Sectors

Neutral - Downgrade Alert Small Bank Trouble Brewing Small Bank Trouble Brewing Absent another fiscal package, banks risk digesting a new wave of credit defaults, further increasing their loan loss provisions as pandemic wounds remain open. Importantly, according to the latest Fed data, small banks1 are at the forefront of sloppy lending activity, warning that those weaker banks have higher exposure to defaults than large banks.2 Small bank C&I loan growth reached a whopping 50% per annum growth rate (second panel). Commercial real estate (CRE) loans are also expanding at a higher rate in small banks compared with large banks (third panel). With regard to concentration, small banks have been making inroads in feverishly doling out loans versus large banks. The former now comprise 40% of total C&I loan books (the largest credit category, bottom panel) and 2/3 of CRE loans – the second largest loan category with $2.4tn outstanding. Inevitably, some loans will sour because of the pandemic and the longer it takes Congress to pass a fresh stimulus bill the higher the pain for banks. One way out of this mess will likely be via much needed industry consolidation. As a reminder the US still has 4,400 banks. Bottom Line: We remain neutral the S&P banks index, which is also on our downgrade watchlist since early September. 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.    Footnotes 1 Small banks are defined as all commercial banks excluding top 25 banks ranked by domestic assets. 2 Large banks are defined as top 25 commercial banks ranked by domestic assets.

Dear Client, Next week I will present our outlook on China’s economic recovery, the direction of economic policy and financial markets for the rest of the year and beyond in two live webcasts. The webcasts will take place next Wednesday, October 14 at 10:00AM EDT (English) and Friday, October 16 at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). Best regards, Jing Sima, China Strategist   Feature We have changed the format of our monthly China Macro And Market Review to deliver our messages more concisely and effectively. This week’s report consists of charts that are the most market relevant. Many charts are either self-explanatory or convey a message with brief comments. These charts present macro fundamentals as well as price signals and valuation profiles of China’s financial markets. Our key observations and investment conclusions are as follows: Recent economic data points to a broadening economic recovery in China. The demand side continues to accelerate, and its pace has outstripped production for three consecutive months. Both external and domestic demand measures jumped to above the 50 boom-bust threshold in September’s manufacturing PMI. Service PMI saw the largest monthly uptick since 2013. Credit expansion remained robust through August. Medium- and long-term bank loans to corporates have partially offset the dwindling short-term loans since May, suggesting that near-term liquidity constraints among corporates may be easing. Moreover, an improving bank loan structure will help to boost corporates’ Capex investments. As noted in last month’s China Macro and Market Review,1 the consistent outperformance in production recovery relative to demand in H1 this year has led to an inventory buildup. The ongoing inventory destocking has impeded China’s imports of major commodities and led to a weakening of commodity prices in the past two weeks. The continued destocking of commodities suggests that China’s demand for commodities will remain soft into Q4. Beyond Q4, however, the acceleration in both domestic and external demand should provide solid support to the ongoing economic recovery. Local governments still hold a substantial amount of unspent proceeds from special-purpose bonds issued earlier this year; the funds must be invested in infrastructure projects. We expect China’s imports of industrial raw materials to bounce back in Q1 2021 once the current inventory destocking runs its course. We remain overweight Chinese domestic and investable stocks in a global portfolio in the coming six to nine months. Even though Chinese share prices have run ahead of the country’s business cycle and have priced in an earnings recovery, they are still less overbought than their global peers. China’s economic recovery remains solid compared with other economies, thanks to its successful containment of the domestic COVID-19 outbreak. In absolute terms, we think Chinese stocks still have ample upside potential, as both monetary and fiscal stances remain historically accommodative and the economic recovery is accelerating. Recent setbacks in onshore and offshore stocks were due to the ripple effects from global equity selloffs. Escalating Sino-US frictions have had a very limited effect on China’s overall market because US sanctions are mostly targeted at individual technology companies. There is an elevated risk of a near-term correction in global equity prices, particularly in the next four weeks leading up to November’s US presidential election. In our view, these corrections will provide good buying opportunities. Both Chinese government bonds and onshore corporate bonds remain attractive in a global fixed-income portfolio, based on their higher yields and better risk-reward profile relative to their global peers. Within China’s onshore bond portfolio, returns on corporate bonds have consistently outperformed their duration-matched government bonds. We continue to recommend onshore corporate bond positions in the next 6-12 months.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Chart 1A Widening Economic Recovery A Widening Economic Recovery A Widening Economic Recovery Chart 2Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021 Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021 Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021   Chart 3ALocal Governments Still Have Plenty Of Unspent Fiscal Firepower Local Governments Still Have Plenty Of Unspent Fiscal Firepower Local Governments Still Have Plenty Of Unspent Fiscal Firepower The divergence between total social financing and M2 growth during the past two months was mainly due to the lack of synchronization between government bond issuances and fiscal spending. Bond issuances are included in social financing and have pushed up fiscal deposits. Fiscal deposits do not derive M2 until they are eventually transferred into fiscal spending. Therefore, we expect that M2 growth will catch up in a few months. Most of the proceeds from government bond issuance have not been dispensed. Local governments have more than enough firepower to continue to support infrastructure spending in the next two quarters. Chart 3BChina's Bank Loan Structure Is Improving China's Bank Loan Structure Is Improving China's Bank Loan Structure Is Improving Chart 3CLoan Demand And Loan Approvals Have Revitalized Loan Demand And Loan Approvals Have Revitalized Loan Demand And Loan Approvals Have Revitalized Chart 4AChina's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... China's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... China's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... Chart 4B...And Will Benefit From A World-wide Economic Recovery ...And Will Benefit From A World-wide Economic Recovery ...And Will Benefit From A World-wide Economic Recovery Chart 5Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Chart 6A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector   Chart 7AMounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Mounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Mounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Chart 7B...But Near-Term Real Estate Construction Should Still Hold Up ...But Near-Term Real Estate Construction Should Still Hold Up ...But Near-Term Real Estate Construction Should Still Hold Up As noted in last month’s China Macro And Market Review,2 recently tightened financing regulations on real estate development3 are not game changers. Historically, the government’s financial rules and land sales have not had a strong positive correlation with real estate investment growth. So far, Chinese authorities have kept property policies flexible, allowing most local governments to have their own housing policies. We expect property restrictions will tighten on tier-one and tier-two cities that are facing upward pressure on housing prices. Housing demand in smaller cities, however, remains soft and may see increased policy support next year.  Chinese policymakers will continue to keep an eye on real estate speculation. In the near term, however, real estate developers need to complete their existing projects, which will support construction activities into H1 next year.   Chart 8AHousehold Consumption Continues To Recover Household Consumption Continues To Recover Household Consumption Continues To Recover Chart 8BRising Employment Should Further Lift Consumption Rising Employment Should Further Lift Consumption Rising Employment Should Further Lift Consumption   Chart 9AChina's Offshore And Onshore Forward Earnings Have Ticked Up China's Offshore And Onshore Forward Earnings Have Ticked Up China's Offshore And Onshore Forward Earnings Have Ticked Up Chart 9BValuations In A Shares Are Not Too Extreme Valuations In A Shares Are Not Too Extreme Valuations In A Shares Are Not Too Extreme   Chart 9CChinese Stocks Are Not Expensive Compared With Global Benchmarks Chinese Stocks Are Not Expensive Compared With Global Benchmarks Chinese Stocks Are Not Expensive Compared With Global Benchmarks Chart 10AChina's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China offshore cyclical stock prices have been driven by hefty valuations since 2016, mostly because investable cyclicals are heavily weighted in high-flying tech stocks. Chinese tech stock prices will likely be extremely volatile in the next one to three months. We expect a tougher stance on China from the US in the next four weeks leading up to the presidential election. Furthermore, even if Trump does not get reelected, the “lame duck” President may still impose sanctions on China before he leaves the White House in January 2021. We are staying the course with our constructive cyclical view on Chinese stocks, even though the market will be more volatile during the next few months. Chinese tech company stocks have been shaken by negative surprises relating to frictions with the US.  However, investors also cheer on even the slightest easing of tensions between the two countries.4 We expect this risk-on and -off sentiment to intensify through Q4. Onshore cyclical stocks have consistently underperformed defensives, driven by a downtrend in relative earnings per share. However, improvements in economic fundamentals of late suggest that the uptick in domestic cyclicals may be strengthening. We remain long on onshore and offshore consumer discretionary and materials relative to their respective broad market indexes. The investment calls are in place until policy dividends on those sectors subside, which we expect in mid-2021. Chart 10BChina's Equity Sectors In Perspective China's Equity Sectors In Perspective China's Equity Sectors In Perspective Chart 10CChina's Equity Sectors In Perspective China's Equity Sectors In Perspective China's Equity Sectors In Perspective Chart 11AA Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors A Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors A Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors Chart 11BChinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment Chinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment Chinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment 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   Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated September 9, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated September 9, 2020, available at cis.bcaresearch.com 3China's widely circulated but unofficial "three red lines" policy sets limits on bank borrowings: a 70% ceiling on a developer’s debt-to-asset ratio after excluding advance receipts; a 100% cap on the net debt-to-equity ratio; and a requirement that short-term borrowing does not exceed cash reserves, according to S&P Global Ratings. 4Please see China Investment Strategy Weekly Report "Sticking With Chinese “Old Economy” Stocks In A Widening Tech War," dated August 12, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Reminiscences Of 2016? Reminiscences Of 2016? We have shown in recent research 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. 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 contracted profits and more importantly revenues. The chart 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. Bottom Line: We are in the tail end of the equity market correction and as election and fiscal policy uncertainties recede they will pave the way for a robust SPX rally. ​​​​​​​

Highlights Portfolio Strategy Buybacks are down but not out. While financials have been weighing heavily on the S&P buybacks index, we would not write off the artificial engineering of higher EPS via equity retirement, especially in a world of ZIRP likely for the next five-to-seven years. COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Recent Changes There are no changes to our portfolio this week. Table 1 Of Buybacks And Bonds Of Buybacks And Bonds Feature Equities sunk late last week, as diminishing chances of fiscal easing coupled with news that the POTUS and the First Lady tested positive for COVID-19 more than offset buyers taking advantage of oversold conditions. Our sense is that the SPX will bounce around key moving averages during October (Chart 1), until the election outcome breaks the stalemate. In the back half of the month, banks also kick-start Q3 earnings season, which is important because banks’ wellbeing rests on a fresh stimulus bill. Peering over at the bond market is instructive in order to try to make sense of these crosscurrents. Two weeks ago, we first highlighted that the corporate bond market was waving a yellow flag. The selloff in the LQD ETF will continue to weigh on equities (top panel, Chart 2) and corroborates our view that the Fed is now a bystander, which puts added pressure on fiscal authorities to act. It is not a coincidence that the Fed’s balance sheet impulse peaked first and soon thereafter so did the LQD. Chart 1Trapped Between Moving Averages Trapped Between Moving Averages Trapped Between Moving Averages Worrisomely, the total return stock-to-bond ratio failed to break out to fresh all-time highs and has likely formed a head and shoulders pattern. The implication is that stocks are not out of the woods yet (bottom panel, Chart 2). Chart 2Bond Market… Bond Market… Bond Market… Junk spreads are also firing a warning shot. The high-yield option-adjusted spread (OAS) was in a tight range between 2017 and 2019. Then spreads exploded higher because of the pandemic. However, unlike the SPX making new all-time highs, junk spreads failed to make new all-time lows and more importantly have not settled back down to the 2017-2019 range (middle panel, Chart 3). The VIX index is following a similar pattern to the high-yield OAS, which is quite unnerving for equity bulls. Put differently, still elevated VIX futures in the 30s warn that in the near-term more turbulence lies ahead for the SPX (bottom panel, Chart 3). As a reminder, we first recommended buying the December VIX futures on July 27 in a joined Special Report with our sister Geopolitical Strategy service, and we continue to recommend such a hedge to long equity exposure. Chart 3…And VIX Signal Trouble For Stocks …And VIX Signal Trouble For Stocks …And VIX Signal Trouble For Stocks Bye-Bye Buybacks? According to the flow of funds data, a large dichotomy has taken shape between corporate debt issuance and net equity retirement. Up to very recently, the two moved in tandem. But now, the pandemic has caused a knee jerk reaction in non-financial corporate businesses that are tapping their credit lines and issuing debt at a breakneck pace. Worryingly, very little of these funds are used for equity retirement, which is a big break from recent past behavior (Chart 4). Not only does the Fed’s flow of funds data signal that buybacks have nearly ground to a halt, but also Standard and Poor’s data show that SPX buybacks collapsed to $88bn in Q2, from roughly $200bn in Q1. Crudely put, SPX buybacks have fallen by a whopping 67% quarter-over-quarter. Such a corporate buyer’s strike is negative for the near-term prospects of the S&P 500 (top panel, Chart 5). Chart 4Unsustainable Dichotomy Unsustainable Dichotomy Unsustainable Dichotomy Chart 5Buybacks Are Down… Buybacks Are Down… Buybacks Are Down… True, buybacks have come under intense scrutiny especially for bailed out sectors of the economy, nevertheless, the V-shaped economic recovery all but guarantees a rebound in depressed share buybacks sometime in 2021 (Chart 6). While our conservative $125/quarter buyback estimate proved overly optimistic in Q2, we maintain such an estimate for the next year (which it is the past decade’s average). On a cyclical 9-12 month horizon we have high conviction that SPX profits will return close to trend EPS of $162, and recovering CEO confidence should pave the way for a resumption of shareholder friendly activities, including equity retirement (middle panel, Chart 6). Drilling deeper beneath the surface is revealing. When we disaggregate the headline buybacks number into GICS1 sectors, we observe that once again the tech titans (comprising the S&P technology and the S&P communication services indexes) are doing all the heavy lifting accounting for 70% of the overall number (Chart 7). Q2 was the first time in recent memory where tech accounts for more buybacks that all the other sectors put together (bottom panel, Chart 5)! Chart 6But Not Out But Not Out But Not Out Chart 7GICS1 Sector Buyback Breakdown: Q1 & Q2 Of Buybacks And Bonds Of Buybacks And Bonds Chart 8 shows the ebbs and flows of sectoral SPX buybacks since late-2006. In order for our estimate to prove accurate in 2021, the Fed will have to allow financials to resume their buybacks, which collapsed from over $45bn in Q1 to just above $5bn in Q2 (Chart 7). Chart 8GICS1 Sector Buyback Breakdown: An Historical Perspective Of Buybacks And Bonds Of Buybacks And Bonds With regard to investable buyback indexes, financials dominate both the S&P 500 buyback index (Chart 9) and the NASDAQ US buyback achievers index. However, if the Fed does not relent and sustains a tight noose around banks’ shareholder friendly activities next year, then this index composition will change significantly in the 2021 rebalancing. While financials have been weighing heavily on the S&P 500 buyback index, its equal weighting methodology also partially explains why it has trailed the market cap weighted SPX by roughly 20% year-to-date (YTD). Nevertheless, in the long-haul buyback achievers come out on top. In fact, the S&P 500 buyback index has more than doubled the SPX’s return since the turn of the century (top panel, Chart 10) and such a portfolio tilt typically manages to shake off recession-related wobbles. Chart 9S&P 500 Buyback Index Sector Composition Of Buybacks And Bonds Of Buybacks And Bonds Bottom Line: We would not write off the artificial engineering of higher EPS via equity retirement, especially in a world where ZIRP is likely for the next five-to-seven years. Already buyback announcements have troughed (bottom panel, Chart 10) and factors are falling into place for a sizable resumption of buybacks in 2021 as the economy stands back on its own feet. Chart 10Buyback Comeback? Buyback Comeback? Buyback Comeback? Is CRE The Next Shoe To Drop? Last December in our 2020 Key Views report, the S&P real estate sector was one of our high-conviction underweight sectors for the year. However, frenetic trading in March compelled us to close out all our high-conviction trades and cement average relative gains of 3.4% in our eight high-conviction calls including 1.1% in the high-yielding S&P real estate sector. Nevertheless, we remained bearish on the prospects of this sector levered to commercial real estate (CRE) because the aftermath of the pandemic would leave this niche sector badly bruised. 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% (Chart 11). In other words, the resilience of these mega cap tech-related REITs masks the carnage ongoing beneath the surface. Chart 11Specialized REITs Masking True Picture Specialized REITs Masking True Picture Specialized REITs Masking True Picture Charts 12 & 13 break down the YTD relative performance of the real estate sector’s sub-groups and it is clear that most REITs categories are in distress with the exception of specialized and industrial REITs. Chart 12REITs Are Weak… REITs Are Weak… REITs Are Weak… Chart 13…Across The Board …Across The Board …Across The Board Not only will the long-term negative ramifications due to the pandemic scar office-, apartment- and mall-exposed REITs, but also uncertainty surrounding the fiscal stimulus bill risks a fresh down-leg in the S&P real estate sector. 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, Chart 14). A fresh stimulus bill could transfer funds directly to unemployed consumers and to cash-strapped business owners and extend the eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent this help, CRE will remain distressed. 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, Chart 14). Recent news that “Cerberus repackaged near junk rated CMBS paper into a AAA rated CDO” (effectively creating a AAA security out of thin air) is eerily reminiscent of the subprime crisis in 2008 and a stark warning that CRE excesses have yet to fully flush out.1 Chart 14More Pain Looms More Pain Looms More Pain Looms Chart 15Deflation Warning Deflation Warning Deflation Warning The downdraft in demand for CRE is already showing up in declining occupancy rates (Chart 15). We fear that there are more skeletons hiding in the closet. First the “amazonification” of the economy is still wreaking havoc on retail/shopping center REITs. Second the new “work from home” reality is putting strains on office landlords. Lastly, lodging will remain in distress at least until a vaccine is readily available. As a result, REITs cash flow growth will remain elusive, which will further dampen prospects of a recovery in the relative share price ratio (Chart 15). Finally, the relentless increase in supply is not showing any signs of abating. Non-residential construction is hovering near previous highs, and multi-family housing starts are perched close to prior cyclical peaks of 400K/annum (Chart 16). Undoubtedly, this excess supply backdrop will continue to weigh on CRE prices. Chart 16Mind The Supply Overhang Mind The Supply Overhang Mind The Supply Overhang Chart 17Valuations Have Yet To Fully Flush Out Valuations Have Yet To Fully Flush Out Valuations Have Yet To Fully Flush Out Despite all this dour news and near all-time lows in relative performance, valuations have only corrected down to the neutral zone, leaving ample room for an undershoot phase (middle panel, Chart 17). Encouragingly, persistent recent selling has pushed our relative Technical Indicator deep in oversold territory signaling that a near-term reflex rebound may be forthcoming. Netting it all out, COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Bottom Line: Stay 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.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://www.bloomberg.com/news/articles/2020-10-01/cerberus-is-repackaging-near-junk-cmbs-into-top-rated-securities   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

Rotation Rotation Rotation Rotation Rotation Rotation Rotation out of the tech titans is a high probability scenario given that the easy money has already been made as AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization near the peak on September 2. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out. Using a concrete rebalancing example to illustrate such a rotation is instructive.1 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift. Bottom Line: As the economy opens up, it pays to rotate out of fully priced tech titans and into the beaten down deep cyclicals.    Footnotes 1 Our example assumes benchmark allocation in all sectors for illustrative purposes.

Fiscal stimulus has been dominating the news flow of late. This is not surprising as COVID-19 affected consumers and businesses alike are running on empty. The Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry. What is surprising, is haggling for roughly one trillion of stimulus dollars that separates Democrats from Republicans. If Congress fails to pass a new fiscal package by October 16 the latest, now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse, and stocks another drawdown. Bottom Line: We continue recommend investors remain patient and not deploy fresh capital just yet. For more details, please refer to this Monday’s Weekly Report. Show Me The Money Show Me The Money

Overweight We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Over in the currency market, the recent debasing of the US dollar should underpin industrials stocks via the export relief valve (third panel). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel). Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector. For more details, please refer to this Monday’s Weekly Report. Chart 1 Industrials - Powering Ahead Industrials - Powering Ahead   ​​​​​​​

In this Monday’s Weekly Report we reiterated our overweight stance in the S&P machinery index owing to a healthy macro backdrop. Starting from overseas, China is providing a large enough stimulus, which is on a par with the early-2016 numbers. On the currency front, the US dollar has entered a bear market, and we expect it to resume once the recent election uncertainty retracement phase fully plays out. The weakening US dollar is a material tailwind for machinery stocks as they derive a significant portion of their revenues from abroad. Domestically, manufacturing surveys are in a V-shaped recovery across the board which will further underpin the machinery stock rally. All of these dynamics are well filtered through our macro sales and earnings models that emit a positive signal (see chart). Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Buy The Machinery Breakout Buy The Machinery Breakout    

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

We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Figure 1The Fiscal Policy Loop Dark (Fiscal) Clouds Gathering Dark (Fiscal) Clouds Gathering The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated on Monday. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. Bottom Line: The odds of a fiscal policy mistake are rising quickly and risk an equity market riot point. We remain cautious on the short-term prospects of the equity market and recommend investors keep their powder dry as a better entry point will likely materialize in the coming months. Footnotes 1  The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth.