Real Estate

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

Highlights The housing market is tight, but not undersupplied, as the construction of new homes has kept up with the pace of household formation. Demand for homes should remain well supported as household formation has room to increase and the economy recovers from the pandemic-induced crisis. But existing barriers to new home construction persist and the economic recovery will help hold down residential mortgage defaults and prevent a wave of listings by desperate sellers. As such, home prices have scope to remain well-bid. Feature US home prices keep grinding higher despite the most severe recession since the Great Depression. In a May Special Report1 entitled “Housing In The Time Of COVID-19”, we highlighted that the initial uptick in home prices was spurred by housing supply falling faster than housing demand. Lockdowns and strict social distancing measures halted the construction of new homes and prompted sellers of existing homes to de-list their properties, thus immediately curbing the supply of homes for sale. Meanwhile, the mortgage forbearance allowed under the CARES Act prevented a wave of defaults and mass property listings by desperate sellers and low interest rates and generous fiscal transfers supported demand. Since then, economic activity has been recovering at a faster pace than widely anticipated and mortgage applications have eclipsed pre-pandemic highs. Yet, building permits and housing starts still have ample room to catch up. Are we heading towards a dearth of housing supply? Tight Or Undersupplied? Most real estate agents would claim that the biggest challenge they have had to face in the past few years was developing a new listing pipeline given low levels of new construction relative to history. The economic data confirms this observation: the inventory of homes for sale, as well as the share of homes currently sitting vacant, both stand at record lows (Chart 1). A rising pool of potential buyers and record-low interest rates make for lost commission opportunity amid this weak supply backdrop. Chart 1A Tight Housing Market A Tight Housing Market A Tight Housing Market All that one can infer from these observations, however, is that the housing market is currently a sellers’ market. Only the assessment of the underlying driver of long-term housing demand – household formations – can determine whether the overall housing market is over or undersupplied. Chart 2The Pre-GFC Extended Period Of Construction Excesses Was An Exception Rather Than The Norm The Pre-GFC Extended Period Of Construction Excesses Was An Exception Rather Than The Norm The Pre-GFC Extended Period Of Construction Excesses Was An Exception Rather Than The Norm There have been four2 extended phases of gains in new home prices since the 1970s (Chart 2). The longest one extended for 14 years from 1992 to 2006 but was also the slowest on a compound annual growth rate basis (CAGR). Nine million building permits were issued over the 103-month span of the most recent phase, a permit-per-month pace that was just two-thirds of the average pace of the preceding three phases (Table 1). Although a declining number of permits issued confirms the on-the-ground observations detailed above, the rate of household formation in the past decade was much slower than it was in the 1970s and 1980s. Table 1The Last Four Phases Of New Home Prices Gains Put In Perspective Barriers To New Housing Supply Barriers To New Housing Supply The number of permits adjusted for household formation shows that the housing cycle that culminated in the Global Financial Crisis (GFC) was marked by excessive construction. During that time, 1.4 building permits were issued for every new household formed. Conversely, in the other three new home price appreciation phases over the last 50 years, that ratio nears one-to-one. An alternative analysis using the number of housing starts instead of housing permits would yield similar results. Therefore, construction has been in line with the growth of new households formed in the latest cycle. As such, the market is not undersupplied. Drivers Of Household Formation Household formation is largely demographic-driven over the long term as today’s population growth trends will only be reflected in household growth a couple of decades down the line, when the newborn population reaches adulthood. Over a shorter horizon, household formation is mostly driven by the economic health of population cohorts in their 20s and 30s. Ample research has shown that today's younger generations have pushed marriage and homeownership to their 30s. Widely accepted reasons include lifestyle changes as well as a relatively more precarious financial situation, which is leading younger individuals to require several more years of income and savings to achieve preceding generations’ level of wealth. The positive takeaway for household formation and housing demand is that today’s 20-something cohorts will likely strike out on their own in the coming years as their financial situations improve. They are not a lost generation of household heads and homeowners, just a delayed one. The pool of young individuals still living at home and the economic recovery constitute a pocket of future household formation, which is the underlying driver of housing demand. We have shown in previous research that 25-34 year olds' financial situation has been improving. They have driven the bulk of the uptick in the homeownership rate and in mortgage applications. As a result, growth in the share of young adults living at home has started to decrease (Chart 3). The economic recovery should sustain this trend. Moreover, a growing pool of individuals aged 20-25 constitutes a pocket of future household formation (Chart 4). Overall, the number of households has room to increase at a healthy rate. Chart 3Improving Financial Situation Among Younger Individuals To Support Household Formation Improving Financial Situation Among Younger Individuals To Support Household Formation Improving Financial Situation Among Younger Individuals To Support Household Formation Chart 4A Growing Pocket Of Future Near-Term Housing Demand A Growing Pocket Of Future Near-Term Housing Demand A Growing Pocket Of Future Near-Term Housing Demand Decreasing Supply Elasticity Conversely, some obstacles are now standing in the way of additional new-home supply. After the decade of over-construction that preceded the 2008 housing crisis, evidence shows that homebuilders have been operating with caution and restraint ever since. Chart 5Banks Are Shifting Away From Relatively Riskier Construction Loans Banks Are Shifting Away From Relatively Riskier Construction Loans Banks Are Shifting Away From Relatively Riskier Construction Loans Researchers at the Bank of England, Norges Bank and Oslo Metropolitan University3 have examined how various degrees of supply elasticity explain the dispersion in home prices across the United States. Supply elasticity measures the extent to which changes in home prices drive new construction. The research paper sheds light on a generalized nationwide trend towards declining supply elasticity. Constrained access to credit partly explains homebuilders’ restraint. Bank lending practices have been relatively muted since the GFC. Lending over the past expansion grew at a markedly slower pace than it did in any other postwar expansion.4 The composition of banks’ balance sheets also reflects more conservative lending behaviors. Their loan books have increasingly shifted away from construction5 loans towards relatively safer multi-family mortgages (Chart 5). Rising construction costs are also likely reducing the number of viable construction projects. In March 2018, the Trump administration announced tariffs of 25% on imported steel and 10% on imported aluminum. The construction sector accounts for half of the global demand for steel and the US is the largest net importer. The price of lumber has increased 125% since March. A crackdown on immigration under the current administration is also contributing to rising labor costs, in an environment where homebuilders have reported that skilled labor availability issues persist. Supply has been constrained over the latest cycle…and we do not expect these supply headwinds to abate any time soon. Our colleagues at BCA’s Geopolitical Strategy remark that by highlighting the risks of globalization and border insecurity, the COVID-19 crisis is reinforcing two of Trump’s major policy themes: tighter borders and a renaissance in domestic manufacturing activity. They also note that immigration policy first started tightening under the Obama administration (Chart 6). Although a potential Biden administration might view immigration more favorably, the highly polarized US political climate and the need to address populist grievances will limit immigration even if the Democrats gain control of both the Senate and the White House. Chart 6US Will Tighten Immigration Laws One Way Or Another Barriers To New Housing Supply Barriers To New Housing Supply Chart 7Increasing Market Share Amongst The Largest Homebuilders Barriers To New Housing Supply Barriers To New Housing Supply An increase in land use regulation may also be stifling homebuilders. A recent NBER research paper6 reports that the level of regulation has generally increased between 2006 and 2018. Moreover, the concentration of big players within the homebuilding sector has increased. The share of total single-family completion by the 50 largest US homebuilders has grown from 24% to 35% between 2000 and 2019 (Chart 7). A higher concentration allows homebuilders to better navigate an increasingly regulated housing market, but it also decreases competition. Empirical evidence shows that firms with high market power may be incentivized to reduce output if doing so contributes to product scarcity, high sale prices and increased profits. On the demand side, so called NIMBYism (Not-In-My-BackYard) may also represent a headwind to additional new construction. The Bank of England, Norges Bank and Oslo Metropolitan University research paper notes that supply elasticity has decreased by a wider margin in states where home prices suffered most in the housing crisis. There is sound basis to hypothesize that since 2008, homeowners have become increasingly focused on maintaining the value of their properties by opposing new development projects. Towards A Supply Squeeze? Chart 8Current And Prospective Homeowners Taking Advantage Of Record-Low Mortgage Rates Current And Prospective Homeowners Taking Advantage Of Record-Low Mortgage Rates Current And Prospective Homeowners Taking Advantage Of Record-Low Mortgage Rates We do not expect the major supply headwinds to abate any time soon. Bank lending standards may ease at the margin as the economy recovers and some of the uncertainty about the credit outlook abates, but stricter bank regulation and more conservative lending standards should prevent a repeat of the subprime era’s construction excesses. Our geopolitical strategists have noted that a Democratic White House and Senate will likely maintain the pressure on China. As such, there is no assurance that tariffs on imported commodities would be reversed in the event of a Democratic sweep. We expect that the apex of globalization and pockets of inflationary pressure from COVID-19 supply disruptions will keep homebuilders’ input costs elevated. Demand has upside, though. It is already holding up well amid the current recession thanks to record-low mortgage rates and fiscal and monetary policy makers’ emergency efforts. The 30-year fixed mortgage rate fell below 3% for the first time in July. Mortgage lenders have reported increased backlogs due to the surging number of mortgage and refinancing applications (Chart 8), and mortgage rates may be headed lower once lenders are convinced that increased demand is sustainable. The extension of the Federal Reserve’s emergency lending facilities through the end of the year, announced last week, should help the economy at the margin. As long as Congress extends fiscal aid, policy makers’ efforts will help sustain the demand for homes and fears of a wave of mortgage defaults and distressed home sales one would expect in a severe recession will not materialize. Putting It All Together If demand remains well supported while the supply of new and existing homes remains muted, home prices do not have much room to decline. In our housing Special Report from May, we had hypothesized that the technical feasibility and increased acceptance of working remotely might lift suburban and satellite city home demand. There is early evidence of this phenomenon taking place in cramped and richly priced housing markets like San Francisco and New York. Moreover, the NAHB not only reported a stellar recovery to pre-pandemic levels in homebuilder sentiment in June and July but also an “increasing demand for families seeking single-family homes in inner and outer suburbs that feature lower density neighborhoods.” It saw improving new home demand “in lower density markets, including small metro areas, rural markets and large metro exurbs, as people seek out larger homes and anticipate more flexibility for telework in the years ahead”. Whether the pandemic will result in a material exodus from large cities is still up in the air. It remains to be seen whether remote working flexibility will recede as the pandemic weakens. Both employers and employees may favor part-time remote working arrangements, as suggested by many surveys, which would still warrant having a pied à terre within commuting distance from one’s workplace. Large metropolitan cities also remain attractive for reasons outside of one’s occupation, such as tourism or access to entertainment and leisure. Downward pressure on rents in large metropolitan areas might be more likely than an outright exodus from the city. Current renters and prospective first-time homeowners might want to take advantage of low mortgage rates and the ability to move further out from one’s workplace (though still within commuting distance) thanks to part-time work-from-home arrangements.   Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Footnotes 1 Please see BCA Research US Investment Strategy Special Report, "Housing In The Time Of COVID-19", dated May 18, 2020, available at usis.bcaresearch.com. 2 The real new home median sale price series goes back to 1963. We have identified four new home prices expansions starting from the first apparent bottom reached in December 1970 (Chart 2, first panel). 3 "The declining elasticity of US housing supply", Knut Aastveit, Bruno Albuquerque, Andre Kallak Anundsen, published 25 February 2020. 4 Please see BCA Research US Investment Strategy Special Report, "How Vulnerable Are US Banks? Part 2: It’s Complicated", dated April 6, 2020, available at usis.bcaresearch.com. 5 Construction loans are typically the most volatile and risky category of commercial real estate loans. Risks stem from frequent delays and sometimes the cancellation of construction projects. Loan delinquencies and defaults are common due to the cycle of booms and busts inherent to the construction industry. 6 Gyourko, J., Hartley, J., & Krimmel, J. (2019). The Local Residential Land Use Regulatory Environment Across U.S. Housing Markets: Evidence from a New Wharton Index. (No. w26573). National Bureau of Economic Research.

Book Gains In the Intra-Real Estate Pair Trade And Move To The Sidelines Book Gains In the Intra-Real Estate Pair Trade And Move To The Sidelines Last week we put a 5% rolling stop on the long S&P homebuilding/short S&P REITs pair trade in order to protect profits. Yesterday, our stop got triggered and we crystalized 10.3% gains since the May 26 initiation date. A slew of better-than-expected homebuilder reports caused the recent spike in this market-neutral trade, confirming that all-time low mortgage rates have brought back residential real estate buyers with a vengeance. While most of the key catalysts for this intra-real estate pair trade remain in place that we first outlined in our late-May report, we obey our risk management metric and choose to move to the sidelines for now. Bottom Line: Lock in two-month gains of 10.3% in the long S&P homebuilding/short S&P REITs pair trade and step aside, but stay tuned. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.  

Our intra-real estate pair trade long S&P homebuilders / short S&P REITs vaulted roughly to the 15% return mark intraday yesterday, compelling us to institute a 5% rolling stop in order to protect handsome profits since the late-May inception. Our thesis for putting on this market-neutral trade remains intact. The Fed’s ZIRP policy as far as the eye can see is perhaps the biggest catalyst for US homebuilders, especially as the one-off pandemic effects begin to wear off and people are able to take advantage of all-time low mortgage rates that recently breached 3%. In fact, the chart below suggests that the pair trade is poised for additional gains in the coming months. Bottom Line: We continue to recommend the long S&P homebuilders / short S&P REITs pair trade as more gains are in store, but from a portfolio management perspective we are instituting a 5% rolling stop in order to protect gains. Intra-Real Estate Pair Trade Update Intra-Real Estate Pair Trade Update

Dear Client, In lieu of our regular report next week, I will present our view on China’s economic recovery, geopolitical risks, and implications on financial markets in two live webcasts. The webcasts will take place next Wednesday, July 15 at 10:00AM EDT (English) and at 9:00PM EDT (Mandarin). Best regards, Jing Sima, China Strategist Highlights China’s economic recovery continues through June, but the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009. The intensity of the PBoC’s monetary easing may start to taper in H2, but the central bank is likely to stay on the easing course and keep liquidity conditions ample. Bank lending to the corporate sector should increase further in H2. Chinese stocks rallied through last week’s enactment of the new national security law for Hong Kong and the subsequently announced sanctions from the US government. The existing US sanctions should have limited impact on Hong Kong and mainland China’s economies and financial markets. We remain positive on Chinese stocks despite the recent rallies in China’s equity markets. Feature June’s official and Caixin manufacturing PMIs indicate that China’s economic recovery continues at a steady rate, with the production side of the economy picking up slightly faster than the demand side. The drag on China’s economic recovery from lackluster demand growth should be temporary. Unlike in 2015 when policy uncertainties hindered the recovery in both economic activity and stock prices, the Chinese government has been determined to support its economy and job market in the current cycle. The massive stimulus implemented since March has tremendously boosted activities in China’s construction sector. While households and the corporate sector remain reluctant to spend and to invest, their marginal propensity to spend usually catches up with credit growth with about a 6-9-month lag (Chart 1). The sharp pickup in credit growth should meaningfully support China’s economic rebound, while a better global growth outlook in H2 should also provide some modest tailwinds. On June 30, the PBoC announced a 0.25 percentage point cut to its relending rates for small and rural enterprises and to its general rediscount rate. While the scale of rate cuts in H2 will unlikely match that of Q1, China’s monetary and fiscal policy support will remain in place through the rest of the year. Chinese investable and domestic equities were some of the best performers among global asset classes in June, whereas they were the third-worst the month prior (Chart 2). In the first week of July, both Chinese investable and domestic stocks rallied even further. As we noted in our last week’s report,1 China’s stronger economic outlook, less uncertainty related to its domestic COVID-19 containment, and policy support should provide more room for Chinese stocks to trend upwards. Last week’s passing of the new national security law for Hong Kong and the subsequently announced sanctions from the US government, in our view, should have limited impact on investors’ sentiment for now. Chart 1China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months Chart 2Chinese Equities Are Taking Flight China Macro And Market Review China Macro And Market Review   Tables 1 and 2 present key developments in China’s economic and financial market performance in the past month, and we highlight several of these developments below: Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review China’s June official manufacturing PMI ticked up to 50.9 from 50.6 in the previous month. The Caixin manufacturing PMI came in at 51.2, beating the expectation of 50.5 and compared to 50.7 in May. Both suggest that China’s manufacturing sector continues to expand, however the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009 (Chart 3). Although the import and export subcomponents have fared better in June from the low levels in April and May, their readings in June were still below the 50 boom-bust line (Chart 4). Headwinds remain strong for global trade as the US and many of emerging economies are still struggling with the pandemic. Even without re-imposing lockdowns, the resurge in the number of new cases in the US may result in a drag on consumption and global trade. The IMF projects a 12% contraction in global trade in 2020. While the external demand may improve in H2, positive contribution to China's GDP growth from the net exports will be limited this year. Chart 3Current Recovery Lies Somewhere Between 2009 And 2015 Current Recovery Lies Somewhere Between 2009 And 2015 Current Recovery Lies Somewhere Between 2009 And 2015 Chart 4Demand-Side Recovery Remains Muted Demand-Side Recovery Remains Muted Demand-Side Recovery Remains Muted   The employment situation in the manufacturing sector has worsened since May, and has returned to contraction following a brief improvement in March and April (Chart 5). An estimated 8.7 million new graduates in 2020,2 a historical high number, will hit the job market in July and August. As such, China’s labor market will likely remain under significant pressure. Even though employment usually lags economic recoveries, depressed expectations on the job market will refrain policymakers from prematurely withdrawing stimulus measures. Small and micro enterprises are an important part of China’s private sector, which provides 80% of jobs in China. The manufacturing PMI of small enterprises fell below the 50 boom-bust line in June, reflecting a persistent weakness in this part of China’s economy. The recent relending and rediscount rate cuts suggest that the PBoC is committed to stay on the easing course. The intensity of monetary easing may start to taper in H2, but the central bank is likely to keep liquidity conditions ample and encourage banks to accelerate lending to the corporate sector. The contraction in Chinese producer prices deepened to -3.7% (year-over-year) in May. However, we think PPI deflation is likely to bottom in Q3. Both the purchasing and producer price subcomponents of the manufacturing PMI ticked up sharply in June, while the drawdown in industrial product inventory relative to new orders has accelerated (Chart 6). The ongoing accommodative policy should provide powerful tailwinds to both economic activity and the PPI in H2. The improvement in the PPI will help to boost industrial profits growth, which turned positive in May (year-over-year) for the first time this year. We expect year-to-date industrial profits to end the calendar year with a modest positive growth rate.  Chart 5Labor Market Pressure Intensifies Labor Market Pressure Intensifies Labor Market Pressure Intensifies Chart 6PPI Deflation Nears Its Bottom PPI Deflation Nears Its Bottom PPI Deflation Nears Its Bottom   China’s property market indicators have notably trended up in May, with year-over-year growth in housing demand normalizing to its pre-pandemic level (Chart 7A & Chart 7B). As the demand in housing rebounded faster than the supply, housing prices have correspondingly turned the corner in May after trending down for 6 consecutive months. Chart 7AHousing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Housing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Housing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Chart 7BStrong Rebound In Property Investments Strong Rebound In Property Investments Strong Rebound In Property Investments   Chart 7B shows that housing investments and land purchases have also recovered to near their pre-pandemic levels. Financing restrictions for property developers that were put in place since 2018 have been loosened in H1, which helped to boost real estate investments. We expect the property sector financing conditions to remain accommodative through the rest of this year. Moreover, there is a possibility that the PBoC will lower the 5-year MLF (medium lending facility) rate in Q3. As downward pressures on China's labor market and household income growth intensify, the government is likely to lower the mortgage rate to ease payment constraints on households. Chart 8Chinese Stocks Rallied Through Frictions Over Hong Kong Chinese Stocks Rallied Through Frictions Over Hong Kong Chinese Stocks Rallied Through Frictions Over Hong Kong Despite the passing of China’s new and controversial national security law for Hong Kong on June 30 and the subsequently announced sanctions from the US government, stock prices in both China’s onshore and offshore markets rallied (Chart 8). While we agree the US may impose further and more concrete sanctions on China during the months leading up to the November US presidential election, our preliminary assessment points to a limited economic cost on China from the existing US sanctions. The removal of Hong Kong’s special trade status will subject Hong Kong’s export goods to the same tariffs the US levies on Chinese exports. But the raised tariffs will barely make a dent in Hong Kong or mainland China’s export status quo. Hong Kong’s economy consists mainly of the financial, logistical and services sectors. The manufacturing sector only accounts for 1% of its overall economy. Chart 9 shows that Hong Kong’s exports to the US only accounted for around 1% of its total exports and 1.3% of its GDP in 2019. More importantly, of the $5 billion goods Hong Kong exports to the US, only 10% is actually produced in Hong Kong. Most of Hong Kong's exports to the US are goods produced in China that are re-exported through Hong Kong, which are already subject to the same tariffs as the goods China exports to the US directly.3 On the other hand, US exports to Hong Kong accounts for 2% of its total exports, with a trade surplus of about $30 billion in the past two years (Chart 9, bottom panel). The US trade surplus with Hong Kong has drastically reduced since the US-China trade war broke out in 2018, suggesting that the US has already imposed restrictions on its export goods to mainland China through Hong Kong. Moreover, the large trade surplus with Hong Kong as well as China’s commitment to the Phase One trade deal may be part of the reason President Trump is unwilling to impose more substantial sanctions on China right now. The US senate and house have also passed a bill which, if signed and implemented by President Trump, will allow the US government to levy any foreign financial institutions for knowingly conducting business with individuals who are involved in jeopardizing Hong Kong’s autonomy. Chinese banks with operations in the US will be mostly exposed to such sanctions. However, Chinese banks are largely domestic-focused with very low reliance on foreign-currency funding (Chart 10). Hence, the direct impact of a deteriorating operating environment in the US will be limited on Chinese banks. Chart 9Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Chart 10Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Weekly Report "Upgrading Chinese Stocks To Overweight," dated July 1, 2020, available at cis.bcaresearch.com 2 iiMediaReport, Analysis report on current situation and development trend of Chinese employment entrepreneurship market in 2020. 3 Please see Nicholas Lardy, “Trump’s latest move on Hong Kong is bluster”. Peterson Institute For International Economies, dated June 1, 2020.   Cyclical Investment Stance Equity Sector Recommendations

Highlights The cost of housing is the one item that has held up US inflation vis a vis European inflation in recent years. But as the cost of housing flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. This means that US and European bond yields will also converge. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Underweight the dollar versus the most defensive European currency, the Swiss franc. Continue to favour long-duration defensive equities, technology and healthcare, whose net present values are most leveraged to a decline in the US T-bond yield. Fractal trade: long GBP/RUB. Feature Chart I-1Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Chart I-2...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? One of the biggest ongoing costs that we face is the cost of housing. Yet economists remain perplexed on how to measure this cost in a consumer price index. For people who rent their homes, the issue is straightforward – the rent paid every month captures the cost of the housing services that are consumed. But for owner occupiers, the biggest ongoing cost tends to be the mortgage interest payment. Therein lies a problem. Measuring Housing Costs Is A Challenge A consumer price index aims to measure the costs of consumption. But a mortgage interest payment measures the cost of borrowing money, rather than a cost of consumption. Therefore, capturing owner occupiers’ housing costs poses a challenge, and economists have developed several theoretical approaches to measure them (Box I-1). Box I-1The Different Methods Of Measuring Owner Occupiers’ Housing Costs Why Housing Costs Matter More Than Ever Why Housing Costs Matter More Than Ever This report focusses on the approach known as rental equivalence or ‘owners’ equivalent rent’. The reason is that rental equivalence is the approach used in the UK CPI including housing (CPIH) – though be aware that the Bank of England still targets inflation using the CPI excluding housing. Rental equivalence is also the approach used in the US CPI and PCE, and the Federal Reserve does target inflation including housing. The treatment of housing costs in inflation matters enormously. The UK versus US comparison reveals something odd. In the UK, owner occupiers’ housing inflation has been running well below overall inflation, whereas in the US it has been running hot (Chart I-1 and Chart I-2). In fact, remove the 25 percent weighting to owners’ equivalent rent from the US consumer price index – to make it comparable with Europe – and the US inflation rate would now be one of the lowest in the world at minus 1 percent! (Chart I-3). Hence, the treatment of housing costs in inflation matters enormously. Chart I-3Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent What Is Driving Housing Costs? A UK Versus US Comparison Rental equivalence uses the rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. The approach answers the question: “how much rent would I have to pay to live in a home like mine?” In other words, the housing services are valued by looking at the cost of the next best alternative to owning the home, namely renting an identical or near-identical property. As rental equivalence aims to measure the cost of housing services rather than the asset value of the house, it should not be expected to move in line with house prices in the short-term. Indeed, the rent for a property is likely to be lower in relation to the house price when the monthly mortgage payment is lower. This is because a lower monthly mortgage payment makes it more affordable to own a house, pushing down the prices of rents and rental equivalence. Economists remain perplexed on how to measure housing costs in a consumer price index. In the UK, mortgages tend to have a variable interest rate linked to the Bank of England policy rate. Hence, the change in short-term mortgage rates explains the profile of housing cost inflation. For the past few years, UK owner occupiers’ housing inflation has been subdued because short-term mortgage rates have been drifting down (Chart I-4). Chart I-4UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate But in the US, mortgages tend to have fixed rates resulting in a different explanation for the profile of housing cost inflation. US owners’ equivalent rent inflation moves in lockstep with actual rent inflation. In fact, the two series are almost indistinguishable (Chart I-5). Raising the question: what drives US rent inflation? Empirically, the most important driver is the (inverted) unemployment rate – which establishes the number of people who can rent a property. Chart I-5US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation This leads to a crucial finding. The last three times that the US unemployment rate moved into the high single digits – in the recessions of the early 1980s, early 1990s, and 2008 – rent inflation plus owners’ equivalent rent inflation flipped from being a strong tailwind to core inflation into a very strong headwind. Given the consistent relationship in each of the last three recessions, and with US unemployment rate now running in double digits, only a brave man would bet on it being any different in the 2020 recession (Chart I-6). Chart I-6Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind The combination of rent plus owners’ equivalent rent – shelter – comprises 34 percent of the US consumer price index, 42 percent of the core CPI, as well as a hefty weighting in the core PCE. It is the one item that has held up US core inflation vis a vis European core inflation in recent years (Chart I-7). But as shelter inflation flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. Chart I-7Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? The Implications Of Converging Inflation As US inflation converges down to European levels, the last few years of divergence in US bond yields from European yields will prove to be a brief aberration. Before 2016, US and European yields were joined at the hip. It is highly likely that they will soon re-join at the hip (Chart I-8 and Chart I-9). Chart I-8The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... Chart I-9...Will Prove To Be A Brief ##br##Aberration ...Will Prove To Be A Brief Aberration ...Will Prove To Be A Brief Aberration All of which reinforces three of our existing investment recommendations: Stay overweight US T-bonds versus high-quality European government bonds. In fact, if the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Meaning that an absolute overweight to the US long bond will also reap rewards. Turning to currencies, yield convergence should be bearish for the dollar versus European currencies. That said, the dollar has the merit of being well bid during periods of economic and financial stress which might prove to be regular occurrences in the coming year. On this basis, the best strategy is to underweight the dollar versus the most defensive European currency, the Swiss franc. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Finally, in the equity markets, continue to favour long-duration growth defensives – whose net present values are most leveraged to a decline in the US T-bond yield. This means technology and healthcare. Fractal Trading System* The rally in the Russian rouble is technically stretched and susceptible to a countertrend reversal. Accordingly, this week’s recommended trade is long GBP/RUB. Set the profit target and symmetrical stop-loss at 3 percent. Chart I-10GBP/RUB GBP/RUB GBP/RUB In other trades, long Australia versus New Zealand closed at the end of its 65 day holding period flat. The rolling 1-year win ratio now stands at 59 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear Client, There will be no US Equity Insights from July 1-3 inclusive, as the US Equity team will be on vacation for the week. Our regular publication schedule will resume on Monday July 13, 2020 with our Weekly Report. Happy Independence Day.  Kind Regards, Anastasios Highlights Portfolio Strategy Odds are high that stocks will move laterally in Q3, digesting the massive gains since the March 23 lows. Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. On all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress. Tack on the potential dividend cuts/suspensions and we were compelled to downgrade exposure to neutral. A dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions enticed us to trim exposure in the S&P investment banks & brokers index to neutral. Recent Changes Last Tuesday we downgraded the S&P banks and S&P investment banks & brokers indexes to neutral. These two moves also pushed the S&P financials sector weighting to neutral.1 Feature The SPX remains in churning mode, consolidating the massive gains since the March 23 lows. Easy fiscal and monetary policies are still the dominant macro themes underpinning markets, and thus any letdown in either loose policies poses a threat to the 1000 point three-month SPX run-up (bottom panel, Chart 1). Importantly, correlations have gone vertical of late with the CBOE’s implied correlation index – gauging the S&P 500 constituents’ pairwise correlations – surging to 70% (implied correlation index shown inverted, second panel, Chart 1). This is cause for concern as it has historically been a precursor to SPX pullbacks. Typically, stocks move in tandem, especially during risk off phases when everything becomes one big macro trade. Similarly, two Fridays ago we highlighted that the VIX and the S&P 500 were becoming positively correlated.2 The 20-day moving correlation between these two assets is shooting higher, approaching positive territory. Since late-2017 every time this correlation has hit the inflection point near the zero line, stocks has subsequently suffered a sizable setback (Chart 2). Chart 1Short-Term Downdraft Risks Are Rising Short-Term Downdraft Risks Are Rising Short-Term Downdraft Risks Are Rising Chart 2Watch SPX/VIX Correlation Watch SPX/VIX Correlation Watch SPX/VIX Correlation Tack on the public’s renewed interest in COVID-19 according to Google trends search results, and the odds are high that stocks will be range bound this summer (top panel, Chart 1). Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. Turning over to profits on the eve of earnings season, our four-factor macro EPS growth model for the SPX has tentatively troughed at an extremely depressed level (Chart 3). Our SPX EPS estimate for next calendar year remains near $162/share which we consider trend EPS and was last hit both in 2018 and 2019.3 Chart 3Our EPS Growth Model Has Troughed Our EPS Growth Model Has Troughed Our EPS Growth Model Has Troughed Moreover, drilling beneath the surface, this week Table 1 updates the sector and subgroup EPS growth expectations. First we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 1). The third columns in Table 1 show the sector growth rate relative to the SPX. Table 1Identifying S&P 500 Sector EPS Growth Leaders And Laggards Drilling Deeper Into Earnings Drilling Deeper Into Earnings The final columns highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Tech, health care and communication services occupy the top ranks with positive EPS growth expectations, while financials, real estate and energy are forecast to contract in the coming 12 months and have fallen at the bottom of the table. Table 2Sector EPS And Market Cap Weights Drilling Deeper Into Earnings Drilling Deeper Into Earnings Given that the tech sector has the highest profit weight in the SPX roughly 23% projected for next year (Table 2) it has really helped the broad market’s profit growth recovery (Chart 4). As a reminder, we continue to employ a barbell portfolio approach and prefer defensive (software and services) to aggressive tech (hardware and equipment). On the flip side, financials have the third largest profit weight roughly 16% in the S&P 500, trailing tech and health care, and pose a big threat to overall SPX profits next year, especially if there are any hiccups with the reopening of the economy (Table 2). Worrisomely, investors are not voting with their feet and are doubting that financials profits will deliver as the market cap weight relative to the profit weight stands at negative 540bps.  Last Tuesday we downgraded the S&P financials sector to a benchmark allocation via trimming the S&P banks and S&P investment banks & brokers indexes to neutral and this week we delve into more details on these two early cyclical subgroups. Chart 4Earnings Finding Their Footing Earnings Finding Their Footing Earnings Finding Their Footing Downgrade Banks To Neutral… We were compelled to downgrade the S&P banks index to neutral last Tuesday in advance of the Fed’s stress test results. There are high odds that a number of banks will cut/suspend dividend payments in coming quarters in line with the Fed’s guidance in the latest round of stress test, especially if profits take a big hit as we expect. As a reminder, dividends are paid out below-the-line. Beyond the Fed’s stress tests and rising political risks,4 yellow flags are waving on all three key bank profit drivers, namely the price of credit, loan growth and credit quality. First, it is disconcerting that bank relative performance has really not taken the yield curve’s steepening cue and has negatively diverged as we showed last week.5 The year-to-date plummeting 10-year yield is weighing heavily on relative share prices (top panel, Chart 5). The transmission mechanism to bank profits of this lower price of credit is via the net interest margin (NIM) avenue (third panel, Chart 5). NIMs will remain under downward pressure as long at the 10-year Treasury yield stays suppressed owing to the Fed’s immense b/s expansion. The rising likelihood of yield curve control could keep interest rates on the long end of the curve depressed for a number of years similar to what happened between 1942 and 1951. Second, on the credit growth front news is equally worrisome. The widening in the junk spread signals loan growth blues in the quarters ahead (second panel, Chart 6). Despite the initial knee jerk reaction, primarily by corporations, of tapping existing C&I credit lines and causing a surge in bank credit growth, bankers are not willing to extend credit according to the latest Fed Senior Loan Officer survey (third panel, Chart 6). The same survey revealed that banks are reporting lower demand for credit across the board, warning that future loan growth will be anemic at best, especially given the collapse in our economic impulse indicator (bottom panel, Chart 6). Chart 5Bank Yellow Flags Waving Bank Yellow Flags Waving Bank Yellow Flags Waving Chart 6Loan Growth Will Suffer Loan Growth Will Suffer Loan Growth Will Suffer Finally, with regard to credit quality, delinquency and charge-off rates are all but certain to spike in the coming months. The third panel of Chart 7 highlights that historically all these credit quality gauges are lagging. However, the near vertical climb in the unemployment rate recently and persistently high continuing unemployment benefit claims near 20mn signal that non-performing loans (NPLs) are slated to soar in the back half of 2020 (bottom panel, Chart 7). True, the recent $2tn+ fiscal package is acting as a Band-Aid solution by putting money in unemployed consumers’ pockets, but when the money runs out on July 31, the going will get tough especially if Congress does not pass a new fiscal package. In addition, there are “extend and pretend” clauses in the existing relief package especially on the residential mortgage front that aim to help homeowners make ends meet. But, the longer workers stay out of the labor force the higher the chances that their skills atrophy making it difficult for them to return to work. As a result, foreclosure risk is on the rise. While residential real estate loans are no longer the largest category in bank loan books they still comprise a respectable 21% of total loans or $2.3tn, a souring housing market could spell trouble for banks (Chart 8). Chart 7Deteriorating Credit Quality Will Sink Profits Deteriorating Credit Quality Will Sink Profits Deteriorating Credit Quality Will Sink Profits Chart 8Housing Arrears Are A Risk Housing Arrears Are A Risk Housing Arrears Are A Risk Already, residential mortgage delinquencies are rising and in May surged to the highest level since November 2011 according to Bloomberg. 4.3mn residential real estate borrowers are in arrears (this delinquency count includes borrowers with forbearance agreements who missed payments) and “more than 8% of all US mortgages were past due or in foreclosure” according to Black Night Inc., a property information service. Tack on the shattering consumer confidence and the consumer loan category (credit card, auto and student debt) is also under risk of severe credit quality deterioration (fourth panel, Chart 7). The commercial real estate (CRE) side of loan books is also likely to bleed. Anecdotes where landlords are demanding past due rent payment from tenants are mushrooming, at a time when the same landlords refuse to service their loan obligations. According to TREPP, CMBS delinquencies are skyrocketing across different REIT lines of business. Importantly, CRE loans add up to $2.4tn on commercial bank balance sheets or roughly 22% of total loans. Encouragingly, in Q1 banks started to aggressively provision for steep credit losses with commercial bank loan loss reserves now climbing just shy of $180bn according to the latest FDIC Quarterly Banking Profile (second panel, Chart 7). This figure is almost twice as high as noncurrent loans and represents a healthy reserve coverage ratio. However, our fear is that if history at least rhymes NPLs will sling shot higher (bottom panel, Chart 7) rendering loan loss reserves insufficient. Putting this provisioning number in context, according to the Fed’s most adverse stress test scenarios banks’ losses could spring to $700bn: “In aggregate, loan losses for the 34 banks ranged from $560bn to $700bn”.6 As a result, banks will have to further provision for futures losses and thus take an additional hit to profitability. Our bank earnings growth model does an excellent job in capturing all these moving parts and warns of a contraction in profit in the back half of the year (bottom panel, Chart 9). Nevertheless, before getting too bearish on banks, there two key offsetting factors. Relative valuations are bombed out, signaling that most of the bad news is likely reflected in prices (bottom panel, Chart 5). Finally, technicals are also extremely oversold. The second panel of Chart 5 shows that relative momentum is as bad as it gets. Netting it all out, on all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress and compel us to downgrade exposure to neutral. Chart 9Dividend Cuts Are Looming Dividend Cuts Are Looming Dividend Cuts Are Looming …And Move To The Sidelines On Investment Banks & Brokers The S&P investment banks & brokers (IBB) group has a similar investment profile to the S&P banks index. But, given its more cyclical nature it typically oscillates violently around banks’ relative performance. Thus last Tuesday, we were also compelled to move to the sidelines on this higher beta financials subgroup.7 The COVID-19 accelerated recession has not only mothballed potential M&A deals that were in the works, but also a number of previously announced deals have been canceled. In addition, the outlook for M&A is grim, at least until the dust really settles from the coronavirus pandemic (second panel, Chart 10), weighing heavily on the sector’s profit prospects. While “Robinhood” (retail investor) trading stories abound, margin debt remains moribund and continues to contract, despite the V-shaped recovery in all major US stock markets since the March 23 lows (third panel, Chart 10). This coincident indicator speaks volumes in the near term direction of the broad market and any sustained contraction in trading related debt uptake will likely dent IBB profitability. According to the American Association of Individual Investors bullish retail investors have been absent from this quarter’s massive stock market rally and equity mutual fund and exchange traded fund flows corroborate this message (fourth panel, Chart 10). With regard to cyclicality, IBB are extremely quick to prune labor in times of duress and aggressively add to headcount during expansions. Recent trimming of IBB input costs signal that this industry is retrenching as it is trying to adjust cost structures to lower revenue run rates (bottom panel, Chart 10). Chart 10Diminishing Activities Are Profit Sapping Diminishing Activities Are Profit Sapping Diminishing Activities Are Profit Sapping Related to the cyclical nature of the IBB industry, an accelerating stock-to-bond ratio has been synonymous with relative share outperformance and vice versa. In early June we turned cautious on the broad market’s near-term return prospects primarily on the back of rising (geo)political risks. The implication is that a lateral move in the broad market would push down the S/B ratio and weigh on relative share prices (Chart 11). However, there are some offsets that prevent us from turning outright bearish on this niche early-cyclical group. First relative valuations are extremely alluring. On a price-to-book basis IBB traded recently at 0.8x in absolute terms and at a steep 68% discount to the broad market (bottom panel, Chart 12). Chart 11Move To The Sidelines On This Highly Cyclical Industry Move To The Sidelines On This Highly Cyclical Industry Move To The Sidelines On This Highly Cyclical Industry Chart 12Some Positive Offsets Some Positive Offsets Some Positive Offsets Second, volatility has gone haywire since late-February and it remains elevated with a VIX reading still north of 30. This is a fertile environment for IBB trading desks and should translate into higher profits (second panel, Chart 12). Third, equity trading volumes have exploded. True, volumes spike on downdrafts, but they have remained at an historically high level recently underscoring that IBB trading desk should be minting money (third panel, Chart 12). Adding it all up, a dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions compelled us to trim exposure in the S&P investment banks & brokers index to neutral. Bottom Line: Downgrade the S&P banks index to neutral for a loss of 32.4% since inception. Trim the S&P investment banks & brokers index to neutral for a loss of 24% since inception. These moves also push the S&P financials sector to a benchmark allocation. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT, and BLBG S5INBK – GS, MS, SCHW, ETFC, RJF, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Insight Report, “Tales Of The Tape” dated June 19, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value ” dated April 27, 2020, and BCA US Equity Strategy Special Report, “Debunking Earnings” dated May 19, 2020, both available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 5    Ibid. 6    https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200625c.htm 7    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

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

Highlights Policymakers vs. the virus remains the story at the macro level: Fiscal support is the wild card, but we expect Senate hawks, caught between the House and the White House, will roll over in the end. The economy is perking up, but it is still too vulnerable to stand on its own: The direction is improving as the economy reopens, but the level still stinks and COVID-19 has not gone away. We’ve reached an accommodation with rich index valuations, … : The alternatives are dismal, the preponderance of professional investors have to participate and the possibility of positive virus surprises cannot be dismissed. … but there’s plenty of silliness at the individual stock level: Retail investors, running amok like Donald Duck’s nephews, appear to have triggered some remarkable moves, especially in small stocks. Feature The big picture remains unchanged, but the view from ground level is becoming increasingly disorienting. The dizzying activity in vulnerable industries and select micro-caps resembles nothing so much as a beach bar after final exams. Sun, noise, adrenaline and a sense of overdue release have come together to wash away any and all inhibitions or standard rules. The pull has been especially strong for newcomers to the scene. We suspect that some of the unusual action in individual equities over the last several weeks may have its origins in an upsurge of active retail participation. Waves of retail interest come and go like the tides, albeit irregularly, and the only thing new about the current iteration, with its smart phone apps and zero commissions, is that it is nearly frictionless. We have nothing against retail investors – we’ve been one since directing our paper route earnings to the purchase of odd lots in Ronald Reagan’s first term – and don’t see them as a portent of doom. Their moves are drawing attention, though, so we review freely available daily data to try to gain some insight into their recent activity and ongoing interest. Novices Versus Experts Chart 1Baseline Change In Robinhood Equity Ownership The Democratization Of Equity Investing The Democratization Of Equity Investing Robinhood is a deep-pocketed retail brokerage oriented toward novice investors. Although its customers’ balances are almost certainly small, it has over 10 million of them, and it has made a profound impact on the industry by pioneering commission-free trading. Data on its customers’ holdings are aggregated and uploaded several times throughout the day to the dedicated website robintrack.net. They are cumbersome – the full database contains over 8,000 spreadsheets – so we focused our analysis on Robinhood customers’ holdings in airlines, cruise ships and selected mortgage REITs. We found that the number of Robinhood accounts owning these stocks exploded since late March, but that datapoint cannot be considered in isolation because the number of accounts has been rising. Robinhood added over 3 million new accounts in the first four months of the year, an increase of as much as 30% from its year-end customer base.1 A blizzard of anecdotal reports characterizing day trading as a substitute for following professional sports reinforce the notion that ownership of all stocks has risen. To get a sense of how baseline equity holdings have changed since the S&P 500 peak on February 19th, we looked at the number of Robinhood accounts holding Apple (AAPL) and the iShares (SPY) and Vanguard (VOO) S&P 500 Index ETFs, and found they have all roughly doubled (Chart 1). Making equity investing more democratic may be a noble aim, but democracy can be messy. By contrast, the number of Robinhood accounts holding six large- and mid-cap airlines has risen 48 times, with component holdings of United (UAL) and Spirit (SAVE) leading the way at 87 and 81 times, respectively (Chart 2, top two panels), and Southwest (LUV) and Jet Blue (JBLU) bringing up the rear at 12 and 21 times, respectively (Chart 2, bottom two panels). The number of accounts owning cruise lines is up 177 times, on average, powered by Norwegian (NCLH), which has increased a remarkable 365 times (Chart 3, top panel). If Robinhood’s customers are representative of the retail investor population, betting that the pandemic will not be fatal for passenger airlines and cruise lines has become an extremely popular pursuit. Chart 2Buying The Dip In The Airlines The Democratization Of Equity Investing The Democratization Of Equity Investing Chart 3Stampeding Into The Cruise Lines The Democratization Of Equity Investing The Democratization Of Equity Investing Chart 4Unafraid Of Falling Knives The Democratization Of Equity Investing The Democratization Of Equity Investing Robinhood customers have also eagerly attempted to rescue ailing mortgage REITs. Mortgage REITs apply several turns of short-term leverage to their mortgage portfolios to fund generous dividend yields that typically range between the high single and low double digits. Mortgage REITs that invest solely in agency mortgage-backed securities (MBS) were stressed when credit spreads blew out in March, but hybrid REITs with sizable concentrations of illiquid non-agency MBS and whole loans faced an existential crisis. Three hybrids – Invesco Mortgage Capital (IVR), MFA Financial (MFA) and AG Mortgage Investment Trust (MITT) – failed to meet margin calls from their repo lenders. MFA and MITT have indefinitely suspended their dividends, while IVR cut its dividend by 96% last week. The companies’ futures were in doubt in late March and early April, but Robinhood customers have poured into the breach. The number of accounts holding the stocks has risen 93-fold, on average, since the S&P 500 peaked in February, with IVR leading the way at 149 times (Chart 4, top panel). Robinhood customer interest began to surge when the three stocks bottomed but increasing numbers of accounts have added them to their portfolios all throughout a turbulent May and June. The stocks are not yet out of the woods and sell-side analysts have panned their recent surges, as it is unclear who else will want to own them when they don’t pay dividends. Stocks from the groups we highlighted all face daunting current predicaments. They might deliver sizable returns if they can emerge mostly unscathed but that is a big if. They have come to account for an outsized share of Robinhood customers’ holdings (Table 1), especially relative to their market capitalizations. Retail treasure hunting may account for some of the recent surges that seemed to spite fundamentals, but we doubt that a community of first-time investors has the heft to move any but the smallest stocks. We suspect that algorithms, hedge-funds and other fast-money pools of capital may be amplifying the momentum that retail activity has set in motion. Retail investors have provided institutions with an opportunity to exit stocks in the three stressed groups. Per weekly data on the level of institutional holdings from Bloomberg, the composition of ownership of all twelve stocks we examined has shifted materially from institutions to individuals (Table 2). In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. Instead of amplifying volatility, they may have tamped it down, while helping to speed the redeployment of institutional capital. Table 1Searching The Bargain Bin The Democratization Of Equity Investing The Democratization Of Equity Investing Table 2Individuals Have Replaced Institutions The Democratization Of Equity Investing The Democratization Of Equity Investing   Direction Versus Level Many investors lament that the equity rally has occurred without regard for fundamental conditions or in seeming defiance of them. The imposition of rigorous social distancing measures to slow the spread of COVID-19 immediately induced a sharp recession, but the economy has begun to bounce back, and a further rollback of virus containment measures will help it build forward momentum. The latest NAHB survey demonstrated that housing is making rapid strides, with buyer traffic smartly reviving (Chart 5, third panel) and builders’ sales expectations snapping back (Chart 5, bottom panel). May housing starts came in well short of the consensus expectation, but leading building permits indicate that a pickup is just around the corner, and the purchase mortgage applications index hit its highest level in eleven years last week (Chart 6). Chart 5Housing Is Coming Back Fast Housing Is Coming Back Fast Housing Is Coming Back Fast Chart 6Low Rates Help The Real Economy, Too Low Rates Help The Real Economy, Too Low Rates Help The Real Economy, Too The various regional Fed manufacturing surveys all bounced in May, and the June Philly Fed (Chart 7, top panel) and Empire State (Chart 7, second panel) readings extended the trend, zooming far past expectations. Their moves bode well for the Richmond, Kansas City and Dallas Fed readings due out this week and next. They are not all the way back to their pre-pandemic levels, but they’re moving in the right direction and point to a continued pickup in manufacturing activity (Chart 8). Chart 7Gaining Traction Gaining Traction Gaining Traction The economic surprise index hit an all-time high last week (Chart 9), reinforcing the point that the improvement in the direction of economic activity is widespread. Activity has not returned to pre-pandemic levels, and it won’t for a while, but it is beginning to pick up or at least weaken at a slower rate. As states progress through their reopening phases, the direction will continue to improve and the level will get closer to its previous position. Chart 8Weak Level, Improving Direction Weak Level, Improving Direction Weak Level, Improving Direction Chart 9Uncoiling The Spring Uncoiling The Spring Uncoiling The Spring A resurgence in infection rates, or a second wave like the one that appears to be emerging in China, is a threat to ongoing economic improvement. Some states which have moved more rapidly to reopen are experiencing increasing infection rates, but they will only see reversals in economic activity if they revert to strict social distancing measures. It is becoming steadily apparent that most communities, here and abroad, no longer have the stomach for broad lockdowns. It seems that government officials are willing to trade a modest pickup in infections for a pickup in economic growth and individuals are willing to trade an increased risk of infection for a return to some sense of normal life. A severe re-emergence could change the calculus, but for now there is powerful momentum to advance along the path to restarting the economy. Policymakers Versus The Virus A record-high economic surprise index distills the improved direction across a broad sweep of indicators. Our view that Washington will extend fiscal lifelines to households, businesses and state and local governments is still intact. Negotiations over an infrastructure spending initiative are progressing, and we expect a successor to the CARES Act will follow before the end of July. As we’ve discussed before, it is simply too risky politically for Senate Republicans to obstruct aid efforts heading into the homestretch of the campaign. Robust fiscal support, combined with whatever-it-takes monetary support from the Fed, should be enough to see the economy across the pandemic abyss provided that testing bottlenecks are resolved and treatment protocols advance. Investment Implications Wagging a finger at retail investors is not our style. Increased retail participation has probably catalyzed some unexpected equity outcomes but the only outright distortions we’ve seen have occurred in micro-cap stocks and do not have a larger macro resonance. Retail participation in the stock market has always waxed and waned, but major market and economic impacts like the dot-com bubble are rare. We therefore do not believe that equities have become unmoored from reality and that a threatening bubble has formed. The fundamental backdrop has improved. The economy is nowhere near recovering its pre-pandemic levels, but the stock market is a forward-discounting mechanism and direction regularly trumps level. There is surely some froth in the market, and 24 times forward four-quarter earnings is a pricey multiple for the S&P 500, especially when it seems that earnings expectations beyond 2020 are overly optimistic. Retail participation in equities comes and goes, and it rarely proves disruptive at the overall index level. There are also plenty of ways that the virus could spring a nasty surprise, and financial markets seem to be ignoring them. Our geopolitical strategists see scope for turbulence at home, as the administration tries to improve its re-election prospects, and abroad, as any of several hot spots from Iran to North Korea to the South China Sea could flare up. The potential for negative surprises, as well as the furious equity rally, keeps us equal weight equities and overweight cash over the tactical timeframe. We remain constructive on equities over a 12-month horizon, however, as things are moving in the right direction and the alternatives – cash with zero yields and Treasuries with microscopic yields – are so unappealing.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Robinhood announced that it had surpassed the 10-million-customer mark in December.

Highlights If policymakers can neutralize default pressures arising from the lockdowns, the lasting impacts of this recession may not be so bad: As Jay Powell put it on 60 Minutes several weeks ago, policymakers just have to keep people and businesses out of insolvency until health professionals can gain the upper hand over the virus. Fiscal spending caused income and savings to spike, … : Generous transfer payments have left the majority of the unemployed better off than they were when they were working, and April household income and savings soared accordingly. … allowing consumers to meet nearly all of their obligations … : April’s income and savings gains showed up in reduced delinquencies across all categories of consumer loans and in solid April and May rent collections. May’s employment gains suggest that the private sector may not be too far away from taking the baton from Congress: The May employment report blew away expectations and sent risk assets surging, but the positive surprise may derail plans for further fiscal support. Feature Since March, investors have been presented with a simple choice: believe their eyes or believe in the government. They could either focus on horrendous economic data illustrating the crippling effects of widespread lockdowns, or they could trust in policymakers’ ability to shield most citizens and businesses from lasting damage. Our base case has been that policymakers would succeed, for the most part, provided they didn’t have to contend with acute COVID-19 pressures for more than six months. There are as many guesses about the virus’ future path as there are commentators, but it seems reasonably conservative to estimate that the most onerous restrictions will be eased by October. Chart 1DC To The Rescue D.C. To The Rescue D.C. To The Rescue In our view, preventing defaults is the key to mitigating the effects of the virus. If newly vulnerable debtors can be kept from defaulting until the economy can return to something resembling normal, a negatively self-reinforcing dynamic will not take hold, the infection will not spread to the financial system and creditworthy individuals’ and viable businesses’ temporary liquidity issues will not morph into solvency issues. Banking system data to confirm or disprove our thesis will not be available until August, however, as Fed and FDIC data are quarterly, and the shutdowns only began in late March. The unemployment safety net has turned into a trampoline; ... In this report, we have turned to a range of other sources for higher-frequency insights into what is happening in real time. We start with an academic paper showing that most laid-off workers are eligible for benefits comfortably exceeding their previous income, a conclusion reinforced by the April personal income data (Chart 1). We then look at April delinquency data from TransUnion, one of the major credit reporting agencies, and April and May rent-collection data from an apartment trade organization and large-cap publicly traded apartment REITs. We also review the Fed’s Survey of Consumer Finances to get a sense of household indebtedness across the income and wealth spectrums. For now, the data support the conclusion that policymakers have successfully defused credit distress pressures. What Comes In … Unemployment benefits typically fall far short of workers’ regular compensation, averaging about 40% of the median worker’s wage. To cushion the blow of unemployment from COVID-19, the CARES Act included a federal supplement to unemployment benefit payments distributed by the individual states. Added onto the average $400 weekly state benefit, the $600 federal supplement would make the average worker whole (mean earnings are a little less than $1,000 a week). As income inequality has intensified, the compensation distribution for all American workers has come to exhibit a pronounced rightward skew. That skew has pulled mean compensation (the average of all Americans’ earnings) well above median compensation (the earnings of the worker at the exact middle of the earnings distribution).1 By targeting mean compensation, the CARES Act opened the door for a lot of lower-income workers to make more money in unemployment than they did when they were working. According to a recent paper from three Chicago professors, 68% of unemployed workers are eligible to receive benefits that exceed their previous income, while 20% of unemployed workers are eligible for benefits that will at least double it. Overall, they calculate that the median worker is eligible to receive benefits amounting to 134% of his/her previous income.2 ... instead of keeping laid-off employees' incomes from falling below 40 cents on the dollar, it's launched them to $1.30. We offer no judgments about the policy merits of a 134% median replacement rate, but unusually generous benefits should help reduce the drag from unemployment that would otherwise ensue with a 40% replacement rate. Thanks to lower-income households’ higher marginal propensity to consume, consumption should rise at the margin (once activity resumes). Thanks to increased income, lower-income households should be better positioned to meet their financial obligations. We suspect the marginal consumption boost may be hard to see with the naked eye, but auto, credit card and mortgage delinquencies should be appreciably lower than any regression model not adjusted to reflect record replacement rates would predict. … And What Goes Out The Personal Income and Outlays data for April reflected the significant impact on household income of the up-to-$1,200 stimulus checks (economic impact payments) and the supplemental unemployment benefits. Despite an annualized $900 billion decline in employee compensation, personal income rose by nearly $2 trillion in April, thanks to a $3 trillion increase in transfer payments. De-annualizing the components, $250 billion in transfer payments offset a $75 billion decrease in compensation. At about $220 billion, the economic impact payments accounted for the bulk of the transfer payments, and they will fall sharply in May. The IRS did not disclose the amount of economic impact payments it had disbursed by April 30, but it appears that around 80% of the distributions have been made, leaving approximately $55 billion yet to be disbursed. Unemployment insurance receipts will rise in May on an extra week of benefits and an increase in the weekly sums of initial and continuing unemployment claims. We project that employee compensation rose about 3% in May, based on a 2% gain in employment and a 1% increase in average weekly earnings. Aggregating the February-to-May changes, it appears that May personal income ought to exceed February (Table 1). Absent another round of stimulus checks, however, personal income will slide below its pre-shutdown level beginning in June. Table 1May Personal Income Should Exceed Its Pre-Pandemic Level So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) Income is not the sole driver of households’ capacity to service their debt, however. Assets matter, too, and even if the surge in cash flow was a one-off event, it left behind an elevated stock of cash as households slashed consumption in both March and April. Real personal consumption expenditures have fallen 19% from February’s all-time high and are now back to a level they breached in January 2012 (Chart 2). Households saved 33% of their April disposable income, and on a level basis, April savings were up nearly fivefold from their 2019 average. They were a whopping 20 times April interest payments, ex-mortgages (Chart 3). Chart 2Eight Years Of Spending Undone In Two Months Eight Years Of Spending Undone In Two Months Eight Years Of Spending Undone In Two Months Chart 3Consumers' Interest Coverage Ratios Have Soared Consumers' Interest Coverage Ratios Have Soared Consumers' Interest Coverage Ratios Have Soared Household Borrowers Are Staying Current … Table 2Consumer Borrowers Are Hanging In There So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) It is possible to make too much of the April income and outlays data. We had been expecting another round of stimulus checks, but lawmakers’ comments even before the blockbuster employment report suggested one may not be forthcoming. Some of the savings activity was forced on homebound consumers, and some pent-up demand will surely be unleashed as the economy re-opens. Households amassed a mighty savings war chest across March and April, however, and it has left them better-positioned to service their debt obligations going forward. Despite an unemployment rate not seen since FDR, households made their scheduled payments in April. According to TransUnion, delinquency rates fell month-over-month across every major consumer loan category and delinquency rates for mortgages and unsecured personal loans declined on a year-over-year basis (Table 2). The TransUnion data comes from its inaugural Monthly Industry Snapshot, intended to provide a higher-frequency read on headline consumer credit metrics than its typical quarterly releases. In addition to crunching the delinquency numbers, the report noted that forbearance programs have helped ease consumer liquidity pressures, consumers have reduced their outstanding credit card balances and credit scores have slightly improved. None of the factors is decisive on its own, but they contribute to a marginally improved consumer credit outlook. … And Apartment Tenants Are Paying Their Rent It is more common for households in the lower half of the income and net worth distributions to rent their residence than own it. Just one in every five households in the bottom two quintiles of the income distribution (Chart 4, top panel), and one in four in the bottom half of the net worth distribution (Chart 4, bottom panel), have a mortgage. Rent is the single largest recurring expense for these households and the shutdowns made paying it a concern. Several newspaper stories have highlighted the plight of distressed renters while discussing grassroots rent-strike movements, but the National Multifamily Housing Council’s (NMHC) Rent Payment Tracker tells a different story.3 Chart 4Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes The Rent Payment Tracker distills the results of a national survey covering over 11 million professionally managed apartment units. Through May 27th, it reported that 93.3% of renters had made full or partial payments for the month of May. The share of paying tenants was down just 150 basis points year-over-year, and up 160 basis points month-over-month. The six apartment REITs in the S&P 500 reported April and May rent collections that were better than the NMHC data. By the end of May, the REITs had collected 94-99% of the April rent they were due, and 93-96% of their May rents (Table 3). (Equity Residential (EQR) reported its April collections through April 7th and did not provide an end-of-month update; on June 1st, it reported that its May collections through May 7th were in line with April’s.) Essex Property Trust (ESS), which owns a portfolio of apartments in southern California, the Bay Area and greater Seattle, provided a table showing how the economic impact payments and the supplemental unemployment benefit would affect the income of unemployed California and Washington state couples without children. Table 4 expands it to cover four income scenarios, illustrating just how far up the income distribution CARES Act relief stretches. Table 3Residential Tenants Are Paying Their Rent So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) Table 4The CARES Act For Essex Property Trust Renters So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC) Who Borrows: Evidence From The Survey Of Consumer Finances Helping the households in the bottom half of the income distribution won’t materially limit credit distress across the economy if those households don’t have access to credit. The latest edition of the Fed’s triennial Survey of Consumer Finances, published in 2017, makes it clear that they do. Those households may be much less likely to carry mortgage debt (Chart 5), but they make up for it by borrowing via other channels. 64% of households in the bottom two quintiles have some debt, and the share grows to 70% when the middle quintile, which qualified for the full $1,200 economic impact payment, is included (Chart 6). Chart 5The Homeownership Income Divide The Homeownership Income Divide The Homeownership Income Divide Chart 6Households In The Lower Two Quintiles Have Debt To Service, Too Households In The Lower Two Quintiles Have Debt To Service, Too Households In The Lower Two Quintiles Have Debt To Service, Too Investment Implications The discussion above focused solely on the consumer, as we discussed the Fed’s efforts to assist lenders and business borrowers in a joint Special Report with our US Bond Strategy colleagues in April.4 Record corporate bond issuance in March and April – before the Fed bought a single corporate bond – testifies to the effectiveness of the Fed’s measures. Its corporate credit facilities bazooka was so large that it was able to soothe the roiled corporate issuance market without firing a single shot. Spreads have narrowed across the spread product spectrum and the primary and secondary markets are once again able to function normally. Too much economic improvement could be self-limiting, and the S&P 500 is trading at an ambitious multiple. We remain equal weight equities over the tactical three-month timeframe. The foregoing review of consumer performance reinforces our view that the SIFI banks should be overweighted relative to the S&P 500. The ongoing data indicate that the SIFI banks will not have to build up their reserves for loan losses as much as investors feared. Our conviction that the SIFI banks are unlikely to face material book value declines has only increased. It has become possible that second- and third-quarter reserve builds may be even less than our optimistic two-times-the-first-quarter view, but the virus will have the final say. The SIFI banks remain our favorite long idea. At the asset allocation level, we remain equal weight equities over the tactical three-month timeframe. We are encouraged by the green shoots visible in the employment report, but stocks are generously valued and the virus outlook is still unclear. The improvement on the ground could prove to be self-limiting if it kills the momentum for further fiscal assistance, or if it encourages officials and individuals to let their guard down regarding the social distancing measures that have been effective in lowering COVID-19 infection rates.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to the Census Department’s annual Current Population Survey, mean household income ($90,000) exceeded median household income ($63,000) by 42% in 2018. 2 Ganong, Peter, Noel, Pascal J., Vavra, Joseph S. "US Unemployment Insurance Replacement Rates During the Pandemic," NBER Working Paper No. 27216. 3https://www.nmhc.org/research-insight/nmhc-rent-payment-tracker/ Accessed June 1. 4 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com.