Sectors

One-Way Ticket For Staples Stocks One-Way Ticket For Staples Stocks Your feedback is important to us. Please take our client survey today. Underweight In yesterday’s US Equity Sector Insight we highlighted why investors should stay on the sidelines when it comes to the defensive S&P household products index. But, with regard to the broader S&P consumer staples sector, our view remains that over the next 9-12 months this safe haven sector, which peaked in the depths of the COVID-19 recession, will continue to underperform. As the pandemic-induced recession disappears from the rear-view window, it no longer pays to favor stable cashflow growth staples companies. In fact, our relative macro earnings model paints a dark picture for this GICS1 sector (middle panel). Among other reasons, one of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis staples stocks cannot benefit from positive currency tailwinds to the same extent as the overall market can. Bottom Line: We remain underweight the S&P consumer staples sector.  

Caught In The Crosscurrents Caught In The Crosscurrents Neutral We remain neutral the S&P household products index. A V-shaped economic recovery following a recession has historically been synonymous with this defensive industry underperforming (top panel). However, the uniqueness of the current recession must be taken into account. The US consumer continues to binge on household products, which are currently outpacing overall retail sales growth by 13% year-over-year (middle panel, relative consumer spending shown truncated). This trend is slated to continue until a vaccine arrives as the second wave of infections emerges. The same story holds for foreign consumers who also have an incentive to keep up their spending on US household products: a softer US dollar. A weaker US dollar will boost competitiveness of US exporters, which will translate into robust top line growth (bottom panel). Bottom Line: Given the strangeness of the current recession, we remain neutral the S&P household products index. The ticker symbols for the stocks in this index are: BLBG: S5HOPR – PG, CL, KMB, CLX, CHD.    

Too Much Homebuilding Euphoria Too Much Homebuilding Euphoria Neutral – Downgrade Alert It no longer pays to chase the S&P homebuilding index higher; it is now on our downgrade alert watch-list. The recent pandemic-induced drubbing in interest rates boosted housing affordability and caused a knee jerk reaction in the mortgage application purchase index, which in turn served as a catalyst for the recent rally (top & middle panels). However, as the economy continues to open up, interest rates will reverse course and flip from a tailwind into a headwind. Sell-side analysts are also upgrading their earnings forecasts at the highest pace since the GFC, and we would lean against this extreme bullishness (bottom panel). Bottom Line: We are neutral the S&P homebuilders index, but it is now on our downgrade watch-list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. For more details, please refer to the recent Weekly Report.  

No Love For Banks No Love For Banks Neutral – Downgrade Alert Banks hit all-time lows again this week on the back of mixed profit results. While Q3 loan loss reserves will rise albeit at a slower pace than H1/2020, net interest income ails and difficulty in growing revenues are significant offsets. This backdrop makes banks hostage to the 10-year US Treasury yield (top panel). With regard to fiscal stimulus and economic uncertainty, Jamie Dimon recently warned that “If the double-dip (recession) happens, we would be under-reserved by $20 billion.” Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket. Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watchlist. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT. For more details, please refer to this Monday’s Weekly Report.  

  Stretched Positioning Stretched Positioning Following up from yesterday’s US Equity Strategy’s sector insight, today we take a closer look at VIX and e-mini futures positioning, again from a contrarian perspective. Using CFTC weekly data, VIX non-commercial speculative positions are net short. In fact, as a percentage of total open interest, net shorts are more extended than the months both prior to “Volmageddon” and to the Q4/2018 20% SPX drawdown. With regard to this year’s equity market carnage, net shorts are almost as extended as in late-2019/early 2020 (VIX net positioning shown inverted, top panel). Similarly, non-commercial speculative positions in S&P 500 e-mini futures are net long on a par with readings recorded in early 2020 (bottom panel). The implication is that speculators are betting on a dying down in volatility and fresh SPX all-time highs. While this will likely materialize post the November election, in the near-term our fear is that speculators will get caught offside, as elevated election and fiscal policy uncertainties will sustain downward pressure on stocks. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.  

Highlights Our model suggests that more rate hikes are ahead in 2021; we project a less than 50bps increase in the PBoC policy rate from the current level. Chinese stock prices positively correlate with interest rates and bond yields. The relationship has strengthened since 2015. In the next six to nine months, Chinese stock prices will likely trend up alongside a rising policy rate and an accelerating economic growth. Feature China’s policy rate and bond yields have been rising sharply since May and are breaching their pre-COVID 19 levels. Meanwhile, Chinese stock prices have moved sideways since mid-July, despite a steady recovery in the domestic economy. While some commentators view higher interest rates as a harbinger of an impending equity market weakness, our research shows that the relationship between China’s stock prices and short-term rates has been positive since 2015. A rally in Chinese stocks and outperformance of cyclical stocks relative to defensives positively correlate with rising interest rates and bond yields (Chart 1A and 1B). Chart 1ARising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Chart 1B...And Offshore Cyclicals ...And Offshore Cyclicals ...And Offshore Cyclicals Chart 2Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 China’s massive stimulus this year generated some self-sustaining momentum that will likely push the nation’s output higher in 1H21(Chart 2). The PBoC may raise the policy rate by as much as 50bps in 2021 from its current level, but strong domestic fundamentals should be able to drive up Chinese stock prices, in both absolute term and relative to global equities in the next six to nine months. PBoC Policy Hikes:Still More Ahead While the PBoC’s policy rate has rebounded sharply, it remains at its lowest level since the Global Financial Crisis. Looking forward, will the central bank bring the policy rate (e.g. 3-month SHIBOR) back to its pre-COVID 19 range of 3 – 3.5% or the pre-trade war level near 5%? The acceleration in China’s economic recovery is expected to continue and would boost China’s annual output growth in 1H21 to two to three percentage points above its trend. Based on these estimates, our interest rate model implies more than 200bps in rate increases in 2021 from the current level1 (Chart 3). Chart 3Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Historically, our model has successfully captured the major turning points in China's policy rate cycles. This time around, however, the pandemic and the subsequent economic recovery may have complicated the model's predictive power. The model suggests that, in 1H21 the policy rate will return to its pre-trade war range of 4-5%, but we think the rate increases will be capped within 50bps.  The model follows a modified version of "Taylor's Rule," in which we assume that the PBoC will target its short-term interest rate based on the deviation between actual and desired inflation rates and the deviation between real GDP growth and China’s trend GDP growth rate. The latest data shows across-the-board strengthening in the economy; most indicators have surprised to the upside, confirming our optimistic  assessment.2 However, Taylor's Rule is not able to account for sudden shocks in the economy, such as a pandemic-induced global recession. Thus, the model exaggerates the magnitude of interest rate bumps, based on an economic growth acceleration following a one-off economic shock.  In a report earlier this year, we noted that the PBoC has been proactive in normalizing its monetary policy following short-term shocks.3 This is contrary to economic downturns when the PBoC has been a reactive central bank and its decisions often lagged a pickup in economic activity. As such, although interest rates have swiftly rebounded after the pandemic-induced growth contraction in Q1, we expect the pace of rate hikes to be slower in 2021. Chart 4Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits External factors are accounted for in the model, though they may be underestimated. The US Federal Reserve Bank has decisively shifted its monetary policy to broadly accommodative and will stay behind the inflation curve in the next few years. The collapse in interest rate differentials between the US and China has made RMB-denominated assets attractive, boosting strong inflows of foreign capital and rapidly pushing up the value of the RMB (Chart 4, top panel).    While we think Chinese policymakers have pivoted to prefer a strong RMB, the recent countermeasures by the PBoC indicate that the central bank will not allow the RMB to climb too rapidly.4 China's drastic tightening in monetary conditions and the sharp rally in the trade-weighted RMB from 2011 to 2014 led to a prolonged economic downturn (Chart 4, bottom panel). Therefore, in the absence of synchronized policy tightening from other central banks, the magnitude of rate hikes by the PBoC will be measured.  Bottom Line: The PBoC will continue to push up the policy rate in 2021, but our baseline view is that the magnitude will be capped below 50bps. Interest Rates And Chinese Stocks Chart 5Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Many investors might think that stock prices tend to react negatively to monetary policy tightening because interest rate upturns and mounting bond yields lead to higher costs of funding for corporations and lower profit growth. However, Chinese stock prices started moving in the same direction with policy rates and bond yields following the burst of the 2014/15 stock market bubble (Chart 5 and Chart 1A and 1B on Page 4 and 2). In general, when China’s economic and profit growth accelerates, share prices can rise with higher interest rates. Share prices can still climb with cuts in interest rates even when economic growth slows but profit growth rate remains in positive territory. However, when profit growth is expected to drop below zero, share prices will drop even if rates are falling (Chart 6A and 6B).  In this vein, the most pertinent reason for Chinese stocks to move in tandem with bond yields is that Chinese stocks are increasingly driven by economic fundamentals, which are supported by the volume of total credit creation (measured by total social financing) rather than the price of money in China. Furthermore, the reverse relationship between the volume and price of money in China broke down after 2015; China’s credit creation has become less sensitive to changes in interest rates. Chart 6AWhen Interest Rates Rise... When Interest Rates Rise... When Interest Rates Rise... Chart 6B...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance Since 2015, the PBOC shifted its policy to target interest rates instead of the quantity of money supply (Chart 7). In order to effectively manage the official interbank rates (the 7-day interbank repo rate), the central bank uses tools such as reserve requirement ratio cuts and liquidity injections in the interbank system (Chart 8).  In other words, the central bank has forgone its control of the volume of money. Moreover, since late 2016, rather than direct interest rate hikes, the PBoC has been taking monetary policy tightening measures through changes in its macro-prudential assessment (MPA). The changes in the MPA are evident in the 3-month / 1-week repo spread.5  As such, an increase in the 3-month interbank repo rate (and SHIBOR) is often intended to curb shadow-banking activities rather than depress aggregate credit creation and business activities (Chart 9). Chart 7Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Chart 8More Open Market Operations Monetary Tightening ≠ Lower Stock Prices Monetary Tightening ≠ Lower Stock Prices Chart 9Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Another idiosyncrasy is China’s fiscal stimulus, which has become a more relevant driver of total social financing since the onset of the 2014/15 economic downcycle (Chart 10). The amount of government bond issuance is specified by the People’s Congress in March each year and is not affected by changes in interest rates or bond yields. Therefore, growth in total social financing can still accelerate despite a higher price of money (Chart 11). Chart 10Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Chart 11Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing By the same token, a rising 3-month SHIBOR can also be the result of rapid fiscal and quasi-fiscal expansions, as seen in Q3 this year.  A flood of central and local government bond issuance drained liquidities from commercial banks, boosting the banks’ needs to borrow money from the interbank system. Nevertheless, the market’s appetite for risk assets increases because fiscal stimulus provides an imminent and powerful reflationary force in China’s business cycles. Chart 12Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Rising policy rates typically push up corporate bond yields. However, bond yields in China play a relatively small role in driving corporate financing costs on an aggregate level, since commercial banks are still dominant in China’s debt market. Commercial banks' average lending rates closely track the PBoC’s policy rate on a cyclical basis, but Chinese authorities periodically use window guidance to target the Loan Prime Rate (LPR), a reformed bank lending rate. Hence, the direction in both the LPR and the average lending rate can temporarily diverge from the policy rate. These measures can boost bank loan growth even in a rising interest rate environment (Chart 12). Bottom Line: The key driver of Chinese stock performance is the country’s domestic credit, business, and corporate profit growth cycles. Since the 2014/15 cycle, the policy rate has not been the determinant of China’s economic or credit growth. Investment Conclusions We expect that this year’s massive monetary and fiscal stimulus to accelerate the country’s economic recovery into 1H21. Therefore, even if interest rates and bond yields advance, Chinese stock prices can still trend upward. Chinese cyclical stocks should also continue to outperform defensives, in both the onshore and offshore markets (Chart 13A and 13B). Chart 13AStay Invested In Chinese Stocks Stay Invested In Chinese Stocks Stay Invested In Chinese Stocks Chart 13BCyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Rates will begin to climb and fiscal policy will also become more restrictive if China’s output moves above trend growth through 1H21. Government bond quotas and fiscal budget will be determined at the National People’s Congress in March. If the economy is strong, odds are that fiscal stimulus will be scaled back. At that point, investors should start to look for a peak in China’s business cycle linked to monetary and fiscal policy tightening. As growth expectations start to downshift in the equity market, yields on long-dated government bonds will start to decline while yields on the short end will not drop. Additionally, the small-cap ChiNext market has been considered as a speculative segment of the domestic financial market with higher multiples and greater volatility than large-cap A shares. The bourse's trailing price-to-earnings ratio and price-to-book ratio are extremely elevated at 79 and 8.6, respectively, much higher than for broader onshore and offshore Chinese stocks. As such, this market will remain the most vulnerable to domestic liquidity tightening.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 based on our estimates for 1h21: 7.5-8.0% GDP growth,  2.5-2.8% headline CPI, 6.5-6.7 USD/CNY, and the fed holding current fund rate unchanged. 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Weekly Report "Don’t Chase China’s Bond Yields Lower," dated February 19, 2020, available at cis.bcaresearch.com 4On October 12, the PBoC removed financial institutions’ Forex reserve ratio of 20%, making betting against the RMB cheaper.  5Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

What To Make Of Spiking VIX Put/Call Ratio? What To Make Of Spiking VIX Put/Call Ratio? Bulls regained control of the equity market, and frenzied buying on Monday pushed the SPX and NDX indexes within striking distance of fresh all-time highs. Our sense is that the market has finally come round to BCA’s view of better-than-even chances of a “Blue Wave” as we first articulated in a joined Special Report with our Geopolitical Strategy service in mid-July “Blue Trifecta: Broad Equity Market And Sector Specific Implications”. However, market leadership is slightly perplexing. While a “Blue Wave” would make a massive fiscal package highly likely in the New Year, bulls bidding tech titans to nose bleed levels anew argues that a new closing of the economy is upon us. The “sleeping giant” 10-year US Treasury yield still hovering below the June highs also signals that something is amiss with the economy, thus boosting the allure of the longest duration equity sector: tech stocks. Finally, the VIX (volume) put/call ratio recently had a 3 handle (shown inverted as a 21-day moving average, top panel). The chart also shows the VIX (open interest) put/call ratio (PCR) that has historically behaved as a contrarian indicator: a high reading leads to a higher VIX and lower SPX and vice versa (PCR shown inverted, middle panel). In other words, as investors are foregoing downside protection the odds are high that an equity pullback would materialize. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.  

Dear client, Next Monday, October 19, we will be hosting our quarterly webcast, “From Alpha To Omega With Anastasios”, at 10am EST; Matt Gertken, BCA’s Geopolitical Strategist will be our guest on the eve of the US Presidential Election. Our regular weekly publication will resume on Monday October 26, 2020. Kind Regards, Anastasios Highlights Portfolio Strategy Homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. While the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index.  Recent Changes There are no changes to our portfolio this week. Table 1 COVID Fatigue, Fiscal Fatigue, Election Fatigue COVID Fatigue, Fiscal Fatigue, Election Fatigue Feature Equities seesawed last week as President Trump returned to the White House (WH) and injected fresh volatility in markets signaling that there will be no fiscal deal prior to the elections. The SPX immediately gapped down and we cannot stress enough the importance of our newly configured Fiscal Policy Loop: fiscal hawkishness causes skittishness in markets culminating to a classic BCA riot point and then policymakers relent and fiscal dovishness restores the equity bull market (Figure 1). While we cannot rule out a slimmed-down stimulus package deal by later this month, fiscal policy- and election-related uncertainties remain elevated. The daily back-and-forth on where Congress and the WH stand with passing a new stimulus bill coupled with the prospects of a contested election that would drag on the presidential race likely into December, have caused investor fatigue. The sooner both of these uncertainties recede, the quicker the SPX will climb to fresh all-time highs (Chart 1). Figure 1The Fiscal Policy Loop COVID Fatigue, Fiscal Fatigue, Election Fatigue COVID Fatigue, Fiscal Fatigue, Election Fatigue Chart 1Receding Uncertainty Will Boost Stocks Receding Uncertainty Will Boost Stocks Receding Uncertainty Will Boost Stocks   We have shown in recent research, and update today, that the fourth year of presidential cycles finds the SPX ending the year on average in the green with a calendar return in the high single digits (Chart 2). Peering back in 2016 is instructive as that presidential election cycle year was in some ways similar to the current one. The economy, in particular, was fighting off a manufacturing recession that spread and infected the services sectors as the vast majority of S&P GICS1 sectors saw profit contraction and more importantly revenue declines. Chart 3 shows a number of asset classes and compares 2016 with 2020. The 10-year US Treasury yield appears poised to rebound significantly, especially if Congress passes a fresh fiscal package that aides the parts of the economy that need the stimulus checks most. Fiscal easing uncertainty remains a thorny issue across different markets and if history is an accurate guide, the SPX could glide lower into the November election before rallying into year-end. Chart 2Back Up Near The Average Profile Back Up Near The Average Profile Back Up Near The Average Profile Meanwhile, a number of investors we talk to also experience COVID-19 fatigue (Chart 4). For the better part of the last 10 months media has constantly bombarded the world with pandemic news, and rightly so. However, all this seems dystopian by now, and we cannot wait for a semblance of normality to make a comeback, which a vaccine will definitively bring about. The equity market has been indurated to this news-flow and has shaken-off the recession. When the vaccine does arrive likely next year, profits will also return back to trend, as we have been arguing for some time, because the global economy will fully reopen. Chart 32016 Versus 2020 2016 Versus 2020 2016 Versus 2020 Already, if we juxtapose leading soft economic data surprises with lagging hard economic data surprises, it is clear that a stellar profit recovery looms (second panel, Chart 5). Similarly, within soft the data universe, the ISM new orders-to-inventories ratio paints a rosy picture for an earnings recovery in 2021 (third panel, Chart 5). Even within hard economic data, a simple liquidity indicator we have used in the past comparing industrial production (IP) with M2 money stock signals that S&P profits have troughed (IP vs. M2 shown advanced, bottom panel, Chart 5) Chart 4COVID Fatigue COVID Fatigue COVID Fatigue Finally, the US Equity Strategy’s four-factor macro profit growth model has slingshot higher recently and signals that a return to $162 level of EPS in calendar 2021 is a high probability outcome (Chart 6). Netting it all out, we are in the tail end of the equity market correction and as election and fiscal policy uncertainties ebb, they will pave the way for a robust SPX rally. Chart 5Profit Recovery On Track Profit Recovery On Track Profit Recovery On Track   Chart 6EPS Model Concurs EPS Model Concurs EPS Model Concurs This week, we continue with our strategy of preferring beaten-down cyclicals to defensives and steer the portfolio away from another safe haven staples industry via downgrading a consumer goods subgroup to underweight. We also delve deeper into the banking industry highlighting some cracks in small commercial banks. Put Homebuilders On Downgrade Alert Homebuilders have had a monster run since the depths of the recession back in March and the question a lot of our clients are now asking is: does it make sense to chase them higher at the current juncture? The short answer is no. Before we get into the details of our analysis a brief recap of our recent residential real estate-related moves is in order. Going into the March carnage we were cyclically underweight the niche homebuilding index. Moreover, last December we had identified homebuilders as a high-conviction underweight in our annual Key Views report. We monetized relative gains of 41% and 43%, respectively from both positions and lifted exposure to a benchmark allocation. While in retrospect we should have upgraded all the way to overweight, we did manage to participate in the V-shaped housing-related returns by opting to go overweight the mega cap home improvement retail index instead. In addition, this summer we eked out another 10% return from a long homebuilders/short REITs pair trade. Homebuilders are enjoying the single family home renaissance as the pandemic has turbo-charged the work from home movement and employees are rushing to move into comfortable spaces in the suburbs as the traditional office is literally declared dead. Indeed, housing starts and permits have renormalized, the drubbing in interest rates has boosted affordability and caused a knee jerk reaction in the mortgage application purchase index, and sell-side analysts are fighting hand-over-fist to upgrade profit projections for the homebuilding group (Chart 7). The end result has been a boom in new home sales that are trouncing existing home sales, and the NAHB’s survey of prospective homebuyers continues to paint a rosy picture for additional demand for new single family homes especially given the low inventory of homes (top & third panels, Chart 8). Chart 7Housing Tailwinds Housing Tailwinds Housing Tailwinds Chart 8Price Concessions Generate Volume Price Concessions Generate Volume Price Concessions Generate Volume This is where all the good news ends. With respect to selling prices, homebuilders are making price concessions compared with existing homes and also in absolute terms new home prices are deflating (second & bottom panels, Chart 8). Therefore, at close to 15%, homebuilding profit margins are near all-time highs and under threat especially from a firming industry wage bill (second & third panels, Chart 9). Tack on surging lumber inflation and a profit margin squeeze is a high probability outcome (bottom panel, Chart 9). As a reminder framing lumber, on average, comprises 15% of a new single family home’s total input costs. While the NAHB survey points to brisk demand for new homes, the sister Conference Board survey shows that consumers’ appetite for a new home has crested (second & third panels, Chart 10). With consumers rushing to move to the suburbs due to the pandemic, there is an element of bringing housing demand forward. Chart 9Beware Margin Squeeze Beware Margin Squeeze Beware Margin Squeeze Chart 10Good News Fully Priced Good News Fully Priced Good News Fully Priced Worrisomely, if the economy continues to open up then interest rates should continue to back up. From all the major asset classes the 10-year Treasury yield is the one that has yet to discount a V-shaped economic recovery. The implication is that rising interest rate would dent affordability and at the margin weigh on housing demand (10-year Treasury yield shown inverted, top panel, Chart 10). Moving on to the credit backdrop, while demand for residential real estate loans has recovered, bankers refuse to extend mortgage credit (second & third panels, Chart 11). According to the latest Fed H8 weekly credit release, residential real estate loans are on the verge of contraction (bottom panel, Chart 11). Finally, the tug-of-war on the fiscal package front is also threatening to sustain the unemployment rate near double digits, which could jeopardize the housing recovery. Historically, housing starts have been near perfectly inversely correlated with the unemployment rate and the current message is for a leveling off in residential construction activity (middle panel, Chart 12). The recent homebuilding run has pushed relative valuations from undervalued to overvalued. The relative P/S ratio trades roughly 30% above the historical mean (a three-year high), and leaves no cushion for any mishaps (bottom panel, Chart 12). Chart 11Bankers Refusing To Dole Out Loans Bankers Refusing To Dole Out Loans Bankers Refusing To Dole Out Loans Chart 12In Desperate Need Of Fiscal Help In Desperate Need Of Fiscal Help In Desperate Need Of Fiscal Help Netting it all out, homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. Bottom Line: Stay neutral the S&P homebuilders index, but it is now on our downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. A Few Words On Banks Pundits around the globe focus on Eurozone and pan-European banks and argue that these outfits have been value destroyers since the history of the data series in late-1986 (bottom panel, Chart 13). Similarly, US banks relative share prices peaked in the mid-1970s and have never looked back, and very recently have tumbled to fresh all-time lows whether one uses monthly, weekly or daily data (top panel, Chart 13). Meanwhile, the recent drubbing in relative share prices suggests that loan loss provisioning is not over. In fact, Q3 loan loss reserves will surpass the level hit in the GFC, and likely close in on the $300bn mark (provisions shown inverted, Chart 14). Chart 13Banks, The World Over, Are Value Destroyers Banks, The World Over, Are Value Destroyers Banks, The World Over, Are Value Destroyers Chart 14More Loan Losses Loom… More Loan Losses Loom… More Loan Losses Loom… Historically, loan loss provisions are the mirror image of bank net operating income and most importantly bank profits decline as provisioning increases (Chart 15). Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket (bottom panel, Chart 16). Chart 15…Which Will Weigh On Profits …Which Will Weigh On Profits …Which Will Weigh On Profits Chart 16Fiscal Policy Easing To The Rescue? Fiscal Policy Easing To The Rescue? Fiscal Policy Easing To The Rescue? Tack on the year-to-date more than halving in the 10-year US Treasury yield and the earnings outlook remains grim for banks (top & middle panels, Chart 17). The transmission mechanism is through net interest margins (NIMs). The fourth panel of Chart 17 highlights that the pair have been joined at the hip and all-time lows in the 10-year US Treasury yield have sank bank NIMs below 3%, which is another all-time low since the history of the FDIC data. Credit growth has crested and our loans and leases model suggests that loan growth will continue to decelerate into 2021 (second panel, Chart 17). Not only is there lack of appetite for new overall loan uptake, but bankers are stringent with extending credit to businesses and consumer alike, according to the most recent Fed Senior Loan Officer survey (Chart 18). Chart 17Credit Growth Blues Credit Growth Blues Credit Growth Blues Chart 18Lack Of Loan Demand And Tightening Credit Supply Lack Of Loan Demand And Tightening Credit Supply Lack Of Loan Demand And Tightening Credit Supply However, there are three significant offsets to all these stiff headwinds that prevent us from downgrading banks to an underweight stance. First, the 10-year US Treasury yield is one of the few assets that has yet to discount any economic recovery. Thus, as uncertainty lifts post the November election, the economy continues to open up and Congress and the new President manage to pass a fresh fiscal stimulus bill, all this could catalyze a catch up phase in the long bond yield. Second, valuations offer a deep enough discount to absorb a little bit of more negative news as analysts and investors alike have thrown in the towel in banks (bottom panel, Chart 19). Finally, the credible Fed’s stress test loom by year-end and assuming banks pass them with flying colors a resumption of shareholder friendly activities will boost the allure of owing banks and unwind extremely oversold conditions (middle panel, Chart 19). In sum, while the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index. Chart 19Unloved And Under-owned Unloved And Under-owned Unloved And Under-owned Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Buybacks Will Be Back Buybacks Will Be Back Most recent Standard and Poor’s data show that SPX buybacks collapsed to $88bn in Q2, from roughly $200bn in Q1, which is a whopping 67% quarter-over-quarter fall. Such a corporate buyer’s strike is negative for the near-term prospects of the S&P 500, but we expect buybacks to come back as the V-shaped economic recovery all but guarantees a rebound sometime in 2021 (top panel). Importantly, CEO confidence has also slingshot higher and coupled with the overall economic recovery, will pave the way for a resumption of shareholder friendly activities (middle panel). Bottom Line: Artificial EPS boosting via equity retirement will come back in 2021, especially in light of the ZIRP that is here to stay for the next five-seven years. For more details, please refer to this Monday’s Weekly Report.

Underweight Avoid REITs Avoid REITs We remain bearish on the prospects of the S&P real estate sector as the pandemic will continue to severely bruise REITs. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25%. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel). A fresh stimulus bill could come to the rescue, but recent news of President Trump halting negotiations jeopardizes chances for near-term relief. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels). Bottom Line: We remain underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO. For more details, please refer to this Monday’s Weekly Report.