufacturers, until these dark profit clouds clear (bottom panel, Chart 15). Netting it all out, firming operating metrics, a capex upcycle, rock bottom valuations and deeply oversold conditions all signal that it no longer pays to be bearish Big Pharma. Upgrade to neutral, today. Bottom Line: Crystalize gains in the S&P pharma index of 12.6% since inception and lift exposure to neutral. We are also removing it from the high-conviction underweight list locking in gains of 10.3% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PHARX– JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, VTRS, PRGO. Buy Biotech Stocks Against The Grain We recommend investors buy the budding recovery in biotech stocks, and today we are boosting the S&P biotech index to an above benchmark allocation. Rising interest rates have dampened demand for biotech stocks as these high growth stocks should command a lower multiple on the back of a rising discount rate (top panel, Chart 16). Add on waning US dollar liquidity and the relative underperformance phase gets explained away (bottom panel, Chart 16). However, there still remains a sizable gap between relative profits and relative share prices. If our four-pronged bullish thesis that we detail below pans out, then a catch up phase looms in crushed biotech stocks (Chart 17). Chart 16Bearish Story Well Documented Bearish Story Well Documented Bearish Story Well Documented Chart 17Peculiarly Wide Gap Peculiarly Wide Gap Peculiarly Wide Gap First, we posit that this highly fragmented industry is prime for consolidation. Even in the large cap S&P 500 biotech index there is scope for M&A activity. Not only intra-industry mergers, but also cash rich and drug pipeline extension thirsty Big Pharma is lurking in the shadows ready to deploy their cash hoard. Already, there is an ongoing mini M&A boom and given the recent biotech firms’ success stories in the race to discover the COVID-19 vaccine, they command a high profile in investment banking board rooms (Chart 18). Second, as long as the Fed remains committed to ZIRP and margin debt balances continue to balloon, some of this excess liquidity will flow toward biotech stocks that are more speculative than their safe-haven health care brethren. Historically, relative margin debt balances and relative share prices have been joined at the hip, and the message from spiking margin debt uptake is to expect a similar rebound in biotech equities (Chart 19). Chart 18M&A Boom Is Bullish M&A Boom Is Bullish M&A Boom Is Bullish Chart 19Speculative Excesses Go Hand-In-Hand With Biotech Stocks Speculative Excesses Go Hand-In-Hand With Biotech Stocks Speculative Excesses Go Hand-In-Hand With Biotech Stocks Third, the sell side has thrown in the towel on the prospects of the S&P biotech index. Relative sales growth expectations are negative, relative 12-month and five-year forward growth numbers are sinking like a stone and probing all-time lows (Chart 20). All this analyst pessimism is gaining steam at a time when the S&P biotech dividend yield is 2.5%, roughly 100bps higher than the 10-year US Treasury yield and 125bps higher than the SPX dividend yield (bottom panel, Chart 20). Finally, not only the relatively large dividend yield gap signals that biotech stocks are cheap, but on a forward P/E basis the S&P biotech index trades at a whopping 50% discount to the SPX (fourth panel, Chart 20). Our Valuation Indicator has collapsed to levels that have marked prior bull phases going back 25 years and similarly technicals are as downbeat as ever (Chart 21). Chart 20Low Threshold To Overcome Low Threshold To Overcome Low Threshold To Overcome Chart 21Cheap And Oversold Cheap And Oversold Cheap And Oversold In sum, a looming M&A boom, excess liquidity leaking into biotech stocks, extremely pessimistic Wall Street analysts’ forecasts and severe undervaluation, all signal that now is the time to go against the grain and overweight biotech equities. Bottom Line: Lift the S&P biotech index to overweight, today. This upgrade along with the S&P pharma upshift to neutral also lift the S&P health care sector to overweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX– AMGN, ABBV, GILD, VRTX, REGN, ALXN, BIIB, INCY.       Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 ​​​​​​​Favor value over growth

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Upside Oil Price Risks Are Increasing Upside Oil Price Risks Are Increasing Chart 2DM Demand Surges This Year DM Demand Surges This Year DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort Shale Is The Marginal Barrel In The Price Taking Cohort Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Supply-Demand Balances in 2021 Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Upside Oil Price Risks Are Increasing Upside Oil Price Risks Are Increasing We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... OPEC 2.0 Policy Continues To Keep Supply Below Demand... OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 OECD Inventories Fall to 2023 OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Brent Forecasts Rise As Global Economy Recovers Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Base Metals Are Being Bullish Base Metals Are Being Bullish Chart 10Gold Prices To Rise Gold Prices To Rise Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Critical Condition Critical Condition Underweight (High-Conviction) Pharmaceutical stocks are melting in line with the broader macro-economic rebound, and given our cyclical and structural bullish market outlooks, we continue to recommend investors fade this defensive sector (CLI and ZEW shown inverted, middle & bottom panels). JNJ’s recent negative blood clotting vaccine news further accelerated the wholesale liquidation of this key health care sub-group. Should the number of vaccine-caused fatal cases rise, more and more countries will be banning this US-manufactured vaccine, putting additional earnings strains on drug stocks. As a reminder, we are currently underweight the S&P pharma index both within our cyclical and high-conviction universes and the positions are up 12.4% and 10%, respectively. Bottom Line: Stay underweight the S&P pharma index. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, VTRS, PRGO.  

Dear client, Next Monday December 14, 2020 we will be hosting our last webcasts for the year “From Alpha To Omega With Anastasios”, one at 10am EST for our US, European and Middle Eastern clients and one at 8pm EST for our Asia Pacific, Australia and New Zealand clients; our final weekly publication for 2020 will be on Monday December 21, 2020 where we will highlight our top charts of the past year. Kind Regards, Anastasios Highlights Portfolio Strategy Our high-conviction overweight calls comprise four “Back-To Work” beneficiaries, and a hedge. In marked contrast, all of our high-conviction underweights are focused on “COVID-19 Winners” that should lose some of their luster next year. Recent Changes Upgrade the S&P real estate sector to overweight, today. Feature Favorable Macro Backdrop Easy monetary and loose fiscal policies will remain intact and sustain flush liquidity conditions next year. As a result, the global economy will continue to gain traction. Importantly, early-August marked a critical economic inflection point. Gold prices peaked and 10-year real and nominal yields troughed (yields shown inverted, top & middle panels, Chart 1). The bullion and bond markets corroborated the economic recovery that equities and the ISM manufacturing surveys sniffed out in late-spring. This is important for cementing the bull market in equities which is predicated on a durable economic recovery. In other words, the rise in real yields serves as a green light for further stock gains as it signals that the economy is on the recovery path. The bottom panel of Chart 1 also highlights that non-US equity markets started sporting accelerating profit growth expectations in August. Eurozone and other ex-US bourses zoomed past the US EPS growth trajectory as the latter reached a plateau. Chart 1Inflection Point Inflection Point Inflection Point This gives us confidence that 2021 will be a bumper year for SPX profits and help carry the market higher near our 4,000 target. As a reminder, on November 9 in a Special Report, we lifted our EPS estimate to $168 for calendar 2021 and introduced an end-2021 SPX target of 4,000 (Chart 2). Chart 2Earnings Will Do The Heavy Lifting In 2021 Earnings Will Do The Heavy Lifting In 2021 Earnings Will Do The Heavy Lifting In 2021 Two Risks To Monitor Nevertheless, the bond market represents a risk to our sanguine equity market view. Simply put, if the 10-year US Treasury yield stalls, then it will also stop the rotation trade in its tracks. The budding improvement in the Chinese and EM economic cycles will likely be sustainable next year, consistent with the Chinese four-year cycles of the past twenty years (Chart 3). Each up-cycle has typically been driven by credit expansion and capital spending, on the back of fiscal and monetary easing. These conditions are in place once again. Chart 3Follow The Chinese Four-year Cycle Follow The Chinese Four-year Cycle Follow The Chinese Four-year Cycle We recently showed that China’s fiscal easing will likely continue to grease the wheels of global trade into mid-2021 and thus debase the greenback (Chart 4), but will likely run out of steam in the back half of next year. Thus, China’s reflation going on hiatus is another key risk we will monitor in 2021 that could serve as a growth scare catalyst and reset stocks. Chart 4Laggard Deep Cyclicals Have The Upper Hand Laggard Deep Cyclicals Have The Upper Hand Laggard Deep Cyclicals Have The Upper Hand Year In Review 2020 is a year to forget as far as the coronavirus human toll is concerned; the economic and EPS recessions, while short lived, were deep. The COVID-19-inflicted wounds, especially to services industries the world over, were deep and there will be severe scarring. Early in the year, equities felt the COVID-19 tremor and collapsed 35% from the February 19 highs, but extremely aggressive monetary and fiscal policy responses filled the void and were the dominant themes in the ensuing recovery that saw the SPX vault to all-time highs. Our portfolio was resilient and was able to absorb the COVID-19 shock as we were bulletproofing it in the back half of 2019 and early-2020 for a recession owing largely to the yield curve inversion. Importantly, we were not dogmatic and on March 16 we turned cyclically bullish. This eventually culminated into the March 23 Strategy Report where we penned 20 reasons to start buying stocks and coincided with the trough in the SPX. This cyclical shift in our view from bearish-to-bullish aided our portfolio performance as we started adding cyclical exposure and trimming defensive exposure in order to benefit from the immense monetary and fiscal policy responses. Early on, we deemed these macro forces were forceful enough to really turn things around and we remained bullish on a cyclical time horizon. All in all, our trades produced alpha to the tune of 425bps. While our pair trades were sub-par (as is custom we are closing the remaining today), our high-conviction trades and cyclical portfolio moves recorded solid gains (please see the final tally below). Ray Of Light Encouragingly, there is light at the end of the tunnel, as a number of vaccines will become available late this year and/or early in 2021. This is great news for the economy and for stocks. We have positioned the portfolio to benefit from the reopening of the economy and the vaccine will act as an accelerant as our flagship publication posited last week while documenting BCA’s upbeat Outlook for 2021. Our portfolio enjoys a cyclical-over-defensive bent, has a small cap bias and we remain committed to the “Back-To-Work” basket versus the “COVID-19 Winners” basket (Chart 5). In the short-term, equities have discounted a lot of good news, which is likely to steal from next year’s returns. However, as populations get inoculated and large parts of the global economy reopen, a virtuous cycle of increasing consumer and business confidence would boost investment and GDP and prove a boon for corporate profits. Already the rally is broadening out with the value line arithmetic and geometric indexes outshining the SPX (Chart 6). An active ETF (RVRS:US) that has a reverse weighting to US large caps is also besting the S&P 500 and signals that more gains are in store in the New Year, especially for the still beaten down deep cyclical laggards. Chart 5Stick With The Reopening Trade Stick With The Reopening Trade Stick With The Reopening Trade Chart 6Rally Is Broadening Out, And That’s Healthy Rally Is Broadening Out, And That’s Healthy Rally Is Broadening Out, And That’s Healthy More Overweights Than Underweights As is custom every year, this Strategy Report introduces our high-conviction calls for 2021. This year we have four overweights, a bonus volatility trade on the long side, three underweights, and a bonus structural trade that we add to our trades of the decade first introduced in mid-December 2019. Our overweights comprise three “Back-To-Work” beneficiaries, a great rotation trade and a hedge. All of our underweights are focused on “COVID-19 Winners” that should lose some of their luster next year. Finally, this year we take a page out of Byron Wien’s annual “10 surprises” list and offer our clients three “also rans”, which got close but ultimately failed to make our high-conviction list.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Overweight Hotels (Back-To-Work Theme) The recent positive vaccine news is a key reason we are warming up to this consumer discretionary sub group. While neither lodging nor cruise line vacationing will return to their previous peaks any time soon, both industries will survive and thus should no longer be priced for bankruptcy. One key industry demand determinant is confidence. Consumer sentiment has staged a W-shaped recovery. It is still flimsy, but the vaccine efficacy news should catapult confidence higher in the coming quarters. The implication is that the wide gulf between consumer confidence and relative share prices will narrow via a catch up phase in the latter (top panel, Chart 7). Moreover, the ISM non-manufacturing survey is on a sling shot recovery following the bombed out spring readings. This rebound also suggests that the path of least resistance is higher for lodging stocks (second panel, Chart 7). Our hotel demand indicator does an excellent job in encapsulating all these different forces and forecasts an enticing lodging services demand backdrop into 2021 (third panel, Chart 7). Already, consumer outlays on hotels are staging a comeback, albeit from an extremely depressed level. The upshot is that an earnings-led bounce is in the cards (fourth panel, Chart 7). Finally, washed out technicals and extremely alluring valuations provide an attractive reward/risk tradeoff at the current juncture (bottom panel, Chart 7). Bottom Line: The S&P hotels, resorts & cruise lines index is a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH. Chart 7Buy Hotels Buy Hotels Buy Hotels Overweight Real Estate (Back-To-Work Theme) Boost the S&P real estate sector all the way to overweight today, in order to benefit from the looming full reopening of the economy on the back of the vaccine’s arrival. We have been bearish this niche S&P sector and delivered alpha to our portfolio both via the cyclical and high-conviction underweights this year. Nevertheless, we do not want to overstay our welcome and the time is ripe for a bullish commercial real estate (CRE) stance. The bearish story is well known, but some bullish undertones are widely neglected. The rebound in relative share prices is substantially trailing the 2009 episode, when REITs outshined the SPX by 65% one year following the March 2009 trough. Currently, on a similar SPX advance from the March 2020 lows, REITs are lagging the S&P 500 by 22% (top panel, Chart 8). As large parts of CRE have been at the epicenter of the pandemic, any return to even semi-normalcy in 2021 should see these beaten down stocks sling shot passed the SPX. When the fiscal package finally passes, it will likely serve as a fresh reflationary bridge to support the economy. The proverbial “kicking the can down the road” will thus lift some uncertainty hanging over CRE landlords receiving rents and also via banks not foreclosing distressed properties which would have further depressed CRE prices. CRE prices will likely recover in the New Year as vulture funds and opportunistic investors are already bargain hunting. Tack on the likely refinancing lifeline bankers will extend to CRE debt originators (middle & bottom panels, Chart 8) and such a backdrop will loosen the noose around distressed property landlords. Bottom Line: Boost the S&P real estate sector to an above benchmark allocation and add it to the high-conviction overweight call list.   Chart 8Upgrade Real Estate To Overweight Upgrade Real Estate To Overweight Upgrade Real Estate To Overweight Overweight Industrials (Back-To-Work Theme) Add the S&P industrials sector to the high-conviction overweight list. Emerging markets (EM) and China represent the key source for the sector’s buoyancy. The EM manufacturing PMI clocking in at 53.9 hit an all-time high (top panel, Chart 9). China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 277 points from -239 to +38 over the past nine months (second panel, Chart 9). The upshot is that US industrials stocks should outperform when China and the EM are vibrant. Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve. A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (middle panel, Chart 9). 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 (fourth panel, Chart 9). Sell-side analysts have never been more pessimistic with regard to the sector’s long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 9)! This bearishness is contrarily positive as a little bit of good news can go a long way. Bottom Line: The S&P industrials sector is a high-conviction overweight.  Chart 9Overweight Industrials Overweight Industrials Overweight Industrials Overweight Small Caps At The Expense Of Large Caps (Rotation Trade) Recent vaccine efficacy announcements have paved the way for a sustainable great rotation trade into small caps and out of large caps. One of the key small size bias drivers is the delta in sector composition between the small and large cap indexes. The relative gap in deep cyclicals alone is 13% as we highlighted in recent research. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirtations with seven-year highs. Thus, the small caps catch up phase has a long ways to go (top & fourth panels, Chart 10). The financials sector gulf is also significant, with small caps’ exposure relative to their large cap brethren clocking in at over 700bps. Already, the yield curve is steepening and there are high odds of a selloff in the bond market as the economy continues to reopen (third panel, Chart 10). In addition, easy fiscal policy is a tonic to the small/large share price ratio. As a flood of money enters the economy with a slight lag, small caps will continue to make up ground lost during the early stages of the pandemic (fiscal balance shown inverted, second panel, Chart 10). Not only is fiscal stimulus providing a lifeline to debt-burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, bottom panel, Chart 10). Bottom Line: A small size bias is a high-conviction call for 2021. Chart 10Prefer Small Caps To Large Caps Prefer Small Caps To Large Caps Prefer Small Caps To Large Caps Long VIX June 2021 Expiry Futures (Hedge Trade) We want to hedge our overweight exposures with a long VIX futures position for the June 16, 2021 expiry. We are spending $25.3 to go long and are comfortable paying up for insurance when the SPX is at all-time highs and there is a risk of some growth disappointment in the next six months. Chart 11 draws a parallel with the March 2009 SPX lows and plots the VIX in 2009 and 2010. While the path of least resistance is lower for volatility, sporadic surges are typical in the year following recessions. The S&P 500 also troughed in March 2020 and if history is an accurate guide, the path to SPX 4,000 will be rocky next year. As a reminder, the S&P 500 suffered a 16% correction in May 2010 and the VIX spiked higher. Positioning remains lopsided with both VIX put/call ratios (volume and open interest) at historically high levels, underscoring investor complacency. Net speculative futures positions as a percent of open interest are also probing multi-year lows, corroborating the complacent options data. Finally, the equity volatility curve has flipped from a 10% backwardation to a steep contango in the past month with the 3rd month now trading at a 25% premium to spot VIX; such a complacent level typically warns of a looming spike in the VIX. Bottom Line: Go long the VIX June 2021 futures as a small hedge to overweight equity positions. Chart 11Go Long VIX Futures As A Hedge Go Long VIX Futures As A Hedge Go Long VIX Futures As A Hedge Underweight Homebuilders (COVID-19 Winner Theme) We deem that most, if not all, of the good news (low mortgage rates, low inventories, high demand, work-from-home reality, all-time highs on the overall NAHB housing sentiment survey) is already priced in galloping homebuilders stock prices and exuberant expectations. While being contrarian is fraught with danger, because more often than not the herd is right, there is a key macro driver that gives us confidence to be bearish homebuilders: interest rates. If our economic reopening thesis proves accurate next year, then the COVID-19 winners – homebuilders included – will take the back seat. Historically, interest rates and relative share prices have been inversely correlated and a steep selloff in the bond market is bad news for homebuilding stocks (top panel, Chart 12). On the operating housing front, some cracks are forming. New home sales, while brisk in absolute terms, are losing out to existing housing sales and homebuilders have resorted to price concessions in order to drive volumes (second & third panels, Chart 12). Profit margins are at the highest level since the subprime crisis and are vulnerable to a squeeze, not only from lower selling prices, but also from rising input costs. Framing lumber comprises roughly 15% of a new home’s commodity related costs and lumber prices have been expanding all year long (bottom panel, Chart 12). Bottom Line: Put the S&P homebuilding index to the high-conviction underweight call list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. Chart 12Avoid Homebuilders Avoid Homebuilders Avoid Homebuilders Underweight Pharma (COVID-19 Winner Theme) The S&P pharmaceutical index is a high-conviction underweight for 2021. On the macro front, the Fed’s ZIRP bodes ill for defensive pharma equities. The Fed was uncharacteristically quick this recession to drop rates to the lower zero bound to reflate the economy. As a result, safe haven equities, Big Pharma included, typically trail the broad market as the economy gets out of the ER and into the recovery room (second panel, Chart 13). Importantly, relative pharmaceutical profits are highly counter cyclical: they rise at the onset of recession and collapse as the economy heals. Currently, as the world economy has transitioned to a V-shaped recovery, the reopening of the economy into the New Year will continue to knock the wind out of relative pharma profitability. Similarly, an appreciating greenback has historically been synonymous with pharma outperformance and vice versa (third panel, Chart 13). Keep in mind, Big Pharma make the lion’s share of their profits domestically, further cementing the positive correlation with the US dollar. This local profit sourcing represents one of the main reasons why politicians on both sides of the aisle are after domestic pharma profits. Pharma prices are on the cusp of contracting. Importantly, President Trump’s late-July executive order “to allow importation of certain prescription drugs from Canada” among other provisions is a direct blow to the profit prospects of Big Pharma (bottom panel, Chart 13). Bottom Line: We are cognizant that the COVID-19 vaccine will lift Big Pharma, but only temporarily, as cyclical forces will more than offset the positive vaccine news. The S&P pharmaceuticals index is a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG – S5PHARX: JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO. Chart 13Sell Pharma Sell Pharma Sell Pharma Underweight Consumer Staples (COVID-19 Winner Theme) Countercyclical consumer staples stocks served their purpose and supported our portfolio in the front half of 2020. Now that vaccines are coming, we are adding the S&P consumer staples sector to the high-conviction underweight call list. The current macro backdrop underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also, consumer confidence is forming a trough (ISM manufacturing shown inverted, second panel, Chart 14). One of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis, staples stocks benefit much less than the rest of the market from a falling currency (third panel, Chart 14). Our relative macro earnings model does an excellent job in encapsulating all these moving parts and paints a dark profit picture for this GICS1 sector in the New Year (fourth panel, Chart 14). Bottom Line: The S&P consumer staples sector is a high-conviction underweight.   Chart 14Underweight Consumer Staples Underweight Consumer Staples Underweight Consumer Staples Short NASDAQ 100 / Long S&P 500 (Secular 10-year Call) We first wrote about the extreme market cap concentration in January when we were cautioning investors of an SPX drawdown and drew parallels with the dotcom era. Back in late-1999/early-2000 the top 5 stocks comprised 18% of the S&P 500. In July we delved deeper and split the S&P 500 in the S&P 5 versus the S&P 495 to highlight the extraordinary narrow returns since 2015. Such extreme concentration in a handful of tech titan stocks is clearly unsustainable. The bullish case for tech is well documented and understood; the COVID-19 pandemic acted as an accelerant to the technological adoption of the new remote working realities. However, $2tn valuations (AAPL, MSFT & AMZN) make little sense to us, especially if there is little earnings follow through and most of the returns are explained by multiple expansion. In all likelihood, the easy money has been made. Going back to the early 1970s is instructive in order to put the tech juggernaut into proper perspective. Every decade or so there have been clearly defined booms and busts in US tech stocks (Chart 15). Schumpeter’s “creative destruction” forces are undoubtedly at play. What is interesting is that not only have tech stocks likely stalled near the dotcom era peak, but also they have been outperforming since the end of the GFC (i.e. roughly a decade); they are due for at least a breather. If history rhymes, we have entered a new bust cycle and the tech sector’s underperformance will play out over the coming decade. Bottom Line: We are compelled to add to our structural trades and recommend investors underweight the tech sector on a ten-year time horizon via the short QQQ / long SPY exchange traded funds which offer the most liquidity. Chart 15Short QQQ / Long SPX For The Next Decade Short QQQ / Long SPX For The Next Decade Short QQQ / Long SPX For The Next Decade Also Rans Within consumer discretionary, automobiles & auto parts & components piqued our interest from the long side. These stocks would greatly benefit from a reopening economy as a semblance of normality returns sometime next year. Nevertheless, two key factors kept us at bay. First, similar to homebuilders, this index has gone vertical since the March lows, besting the SPX by a factor of 2:1 (top panel, Chart 16). We maintain exposure via our “Back-To-Work” basket with GM, but even this auto manufacturer is up 50% since the September 8, 2020 inception. Finally, TSLA is about to enter the SPX at a stratospheric valuation that would dominate the automobile sub group. This is eerily reminiscent of YHOO’s SPX inclusion in late-1999 that led the dotcom bubble peak by four months. The parallel is making us nervous, therefore we are staying patiently on the sidelines. On the underweight side we wanted to include the niche S&P semi equipment index, but opted not to as the Bitcoin mania has really pushed these stocks to the stratosphere (middle panel, Chart 16). In addition, this chip sub-group has one of the highest export exposures in the SPX with a large slice of foreign revenue originating in China. Hence, news of a Biden presidency also served as a catalyst to propel them higher (i.e. at the margin, a less hawkish president on the Sino/American trade war). We really struggled with global gold miners (GDX:US). Our initial thinking was to downgrade them to underweight (from currently neutral), which is consistent with global growth reaccelerating and interest rates rising. However, we missed the boat when it set sail in early August (bottom panel, Chart 16). Now, the gold bearish trade is gaining momentum and has become a consensus trade as big macro investors (Tudor and Druckenmiller among others) are shifting toward Bitcoin and have been vociferous about their positioning. Thus, we preferred to remain on the sidelines with a benchmark allocation. Chart 16Three “Also Rans” Three “Also Rans” Three “Also Rans” Footnotes   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations 2021 High-Conviction Calls 2021 High-Conviction Calls Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives 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  

Your feedback is important to us. Please take our client survey today Highlights Portfolio Strategy An easy Fed, the drubbing in the US dollar, the opening up of the global economy, poor pharma operating metrics and the specter of a “Blue Wave” more than offset the likelihood of a COVID-19 vaccine and oversold technicals, and compel us to cut pharma exposure below benchmark. This downgrade of the heavyweight pharma index also pushes the S&P health care sector down to a neutral position. Recent Changes Downgrade the S&P pharmaceuticals index to underweight, today. Trim the S&P health care sector down to a benchmark allocation, today. Table 1 Peering Across The Election Valley Peering Across The Election Valley Feature On the eve of the election, the SPX oscillated violently last week as it became evident that there will be no agreement on a bipartisan fiscal package. Thus, the odds are rising of a mega fiscal package next year irrespective of the election outcome. The longer politicians wait the larger the stimulus bill will end up being. Realistically now a fresh fiscal impulse is pushed out to late-January at the earliest, casting a dark cloud over the current quarter’s economic and profit growth prospects.   In mid-October we highlighted that positioning remained stretched in both VIX and S&P 500 e-mini futures, which warned that investors were prematurely betting on subsiding volatility. Similarly, we cautioned that VIX options activity corroborated the stretched positioning message as investors were piling into VIX puts and neglecting to buy any election protection in the form of VIX calls. The final blow came early last week when the equity vol curve inverted with the VIX spiking north of 40 and implying that the SPX would move by +/- 12% in the next 30 days. Given so much fear priced in the VIX, last Thursday we decided to close our election protection in the form of VIX December 16, 2020 expiry futures that we held since our July 27 Special Report we penned with our sister Geopolitical Strategy on the rising odds of a contested US election. Our view remains that the SPX could glide lower into the November election before rallying into year-end courtesy of receding election and fiscal policy uncertainties. Nevertheless, at the risk of getting overly bearish a few offsetting observations are in order. While there is a chance that the VIX will continue to roar as it did early in the year and push the equity vol curve deeper in backwardation, our sense is that the correction that commenced in early September is close to running its course. Historically, Chart 1 shows that the VIX curve inversion is typically short-lived and more often than not serves as a launchpad for the SPX. Chart 1Correction Enters Third Month Correction Enters Third Month Correction Enters Third Month With regard to market internals, a flurry of M&A activity has propelled the Philly SOX index to all-time highs in absolute terms and to nineteen-year highs versus the SPX. IPO activity has also resumed and the Renaissance IPO exchange trade fund is on a tear breaking out recently to uncharted territory. Moreover, the SPX advance/decline line is also probing all-time highs and signaling increased participation beyond the top 5 tech titans (Chart 2). While the Fed has been a bystander of late – trying to exert some pressure on Congress to pass a fresh stimulus package – and the fiscal circus continues unabated in Washington D.C., both the money supply release and the American Association on Individual Investors confirm that a lot of dry powder remains on the sidelines. The implication is that as election uncertainty recedes then this idle cash courtesy of the sloshing liquidity will make its way through the markets. In other words decreasing cash balances push the SPX higher and vice versa (Chart 3). Chart 2Market Internals: A Few Rays Of Light Market Internals: A Few Rays Of Light Market Internals: A Few Rays Of Light Chart 3Lots Of Dry Powder Lots Of Dry Powder Lots Of Dry Powder Meanwhile, following up from last week’s debt discussion we delve deeper into the non-financial corporate sector’s debt profile. The pandemic has pushed non-financial business debt to an extreme almost on a par with nominal GDP (top panel, Chart 4). The big difference this cycle is that, according to Moody’s, subordinated debt that has defaulted sports a recovery rate in the teens, a far cry from previous recessionary troughs (second panel, Chart 4). The overall junk bond recovery rate is near 25 cents on the dollar plumbing historical lows (a recent Bloomberg article highlighted that COVID-19 has ushered in this “new era of US bankruptcies” with ultra-low recovery rates).1 The risk remains that the default rate will continue to rise (bottom panel, Chart 4): the longer the fiscal stimulus package takes to arrive the higher the bankruptcies will be.   Importantly, the deep cyclicals (tech, industrials, materials and energy) net debt-to-EBITDA ratio has crossed above 1.5x during the recession on the back of cash flow ails. In fact cyclicals have been paying down net debt in absolute terms during the pandemic (bottom panel, Chart 5). Chart 4Beware Low Recovery Rates Beware Low Recovery Rates Beware Low Recovery Rates Chart 5Debt Saddled Defensives Debt Saddled Defensives Debt Saddled Defensives In marked contrast, the defensives (health care, consumer staples, utilities and telecom services) net debt-to-EBITDA ratio is hovering near 3x, as these debt saddled sectors have not been able to pay down net debt. Not only is net debt roughly $2tn, but it also comprises 50% of the broad market’s net debt at a time when the market cap weight is close to 30% (Chart 5). Taken together, the relative debt profile clearly favors cyclicals at the expense of defensives and we continue to recommend a cyclicals versus defensives portfolio bent. One neglected part of the Baker, Bloom and Davis policy uncertainty has been the trade-related uncertainty. The pandemic has put the trade dispute in the back burner. Moreover, the odds remain high of a Biden win; at the margin, a Democratic President will be less hawkish on trade and will try to deescalate global trade tensions. This backdrop is a de facto positive for cyclicals/defensives, especially given our view of a reopening of the global economy in 2021 (Chart 6). This week we continue to augment the cyclical/defensive bent of our portfolio by taking a defensive sector down a notch. Chart 6Cyclicals Benefit From Dwindling Trade Uncertainty Cyclicals Benefit From Dwindling Trade Uncertainty Cyclicals Benefit From Dwindling Trade Uncertainty Comatose Big Pharma shares broke down recently and we are compelled to downgrade exposure to underweight on the eve of the US election. While a short term reflex bounce may be in the cards, we would sell that strength as relative share prices are teetering and are on the verge of giving up 25 years of relative returns (top panel, Chart 7). Stiff macro headwinds, tough operating metrics and hawkish political rhetoric more than offset positive COVID-19 vaccine-related news.  On the macro front, the Fed’s ZIRP bodes ill for defensive pharma equities. The Fed was uncharacteristically quick this recession to drop rates to the lower zero bound to reflate the economy. As a result, safe haven equities, Big Pharma included, typically trail the broad market as the economy gets out of the ER and into the recovery room (middle & bottom panels, Chart 7).  Importantly, relative pharmaceutical profits are highly counter cyclical: they rise with the onset of recession and collapse as the economy stands back on its own two feet. Currently, as the COVID-19 hit to the world economy has transitioned to a V-shaped recovery, the reopening of the economy into the New Year will continue to knock the wind out of relative pharma profitability (global manufacturing PMI shown inverted, middle panel, Chart 8). Chart 7A Tough Pill To Swallow A Tough Pill To Swallow A Tough Pill To Swallow Chart 8Sell The Pharma Counter-Cyclicality Sell The Pharma Counter-Cyclicality Sell The Pharma Counter-Cyclicality Similarly, an appreciating greenback has historically been synonymous with pharma outperformance and vice versa (third panel, Chart 8). Keep in mind, Big Pharma make the lion’s share of their profits domestically further cementing the positive correlation with the US dollar. This local profit sourcing represents one of the main reasons why politicians on both sides of the aisle are after domestic pharma profits (more on this below). Worrisomely and likely tied to the domestic nature of the industry’s profit extraction, the debasing of the US dollar fails to provide any export relief. In fact, exports have been historically positively correlated with the greenback (bottom panel, Chart 8). Pharma prices are on the cusp of contracting. Importantly, President Trump’s late-July executive order “to allow importation of certain prescription drugs from Canada”2  among other provisions is a direct blow to the profit prospects of Big Pharma (second panel, Chart 9). Other operating factors also weigh on pharma earnings. Industry shipments have risen to a level that has marked prior peak growth rates. Any letdown on the demand side coupled with the recent inventory build, will lead to pricing power losses. Tack on accelerating productivity losses despite recovering pharma industrial production and factors are falling into place for a relative profit driven underperformance phase (Chart 9). With regard to the election outcome, a Biden win accompanied by a Senate flip to the Democrats would be the worst possible outcome for the pharmaceutical industry, as we posited in our recent Special Report penned with our sister Geopolitical Strategy services on sector implication of a “Blue Trifecta”, and reiterate today (Chart 10). Chart 9Pricing Power Blues Pricing Power Blues Pricing Power Blues Nevertheless, we are cognizant that definitive news of a COVID-19 vaccine will likely lift Big Pharma, but only temporarily, as cyclical forces will more than offset the positive vaccine news. Finally, with regard to valuations and technicals, pharma is not offering compelling value but rather is a value trap and we would use any reflex rebound to lighten up exposure to this defensive industry (Chart 11). Chart 10Heightened “Blue Sweep” Risk Heightened “Blue Sweep” Risk Heightened “Blue Sweep” Risk Chart 11Value Trap Value Trap Value Trap Netting it all out, an easy Fed, the drubbing in the US dollar, the opening up of the global economy, poor pharma operating metrics and the specter of a “Blue Wave” more than offset the benefits of a COVID-19 vaccine and oversold technicals. Bottom Line: Downgrade the S&P pharmaceuticals index to underweight today. The ticker symbols for the stocks in this index are: BLBG – S5PHARX, JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO. A Few Words On Health Care The Big Phama downgrade to underweight also pushes the S&P health care sector to a benchmark allocation from a previously modest overweight stance. This leaves the S&P medical equipment index as the sole overweight in this defensive sector that enjoys cyclical and structural tailwinds (especially in emerging markets that are instituting the health care safety nets the developed markets already enjoy) more than offsetting the safe haven characteristics that typically overshadow health care outfits (second panel, Chart 12). Moreover, we are putting the S&P health care sector on downgrade alert as we reckon most of the positive profit drivers are already reflected in cycle high relative profit growth figures and are at major risk of deflating if our thesis of a global reopening of the economy takes shape in the New Year. Our relative macro driven EPS growth models corroborate that earnings are at heightened risk of major disappointment next year (Chart 13). Chart 12Stick With Health Equipment Stick With Health Equipment Stick With Health Equipment Chart 13Put The S&P Health Care Sector On Downgrade Alert Put The S&P Health Care Sector On Downgrade Alert Put The S&P Health Care Sector On Downgrade Alert Bottom Line: Trim the S&P health care sector to neutral today and also put it on downgrade watch.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.bloomberg.com/news/articles/2020-10-26/bond-defaults-deliver-99-losses-in-new-era-of-u-s-bankruptcies 2     https://www.whitehouse.gov/presidential-actions/executive-order-increasing-drug-importation-lower-prices-american-patients/   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives 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