Valuations

Highlights New recommendation: Go neutral growth versus value on a 6-12-month horizon… …and exploit the greater opportunities within the growth universe and within the value universe. Within the growth universe, overweight healthcare versus technology. New recommendation: Within the value universe, overweight utilities versus banks. Downgrade tech-heavy Netherlands from overweight to neutral. Upgrade utilities-heavy Portugal from neutral to overweight. Fractal trade: Overweight Portugal versus Italy. Feature Chart of the WeekBank Profits In Structural Decline Bank Profits In Structural Decline Bank Profits In Structural Decline Last week, Fed Chair, Jay Powell explained: “We’re not going back to the same economy. We’re going back to a different economy.” What will the different economy look like? We will only really know when the pandemic ends and short-term palliatives like government-funded job furlough schemes and rent and debt payment moratoriums are removed. Only then will we get the true price discovery to know which activities, jobs, and debts are viable and which are not. At the very least, the now widespread acceptance of remote working, remote shopping, and remote business meetings means that city centres, bricks and mortar retailers, and business aviation will become pale shadows of their former selves. This is worrying because the retail sector, on its own, employs 10 percent of all workers. Furthermore, economic shocks give impetus to structural changes that were already underway. Case in point, the UK government has just announced a ban on petrol and diesel cars from 2030. The lockdowns gave the British people the taste of clean air, and the British people liked it, so the government accelerated its initiative to abolish fossil fuels. To paraphrase Ernest Hemingway, there are two ways that sectors go bankrupt: gradually, then suddenly. A Textbook Market Slump… But Will We Get A Textbook Recovery? During an economic slump and the subsequent recovery, three fundamental drivers shape the evolution of stock prices. The first two drivers are well understood by any student of Financial Markets 101, but the third driver is not so well understood. More on that later. The first well understood driver of stock prices is the outlook for near-term profits. During a slump, the profits of ‘defensive’ sectors that are insensitive to fluctuations in the economy, outperform those of ‘cyclical’ sectors that are sensitive to the economy. For example, during this year’s slump, the profits of defensive healthcare remained remarkably resilient, whereas the profits of cyclical banks collapsed by 30 percent (Chart I-2). During the recovery, this should reverse, says the textbook. Cyclical profits should outperform defensive profits. Chart I-2Defensive Profits Outperformed In The Slump, But What About The Recovery? Defensive Profits Outperformed In The Slump, But What About The Recovery? Defensive Profits Outperformed In The Slump, But What About The Recovery? The second well understood driver of stock prices is the discount rate applied to long-term profits. The present value of long-term profits is highly sensitive to the (inverted) bond yield. As discussed last week, this sensitivity becomes hyper-sensitivity at ultra-low bond yields. When the bond yield collapses to an ultra-low level, the present value of long-term profits surges. This favours ‘growth’ sectors like technology, whose profits are weighted to the distant future, versus ‘value’ sectors like utilities, whose profits are weighted closer to the here and now. ‘Cyclical value’ stocks should outperform when the economy recovers, but markets do not always follow the textbook. During this year’s slump, the near-term profits of technology and utilities performed similarly (Chart I-3). But when the bond yield collapsed and boosted the value of long-term profits, the multiple paid for near-term profits surged by 20 percent for technology, while remaining unmoved for utilities (Chart I-4). When the bond yield rises, this relative move should reverse, says the textbook. Value sector multiples should outperform growth sector multiples. Chart I-3Tech And Utilities Profits Performed Similarly... Tech And Utilities Profits Performed Similarly... Tech And Utilities Profits Performed Similarly... Chart I-4But 'Growth' Tech Got A Bigger Valuation Boost Than 'Value' Utilities But 'Growth' Tech Got A Bigger Valuation Boost Than 'Value' Utilities But 'Growth' Tech Got A Bigger Valuation Boost Than 'Value' Utilities So far, so good. The student of Financial Markets 101 will tell you that ‘defensive growth’ stocks outperform when the economy slumps, and bond yields collapse. Whereas ‘cyclical value’ stocks should outperform when the economy recovers, and bond yields rise. Yet as we all know, the real world is not that simple. Financial markets do not always follow the textbook. Major Economic Shocks Can Destroy Industries One real-world complication to the textbook recovery is that the bond yield might not be able to rise meaningfully before causing a relapse in the economy. This could be because of a high structural level of debt, a high structural level of unemployment, or a high structural level of risk-asset valuations. Any one of these three structural fragilities would make the economy incapable of tolerating a higher bond yield. Yet today the worry is not one fragility, it is all three of the above! Still, even if the bond yield cannot rise meaningfully, it might not fall much either, making the choice between value and growth unclear. The other real-world complication to the textbook is that major economic shocks cause structural breaks from the past. The point that Jay Powell made last week, and which forms the title of this report. Major economic shocks cause structural breaks from the past. This brings us to the third – less well-understood – driver of stock prices during and after a slump: the structural change in the sector’s long-term profit outlook. For some sectors, the long-term profit outlook phase-shifts down. Meaning that even if the bond yield does not keep falling, value sectors could continue to underperform as the collapse in their long-term profits gets recognised. For example, after oil and gas profits reached an all-time high in 2008, each slump has been followed by a progressively lower subsequent peak (Chart I-5). European banks look even worse. In the recovery following each slump since 2008, profits have regained only a third of the preceding slump’s losses. This implies that after each slump, the long-term profit outlook for the banks is phase-shifting down (Chart of the Week). Chart I-5Oil And Gas Profits In Structural Decline Oil And Gas Profits In Structural Decline Oil And Gas Profits In Structural Decline Hence, European banks have failed to generate sustained outperformance in any recovery, even though the textbook says that as ‘cyclical value’ stocks, they should. Only a brave person would bet that it will be any different this time (Chart I-6). Chart I-6European Banks Have Failed To Generate Sustained Outperformance In Any Recovery European Banks Have Failed To Generate Sustained Outperformance In Any Recovery European Banks Have Failed To Generate Sustained Outperformance In Any Recovery The Big Opportunities Are Within The Growth And Value Universes After a major economic shock, a structural change in a sector’s long-term profit outlook renders any backward-looking valuation framework obsolete. In such cases we cannot use mean-reversion to inform our investment strategy, because the past will be a poor guide to the future. As European banks have taught us for fifteen years, it is extremely dangerous to follow the textbook recovery play of value versus growth on any sustained basis. It is extremely dangerous to follow the textbook recovery play of value versus growth on any sustained basis. Right now, there is a much smarter investment strategy. Go neutral growth versus value, and exploit the bigger opportunities within the growth universe and within the value universe where mean-reversion strategies are more justified. Specifically, within the growth universe, the valuation premium on technology versus healthcare is at its highest level since 2009 (Chart I-7). Even more extreme, the US technology versus US healthcare valuation premium is approaching the peak of the dot com bubble (Chart I-8). Hence, we reiterate last week’s recommendation. Chart I-7The Valuation Premium On Tech Versus Healthcare Is High... The Valuation Premium On Tech Versus Healthcare Is High... The Valuation Premium On Tech Versus Healthcare Is High... Chart I-8...And In The US, Approaching The Dot Com Bubble Peak ...And In The US, Approaching The Dot Com Bubble Peak ...And In The US, Approaching The Dot Com Bubble Peak Go overweight healthcare versus technology. The regional and country allocation implications are to go overweight healthcare-heavy Europe versus technology-heavy Emerging Markets. And within Europe, to go overweight healthcare-heavy Denmark and Switzerland versus technology-heavy Netherlands. The upshot is that today we are downgrading Netherlands from overweight to neutral. Turning to the value universe, the performance of cyclical banks versus defensive utilities just tracks the bond yield (Chart I-9). This means that the recent snapback rally in banks versus utilities needs higher bond yields for support. Absent a sustained rise in bond yields, the rally is fragile and vulnerable to reversal. Chart I-9Banks Vs. Utilities = The Bond Yield Banks Vs. Utilities = The Bond Yield Banks Vs. Utilities = The Bond Yield Yet as we explained last week, the 10-year T-bond yield can rise by only 30 basis points or so before undermining the broad stock market. On this basis, we are making a new recommendation. Go overweight utilities versus banks. Within Europe, the implication is to go overweight utility-heavy Portugal versus bank-heavy Spain and Italy (Chart I-10). Chart I-10Portugal Vs. Italy = Utilities Vs. Banks Portugal Vs. Italy = Utilities Vs. Banks Portugal Vs. Italy = Utilities Vs. Banks The upshot is that today we are upgrading Portugal from neutral to overweight. Fractal Trading System* Fractal analysis confirms that Portugal’s underperformance is approaching a potential reversal point if bond yields do not rise meaningfully. Accordingly, this week’s recommended trade is overweight Portugal versus Italy. Set the profit target and symmetrical stop-loss at 6.6 percent. In other trades, long coffee versus corn achieved its 12 percent profit target. The rolling 12-month win ratio now stands at 53 percent. Chart I-11MSCI: Portugal Vs. Italy MSCI: Portugal Vs. Italy MSCI: Portugal Vs. Italy   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  

Highlights The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Sell stocks and wait on the side lines if the 10-year T-bond yield rises by 0.3 percent. Go aggressively overweight T-bonds on any modest rise in yields. New recommendation: Go overweight healthcare versus technology on a 6-12-month investment horizon. New recommendation: Go overweight Europe versus Emerging Markets on a 6-12-month investment horizon. Fractal trade: Fractal analysis supports the decision to go overweight healthcare versus technology. Feature Since early 2018, a rise in the long bond yield has sent shudders through the stock market on four occasions: February 2018, October 2018, April 2019, and January 2020. On all four occasions, the tipping point was the earnings yield premium on tech stocks versus the 10-year T-bond yield falling towards its lower limit of 2.5 percent (Chart of the Week). Chart of the WeekSell Stocks If The Bond Yield Rises By 0.3 Percent Sell Stocks If The Bond Yield Rises By 0.3 Percent Sell Stocks If The Bond Yield Rises By 0.3 Percent Today, this all-important yield premium stands at 2.8 percent. Meaning that it would take the 10-year T-bond yield to rise by just 30 basis points to retest this four times tipping point. Alternatively, with the T-bond yield unchanged, the tipping point would be retested if tech stocks rallied by around 10 percent. The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Crucially, this means that the stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. We recommend selling stocks and waiting on the side lines if the earnings yield gap on tech stocks versus the T-bond yield approaches its lower limit of 2.5 percent – from any combination of moderately higher bond yields or higher stock prices over the coming weeks. Record Low Bond Yields Have Lifted The Stock Market To An All-Time High   ‘A once-in-a-century global pandemic lifts the world stock market to an all-time high’ sounds like an obscene headline. Yet this is the correct narrative for 2020. Yes, the European stock market is still languishing 10 percent below its mid-February peak. But the much larger and tech-heavy US stock market stands 10 percent higher, taking the world market to around 5 percent higher (Chart I-2). How can the aggregate market stand at an all-time high when a terrible plague continues to ravage the global economy? The simple answer: because of record low bond yields. Chart I-2Record Low Bond Yields Have Lifted The Stock Market To An All-Time High Record Low Bond Yields Have Lifted The Stock Market To An All-Time High Record Low Bond Yields Have Lifted The Stock Market To An All-Time High Back on February 27, we wrote: “for stock markets, the best inoculation against Covid-19 is ultra-low bond yields.” And so it proved. Though stock market profits are down by 15 percent this year, the multiple paid for those profits is up by 20 percent, resulting in a 5 percent uplift in the market price (Chart I-3). Chart I-3Valuations, Not Profits, Are Driving The Stock Market Valuations, Not Profits, Are Driving The Stock Market Valuations, Not Profits, Are Driving The Stock Market Specifically, tech sector valuations have become hyper-sensitive to any change in the long bond yield (Chart I-4). Meaning that for those stock markets with a high weighting to tech stocks, the valuation boost from a decline in bond yields has more than countered the profit slump from the pandemic. In fact, the pivotal role of bond yields precedes the pandemic. For the past three years, a good motto for investors has been: don’t focus on profits, focus on valuations. Chart I-4Valuations, Not Profits, Are Driving The Tech Sector Valuations, Not Profits, Are Driving The Tech Sector Valuations, Not Profits, Are Driving The Tech Sector The Biggest Threat To The Stock Market Is Higher Bond Yields   Through 2018-19, stock market profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018 then surged in 2019. In 2020, as the pandemic devastated profits, a further surge in the multiple immunised the stock market against the ravages of Covid-19. The dramatic swing in multiples was driven by the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing long-duration bonds. But at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. When bond yields approach their lower limit, bond prices approach their upper limit. This means that the scope for further price rises diminishes while the scope for price collapses increases. For proof, just look at Swiss 10-year bonds. Their prices can barely rise anymore! Yet they can fall precipitously (Chart I-5). In short, the lower that bond yields go, the riskier that bonds become as an investment. Chart I-5Swiss Bond Prices Can Barely Rise, But They Can Fall A Lot Swiss Bond Prices Can Barely Rise, But They Can Fall A Lot Swiss Bond Prices Can Barely Rise, But They Can Fall A Lot As bonds become a riskier investment, the excess return on equities versus bonds, the equity risk premium (ERP), collapses towards zero. After all, if the riskiness of equities and bonds converges, then any risk premium must disappear. The result is that the prospective return (discount rate) required on equities declines exponentially, because both of its components – the bond yield plus the ERP – decline in tandem. Given that valuation is just the inverse of the discount rate, the valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Conversely, the valuation of equities falls exponentially when the bond yield rises from an ultra-low level. The valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Yet doesn’t a higher bond yield also imply a higher nominal growth rate for profits, which should be good for the stock market? Yes, but understand that the increase in the discount rate (nominal bond yield plus ERP) will be much larger than the increase in the profit growth rate. The result is a plunge in the stock market’s net present value. Once you grasp this exponential relationship, the penny suddenly drops. The pandemic has proved that the biggest structural threat to the stock market does not come from a negative growth shock like a once-in-a-century global plague. The pandemic has been good for the aggregate stock market because it has forced bond yields to decline to ultra-low levels. Instead, the biggest threat to the stock market is higher bond yields. Please note that this disagrees with the BCA house view – which does not preclude stocks from rising even if yields rise by 0.3 percent, if this takes place against the backdrop of better growth prospects. Sell Stocks If The Bond Yield Rises By 0.3 Percent As the first chart powerfully illustrates, higher bond yields sent shudders through the stock market on four occasions in the past three years. We are close to a similar near-term valuation test. Of course, given enough time, a gradual rise in earnings can lift the tech earnings yield gap versus the bond yield to well above its danger level of 2.5 percent. However, over shorter periods, it would require stock prices and/or bond yields to stop rising. Or indeed, to reverse. For equities, the upshot is that the 60 percent rally since mid-March is reaching near-term exhaustion. We recommend selling stocks and waiting on the side lines if the 10-year T-bond yield was to rise by another 30 bps. For bonds, the upshot is that all else being equal, 10-year bond yields can rise by no more than 30 basis points before sending shudders through the stock market. Which would then cause bond yields to give back their gains, as they did on each of the four previous occasions that higher bond yields spooked the stock market. On this basis, it is not worth underweighting bonds. The much smarter strategy is to go aggressively overweight T-bonds on any modest rise in yields. Within equity sectors, there are three arguments in favour of healthcare. First, while the tech sector earnings yield gap versus the T-bond yield is approaching its lower limit of 2.5 percent, the healthcare sector earnings yield gap stands at a very comfortable and attractive 4.1 percent, well above its recent lower limit of 2.0 percent (Chart I-6). Second, unlike tech, the healthcare sector rally is being driven by profits, not by a valuation uplift (Chart I-7). Third, fractal analysis confirms that the massive underperformance of healthcare versus technology is reaching technical exhaustion (see last section). Chart I-6Healthcare's Earnings Yield Premium Looks Very Attractive Healthcare's Earnings Yield Premium Looks Very Attractive Healthcare's Earnings Yield Premium Looks Very Attractive Chart I-7Profits, Not Valuation, Are Driving The Healthcare Sector Profits, Not Valuation, Are Driving The Healthcare Sector Profits, Not Valuation, Are Driving The Healthcare Sector Hence, today we are recommending that on a 6-12-month horizon, equity investors should go overweight healthcare versus technology.  Go Overweight Europe Versus Emerging Markets Finally, sector strategy has huge implications for regional and country allocation. Given that the European stock market is overweight healthcare and emerging markets (EM) is overweight technology, the decision to overweight Europe versus EM is simply the decision to overweight healthcare versus technology. Nothing more, and nothing less (Chart I-8). Chart I-8Europe Versus EM = Healthcare Versus Tech Europe Versus EM = Healthcare Versus Tech Europe Versus EM = Healthcare Versus Tech Hence, today we are also recommending that on a 6-12-month horizon, equity investors go overweight Europe versus emerging markets. Fractal Trading System* Supporting the fundamental arguments for healthcare versus tech in the main body of this report, the 130-day fractal structure of relative performance is extremely fragile. This implies that the massive underperformance of healthcare versus tech is at a potential inflection point. Accordingly, this week’s recommenced trade is to go long healthcare versus technology. Set the profit target and symmetrical stop-loss at 6 percent. In other trades, we are pleased to report that long financials versus basic resources achieved its 3.5 percent profit target, and short MSCI India versus MSCI Czech Republic achieved its 8 percent profit target. The rolling 1-year win ratio now stands at 54 percent. Chart I-9 World: Healthcare Vs. Technology World: Healthcare Vs. Technology 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    

Your feedback is important to us. Please take our client survey today. Feature Feature ChartHouse Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) House Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) House Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) Real estate is the world’s most important asset class. It accounts for 60 percent of the $500 trillion of mainstream global assets. To put this into context, the $300 trillion worth of global real estate makes the $7 trillion worth of all the gold ever mined look like chicken feed. It even dwarfs the $90 trillion global economy by more than three to one. In recent years, the valuation of global real estate has decoupled from underlying rents, and has become critically dependent on ultra-low bond yields. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of the world’s income, would make the pandemic’s economic shock feel like a waltz in the park. Hence, to anybody calling for significantly higher bond yields, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate? House Prices Have Decoupled From Rents The $300 trillion valuation of global real estate in 2020 is an 80 percent increase compared with 2010. Coincidentally, the value of the global stock market has also increased by 80 percent over the past decade. But the stock market’s $75 trillion capitalisation is small fry compared to the $300 trillion real estate market.1  Within the real estate market, residential real estate constitutes the lion’s share, accounting for around 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. The valuation of global real estate has become critically dependent on ultra-low bond yields. It follows that the most important component of the real estate market is the homes that people live in. The overwhelming majority of these homes are owner-occupied. Making house prices the indicator that drives, as well as reflects, the fortunes of ordinary people. The 2010s was remarkable as the first decade in which there was a synchronised boom in housing markets around the world. In the previous decade’s global financial crisis, house prices had crashed in several major economies: most notably, the UK and the US. Yet the UK and US housing markets did not suffer long hangovers. In the 2010s, the party restarted, and got even wilder (Chart I-2). Chart I-2The UK And US Housing Markets Resumed Their Parties In The 2010s The UK And US Housing Markets Resumed Their Parties In The 2010s The UK And US Housing Markets Resumed Their Parties In The 2010s Meanwhile, in Sweden, Canada, Australia, and China the global financial crisis barely interrupted their housing market parties, which continued seamlessly into the 2010s (Chart I-3). But perhaps most important of all, in the 2010s, the previous decade’s housing market wallflowers such as Germany and Japan started partying too (Chart I-4). What was behind this synchronised and broad boom in real estate values during the 2010s? The common denominator is the universal decline in bond yields. Chart I-3In Sweden, Canada, Australia, And China, The Parties Never Stopped In Sweden, Canada, Australia, And China, The Parties Never Stopped In Sweden, Canada, Australia, And China, The Parties Never Stopped Chart I-4Germany And Japan Started Their Parties In The 2010s Germany And Japan Started Their Parties In The 2010s Germany And Japan Started Their Parties In The 2010s As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields. Now that yields have little room to shift further downward, the scope for capital growth becomes more limited and dependent on rental growth happening first” Empirically, there is a tight long-term connection between house prices and underlying rents (Feature Chart). For example, through the past forty years, US house prices have closely tracked rents, with only two significant deviations. The first deviation happened during the housing bubble of the early 2000s. When that bubble burst in 2007, house prices promptly crashed back to their established relationship with rents. The second deviation is happening now. Since 2012, US house prices have outperformed rents by 25 percent (Chart I-5). In Europe, German house prices have outperformed rents by 20 percent (Chart I-6). The concern is that this house price outperformance versus rents is justified only if bond yields remain ultra-low and rental growth remains robust. Chart I-5House Prices Have Outperformed Rents By 25 Percent In The US... House Prices Have Outperformed Rents By 25 Percent In The US... House Prices Have Outperformed Rents By 25 Percent In The US... Chart I-6...And By 20 Percent In ##br##Germany ...And By 20 Percent In Germany ...And By 20 Percent In Germany   The Pandemic Is Depressing Housing Rents Unfortunately, the pandemic is putting pressure on housing rents. Rent inflation is driven by the security and growth of wages, which itself is inversely tied to the structural unemployment rate. When the number of permanently unemployed workers rises, rent inflation collapses. Indeed, in the aftermath of the global financial crisis, US rent inflation turned negative. Therefore, for the housing rent outlook, the key question is: what is the outlook for structural unemployment? (Chart I-7) Chart I-7Higher Structural Unemployment Depresses Rents Higher Structural Unemployment Depresses Rents Higher Structural Unemployment Depresses Rents The biggest driver of the structural unemployment rate will be the pandemic. Unlike China, large liberal democracies like the UK cannot control the pandemic with a universal track and trace system, because not enough of the UK population will allow the government to track their every move. Hence, until an effective vaccine has protected most of the population, liberal democracies like the UK must go down the route of physical distancing and the use of face masks.  When the number of permanently unemployed workers rises, rent inflation collapses. But as we explained in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs, physical distancing and facemasks restrict any economy activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three labour-intensive sectors – hospitality, retail, and transport – which employ 25 percent of all workers. Hence, if physical distancing and facemasks force these labour-intensive sectors to operate at one third below full capacity, the economy will lose 8.3 percent of jobs. On less optimistic assumptions the economy could lose 10 percent of jobs. Will a vaccine be a gamechanger? Not immediately. While it will mark progress, it will certainly not ‘take us back to normal’. This is because the proportion of the population that is immunised is unlikely to be high enough, fast enough. First, note that: Immunisation rate = Vaccination efficacy rate * Vaccination rate Second, note that no vaccine is 100 percent effective; and that a significant minority of diehards will refuse to get vaccinated. Perhaps understandably so if the vaccine has been rushed out. Even if we optimistically assume that the first vaccine is 70 percent effective, and that 70 percent of the population gets vaccinated, then the resulting 49 percent immunisation rate will still leave most people as sitting ducks for the virus. Under less optimistic – and arguably more realistic – assumptions, the number of unprotected people will be even larger. This means that social and physical distancing will continue for much longer than many people realise. Moreover, some of the reduction in ‘social consumption’ and its associated jobs will become permanent. The result is that the structural unemployment rate will continue to head higher, until the economy fully adapts to the post-pandemic way of living, working, and interacting. For the foreseeable future, this will put further pressure on housing rents, and keep the housing market crucially dependent on ultra-low bond yields. Concluding Remarks The main purpose of this Special Report is to highlight that the $90 trillion global economy is dwarfed by the $300 trillion global real estate market, whose valuation is critically dependent on ultra-low bond yields. If we add in equities, corporate bonds, and emerging market debt, the valuation of so-called ‘risk-assets’ rises to over $450 trillion. Yet many people still put the cart before the horse. They say the economy will drive the asset markets. This year has proved them wrong. A deflationary impulse from the economy unleashed an inflationary impulse in the much larger asset markets, which then helped to stabilise the economy. Unfortunately, the reverse would also be true. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets, which would then destabilise the economy. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets. Of course, any government with its own fiat currency can generate inflation if it really desires. Just look at Argentina or Turkey. But why would an advanced economy like the US, the UK, or the euro area make such a reckless journey, when it is already in the best place, the place it took a lot of blood and sweat to reach – namely, the place known as price stability? Still, if the advanced economies do take the road to inflation, they should realise that the road isn’t straight. The deflationary impulse that would come from the collapse in $450 trillion of risk-assets means that the road to inflation goes via deflation. For investors, this means that the road to much higher bond yields, if ever taken, reverses on itself. The road to much higher bond yields goes via the lower bound. Fractal Trading System* This week’s recommended trade is a soft commodities pair-trade. Go long coffee versus corn. The specific contracts are Brazilian coffee New York traded and Corn number 2 yellow central Illinois. The profit target and symmetrical stop-loss is set at 12 percent. Chart I-8Coffee Vs. Corn Coffee Vs. Corn Coffee Vs. Corn The rolling 1-year win ratio stands at 54 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 Footnotes 1 $300 trillion is our conservative uplift to the $281 trillion assessment that Savills made in 2018. The 2020 valuation constitutes a 40 percent increase versus its 2015 valuation. Before 2015, Savills did not provide an aggregated valuation for global real estate. However, as a good proxy, the firm tells us that the capital values in the top 12 world cities rose by 30 percent in the first half of the 2010s. Please see Savills: 8 things to know about global real estate value, July 2018; What price the world? 28 January 2016; and 12 Cities, H1 2015. 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  

Highlights Chart 1Spending Held Up In August Spending Held Up In August Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Weathering The Storm … For Now Weathering The Storm … For Now Table 3BCorporate Sector Risk Vs. Reward* Weathering The Storm … For Now Weathering The Storm … For Now High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Weathering The Storm … For Now Weathering The Storm … For Now Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 63 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 63 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Weathering The Storm … For Now Weathering The Storm … For Now Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights An uptick in COVID-19 infections and squabbling on Capitol Hill are making investors newly uneasy, … : A rising 7-day moving average of new virus infections and falling probability of new fiscal aid weighed heavily on equities last week. … turning their focus back to the economy and equities’ seeming disconnection from it, … : Multiple retail, hospitality and entertainment concerns are under extreme pressure but the overall economy has held up far better than most commentators acknowledge. Households’ massive pile of new savings will help support consumption and credit performance well into next year even if Congress fails to provide a new round of stimulus. … and causing them to re-assess their comfort with dot-com-era valuations: We may not like the S&P 500 at 23 times forward four-quarter earnings, but the current valuation climate is a given and we have to figure a practical way to navigate through it. We are not abandoning equities yet. Feature COVID-19 appears to be making a comeback, in the US and around the globe, and its revival has investors reconsidering the sustainability of the spectacularly potent rally. How much longer can we go without a vaccine? How long before the economy succumbs without a new round of fiscal aid? How long can equities diverge from the economy? How long can equity multiples stay so high? COVID-19 infections have made another leg up and the 7-day average of new US cases is up over 25% since the second-wave bottom on September 12th (Chart 1). Even with most colleges and universities limiting in-person attendance and on-campus residence, the siren song of alcohol, fellowship and potential romance has turned many college towns into pandemic hot spots. The nation’s elementary and secondary schools could become another source of infections as children, teachers and staff return to classrooms, and the approach of cooler weather across most of the country brings no small measure of trepidation. The disease seems not to spread nearly as easily outside, but case counts threaten to pick up as activity moves indoors in fall and winter. Chart 1Daily New US COVID-19 Infections Sustainability Sustainability A much-slowed mortality rate mitigates the gravity of the rise in infections. Improved treatment protocols and heightened efforts to keep the most vulnerable out of harm’s way have pushed fatalities well below their April peak and considerably shy of their late July-early August levels, when new cases peaked (Chart 2). Indeed, one benefit of outbreaks on university campuses is that young adults are apparently much less likely to succumb to the virus. Unfortunately, the likelihood that invincible 18-to-22-year-olds won’t suffer too terribly if they contract COVID-19 may encourage them to disregard social distancing measures, contributing to its spread across the entire population. Chart 2Daily US COVID-19 Deaths Sustainability Sustainability Bottom Line: There is no reason to expect the virus to disappear when it is gaining new footholds in college towns across the country and a large measure of activity is headed back indoors. How Much Does The Economy Have Left? The good news about the reduced mortality rate is that it would seem to lessen the likelihood that state and local officials would feel the need to impose lockdowns as severe as the ones in early spring. The bad news, as our European Investment Strategy colleagues have stressed, is that lockdowns have less bearing on activity than economic actors’ personal perceptions of safety. If people are as unconcerned about contracting COVID-19 as many undergraduates appear to be, they’ll gather around the keg as closely as if they were riding the Tokyo subway at rush hour no matter how often they’re reminded that it’s unsafe. If they become fearful of getting sick, they’ll shun common carriers, offices, stores and gyms regardless of official rules giving them the green light to return. Last week’s release of European flash September PMIs may have illustrated the way personal concerns can override official rules. The divergence between solidly rising manufacturing PMIs, which comfortably topped expectations, and sharply and surprisingly weaker services PMIs, which crossed below the 50 expansion/contraction threshold, was stark (Chart 3). Modern manufacturing can be carried out in controlled environments by a comparatively modest number of workers whereas services demand is much more tied to public confidence, which appears to be fraying in Europe. Chart 3Europe's Demand For Services Has Slipped Europe's Demand For Services Has Slipped Europe's Demand For Services Has Slipped Developed economies employ considerably more people in services than manufacturing. If progress in reducing unemployment stalls upon upticks in COVID-19 cases, and mass manufacturing and distribution of an effective vaccine is still at least six months away, economies will require more fiscal support than initially envisioned in the spring. In the United States, the need for additional support places attention squarely on the off-again, on-again negotiations to extend key CARES Act provisions. Although we would expect households to have more difficulty keeping up with their obligations now that CARES Act flows have ceased, the data don't yet reveal any signs of strain. With the federal unemployment benefit supplement having expired at the end of July, households with laid-off wage earners are clearly at risk and they could light the fuse to spark a chain reaction of defaults. Despite the withdrawal of some federal support, however, the apartment rent collection and consumer delinquency data we’ve been following continue to indicate that households are managing to stay current on their obligations. The wobble in apartment rent collections through the week ended September 6th was apparently a function of the late Labor Day, as they have returned to the 2-percentage-points-below-2019 level they've occupied since the CARES Act took effect (Table 1). TransUnion’s latest monthly consumer credit update showed that consumers didn’t skip a beat in August, maintaining their streak of reducing month-over-month delinquency rates and shrinking them relative to their year-ago levels (Table 2). Table 1US Households Are Still Paying Their Rent ... Sustainability Sustainability Table 2... And They're Still Servicing Their Debt Sustainability Sustainability The forward-looking question is how long they can keep it going in the absence of additional help. A simple analysis of the data in the monthly Personal Income release suggests that households stored up over $1 trillion of excess savings in the five months through July, possibly enough to tide them over through the rest of the year (Box 1). Our estimate in last week’s report1 that households will need at least $800 billion of direct aid to bolster consumption into the second half of next year did not address the possibility of deploying some of the new savings and may thus be a little high. Although we continue to believe a bill will be passed ahead of the election despite increasing worries that Congress will not be able to reach an agreement, the near-term impact may not be as severe as feared. Box 1: What About All The New Savings? The upward explosion in the savings rate (Chart 4, top panel) and the associated plunge in consumption (Chart 4, bottom panel) illustrate that households squirreled away a record share of income while they were under lockdown and CARES Act measures were in force. This analysis attempts to determine the size of the savings windfall and households’ capacity to deploy it to support consumption and debt service until the economy can return to operating at its pre-pandemic capacity. Chart 4Two Sides Of The Same Coin Two Sides Of The Same Coin Two Sides Of The Same Coin Table 3 illustrates the steps we followed to estimate the quantity of pandemic-driven excess savings. The top two rows in the top panel show actual disposable income and outlays for each month from February through July and sum the five post-pandemic months in the Mar-Jul column. Savings are equal to the difference, and the savings rate is simply savings divided by disposable income. Table 3Household Savings, With And Without The Pandemic Sustainability Sustainability The bottom panel of the table models the outcome that might have occurred had there been no pandemic, assuming disposable income grew each month at a 4% annualized nominal rate, in line with the US economy’s real trend growth rate of ~2% plus ~2% inflation. We held the savings rate constant at February’s 8.3% to solve for baseline monthly outlays and savings. We aggregated our annualized monthly savings estimates ($7 trillion) and subtracted them from actual annualized savings ($19.6 trillion) to get $12.6 trillion annualized excess savings, or slightly more than $1 trillion, de-annualized (all four savings figures circled in the table). Table 4 quantifies the monthly consumption shortfalls that may occur in the absence of a new round of fiscal aid, projecting the path of the six broad disposable income categories for the rest of the year. We assume that employee compensation, proprietors’ income and taxes maintain July’s modest month-over-month growth rate in August and September and are then flat for the rest of the year. Rental income and interest and dividends are assumed to be unchanged from their July levels, as are transfer receipts, which incorporate only the share of July transfers that resulted from automatic stabilizers. (Though we tried to err to the side of conservatism, there is a meaningful possibility that virus-driven pessimism could produce a consumption double dip, causing income to fall short of our estimates.) Table 4Excess Savings Could Cover Projected Consumption Shortfalls Sustainability Sustainability We assume that the savings rate declines to 16.5% in August (twice February’s pre-pandemic rate) but remains there the rest of the year as households continue to exercise caution. Using our assumed savings rate and modeled disposable income, we calculate monthly outlays and compare them to the outlays that would meet economists’ consensus third and fourth quarter growth projections. That comparison yields around $300 billion of consumption shortfalls through the end of the year, a modest sum relative to the $1 trillion of excess savings that were accumulated from March through July. Investors interpreting our simple analysis should recognize that the possible range of actual results is quite wide and projecting how animal spirits will drive household consumption decisions is inherently uncertain. It is clear to us, however, that the direct aid households received from the CARES Act is not yet exhausted. The massive savings that households built up from March through July will allow the second quarter’s fiscal thrust to act something like a time-release medication, especially when it comes to consumer credit performance. The surprisingly low delinquency rates reported so far do not appear to have been a fluke when viewed against a $1 trillion cache of unanticipated savings. How Long Can Equities Float Free Of The Economy? One would expect that a once-in-a-century shock like a deadly pandemic would induce a brutal recession. In terms of the unemployment rate and GDP contraction, COVID-19 has not disappointed, delivering the worst numbers this side of the Depression. Movie theaters, concert venues, pro sports franchises, airlines, car rental companies, retailers, gyms, restaurants and bars face significant losses and potential extinction. For all the disruption in select individual businesses and industries, however, there has not yet been significant systemwide damage. We don't think the economy is doing as badly as the majority ofcommentators believe, ... Fiscal transfers and monetary accommodation have forestalled the unchecked wave of defaults that might otherwise have occurred, shielding the banking system from stress and preventing a negatively self-reinforcing cycle of illiquidity and reduced credit availability from taking hold. Away from businesses that depend on physical crowds and their landlords and lenders, the economy is not doing too badly. Disposable household income grew at a record rate in the second quarter, four standard deviations above its seven-decade mean (Chart 5); corporations issued record amounts of bonds at low rates that will reduce their long-run funding costs; and private equity funds and other entities with visions of the post-GFC recovery dancing in their heads are itching to deploy the ample capital they’ve raised to buy businesses at deep discounts. There will be many pandemic business casualties, but at the level of the overall economy, we expect a reasonably orderly transfer of viable assets from weak hands to amply funded strong ones. Chart 5Despite The Recession, Fiscal Shock And Awe Made Households Flush Despite The Recession, Fiscal Shock And Awe Made Households Flush Despite The Recession, Fiscal Shock And Awe Made Households Flush The bottom line is that we don’t think the economy is suffering all that badly, and that it won’t going forward provided that fiscal and monetary policy makers continue to pursue the measures that have successfully suppressed defaults and bankruptcies so far. Austrian School devotees may suffer severe emotional distress and deficit hawks will rant and rave, but investors should come out of it all okay. Equities quickly sized that up and the reversal of their steep losses can be viewed as a rational response to Congress’ and the Fed’s shock-and-awe measures. In our view, financial markets are not disconnected from the economic backdrop per se; they’re disconnected from the economic backdrop that would have unfolded were it not for policy makers’ extraordinary measures. Commentators with a more pessimistic bent seem to be focusing more on the scenario that didn’t occur than the one that actually did. And About Those Valuations? We frankly confess to discomfort with an S&P 500 valuation of 23 times forward four-quarter earnings. In forward estimates’ 41-year history, the index has only ever traded at a multiple of 23 or more at the 1999-2000 height of the dot-com mania (Chart 6). It is not a level that bodes well on its face for the index’s intermediate- and long-term prospects. By collectively bidding up the forward multiple to the 97th percentile as of the end of August, investors would seem to have pulled future returns into the present. ... because it seems that they've been focusing on the worst-case scenario that didn't occur, rather than the much milder one that policy makers have so far been able to engineer. Chart 6Back To The Future Back To The Future Back To The Future When asked if we can justify current equity valuations and if they can be sustained, we tread carefully, replying that we can make our peace with them for short stretches of time. We are not trying to dodge the tough questions, we are simply seeking practical ways for professional investors, judged on a relative performance basis, to navigate through a tricky backdrop. For a professional manager to align his/her portfolios with a view that today’s valuations are unsupportable, s/he would have to possess two things: extremely high conviction in that view and clients willing to stick with him/her despite tracking error that would make a pension consultant faint dead away and may well involve extended underperformance. Table 5How Expensive Is Too Expensive? Sustainability Sustainability Alpha is only earned by swimming against the tide but resisting a move like the rally from the March bottom is akin to an all-in bet, and all-in bets should be made sparingly if at all. Forward multiples have exceeded the dot-com heyday’s 20 level every month-end since April. Assuming the forward multiple series is normally distributed, there was only a 6% chance that the multiple would exceed its April level and the probabilities have shrunk every succeeding month as the multiple itself has climbed (Table 5). Based on valuation, a manager could have begun leaning against the rally in April and may have resisted participating in it at the end of March, given that the forward multiple never signaled that stocks were cheap. The dot-com mania, when the S&P traded two standard deviations above its forward multiple’s mean for fifteen straight months before peaking, presents an even starker example. Five quarters of sizable underperformance would have tested a manager’s commitment, not to mention his/her clients’. The bottom line is that valuations are a notoriously poor timing indicator. We tend to pay close attention to them only at extremes, but we never view them as decisive on their own – two standard deviations can become two-and-a-half or three before surges or plunges fully play out. The catalyst that might provoke mean reversion in the S&P 500’s forward multiple is still unclear, and we prefer to maintain a benchmark equity exposure until the potential catalyst(s) and the timetable over which it/they might emerge becomes clearer. If this really is a mania, there will be plenty of money to be made from betting against it over the last three quarters of its unwind; there’s no need to rush to be the first to call a top, which can prove to be a costly pursuit. For now, we are content to continue to watch and wait.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 21, 2020 US Investment Strategy Weekly Report, "The Fundamental Theorem Of Macroeconomics," available at usis.bcaresearch.com.

Highlights Global GDP growth estimates from the OECD point to a stronger recovery in oil demand than markets are pricing in at present (Chart of the Week).  Our forecast for Brent remains at $46/bbl for 2H20 and $65/bbl on average for 2021. Global trade data – particularly EM import volumes, which are highly correlated with income (GDP) – remain supportive, as does monetary policy, particularly out of the US, EU and China.  Doubt surrounds the US Congress’s determination to extend the fiscal support that underpins many households’ and firms’ budgets, but we expect a deal. Aggregate demand uncertainty remains high.  COVID-19 infections are increasing globally.  However, death rates appear to be trending lower, which likely will keep lockdowns localized. On the supply side, the leaders of OPEC 2.0 – Saudi Arabia (KSA) and Russia – continue to insist on full adherence to agreed production levels among member states.  This carries an implicit threat the leadership may be willing to flood the market with oil to remind the laggards of the consequences of cheating, which would hit non-Gulf OPEC members particularly hard. Longer term, sharp reductions in capex point to higher prices in the mid-2020s. Feature Stronger-than-expected growth estimates, most recently the OECD’s, suggest the decline in aggregate demand to the end of this year will not be as gruesome as earlier feared. Realized oil demand continues its V-shaped recovery, in line with rising GDP in the wake of the COVID-19 pandemic. Stronger-than-expected growth estimates, most recently the OECD’s, suggest the decline in aggregate demand to the end of this year will not be as gruesome as earlier feared, and that growth could be stronger in 2021 than earlier anticipated, as seen in the Chart of the Week.1 The OECD is expecting global GDP growth to contract 4.5% this year vs. its June estimate of a 6% decline. The World Bank’s forecast of a 5.2% contraction in global GDP this year drives our oil-demand estimate, so the OECD’s estimate is more bullish for oil demand. Incoming data for EM import volumes suggest income is on track to recover by year-end or early 2021 in developing and emerging markets (Chart 2). EM import growth is driven by income growth; EM demand is the most important driver of global oil-demand growth. Chart of the WeekOECD Raises Global Growth Estimates Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery Chart 2EM Import Volumes Remain On Recovery Path EM Import Volumes Remain On Recovery Path EM Import Volumes Remain On Recovery Path Growth estimates continue to be overshadowed by fears of another round of widespread lockdowns arising from a second wave of COVID-19 infections and deaths. For next year, the OECD expects global growth to expand at a 5% rate vs. the World Bank’s 4.2% rate. We are awaiting the Bank’s updated income (GDP) estimates before revising our oil demand estimates. We already show EM oil demand, proxied by non-OECD consumption, recovering to pre-COVID-19 levels by the middle of next year, while DM demand flattens at a lower level (Chart 3). A confirmation of better-than-expected growth – particularly from EM economies – would move our expectation of a full recovery in EM oil-demand into 1H21 and could push DM demand up slightly. Chart 3EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 Chart 4COVID-19 Infections Rising, But Death Rates Are Falling Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery These growth estimates continue to be overshadowed by fears of another round of widespread lockdowns arising from a second wave of COVID-19 infections and deaths. This perforce makes any bullish demand recovery suspect. For the present, while COVID-19 infections are rising, death rates appear to be trending lower recently (Chart 4). If, as appears to be the case, a vaccine for the virus is approved later this year or in early 2021, markets likely would re-orient to discounting the time at which it is available globally to estimate a demand-recovery vector. Our estimate of the global oil-demand loss for this year is slightly larger than last month – -8.15mm b/s vs. -8.1mm b/d in August (Table 1). The US EIA and IEA also increased their estimates of 2020 global demand loss slightly this month as well, to -8.3mm b/d and -8.4mm b/d, respectively. OPEC once again is an outlier – albeit a very important source of information – in expecting a loss of -9.5mm b/d of demand this year. For 2021, we expect demand to grow 7.3mm b/d, vs. 6.5mm b/d from the EIA. OPEC expects oil-demand growth of 6.6mm b/d next year vs. last month’s forecast of 7mm b/d. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery OPEC 2.0 Production Discipline Holds Our expectation for OPEC 2.0 production is driven by our belief the group is targeting higher prices next year, and will adjust output to reach that goal. OPEC 2.0 continues to manage member-states’ output effectively. Compliance with the production cuts agreed by OPEC 2.0 remained strong in August – at 102%, based on OPEC’s calculations. The group’s production cut will be reduced to 5.8mm b/d starting in January 2021 from 7.7mm b/d currently (Chart 5). At its September 17 meeting, the coalition’s Joint Ministerial Monitoring Committee (JMMC) reiterated the importance of all countries complying with the agreed cuts, and recommended the so-called “compensation period” for underperforming countries failing to meet their production cuts be extended to the end of December 2020. This is meant to keep production below demand in 4Q20. For 2021, we continue to expect the group will accommodate higher demand growth by gradually increasing production beyond the currently planned January increase in quotas. This will limit the rise in prices, and will keep them below $70/bbl (Chart 6). Chart 5OPEC 2.0 Production Discipline Holds ... OPEC 2.0 Production Discipline Holds ... OPEC 2.0 Production Discipline Holds ... Chart 6... And Continues To Support Prices ... And Continues To Support Prices ... And Continues To Support Prices Our expectation for OPEC 2.0 production is driven by our belief the group is targeting higher prices next year, and will adjust output to reach that goal. KSA and Russia are making it abundantly clear in their public remarks they intend to keep the pressure up on the rest of OPEC 2.0 to move prices higher – their budgets have been hammered by the COVID-19 pandemic, after just starting to recover from the 2014-16 market-share war launched by OPEC when the pandemic hit earlier this year.2 Even in the current relatively low-price environment, KSA imposed a value-added tax (VAT) and is paring back social spending, while Russia is signaling it will increase in taxes on oil producers and metals companies and others to raise revenues.3 In the US, we believe most of the previously shut-in wells have been brought back on line. In our modeling, we marginally reduced OPEC 2.0’s production increase in this month’s forecast due to the slight downward revisions in demand. We now expect the group to increase its production to ~ 45mm b/d by December 2021, vs our previous expectation of ~ 46mm b/d. In our lower-demand scenario, which is driven by OPEC’s 2020 and 2021 demand estimates, we estimate prices would peak at ~ $50/bbl next year when keeping OPEC 2.0’s production unchanged vs. our base case. However, without the strong upward demand pressure, we believe OPEC 2.0 will keep its 5.8mm b/d production cuts in place for most of 2021 and that KSA, and to a lesser extent Russia, will push for strict production discipline at that level. This is sufficient to move prices close to $60/bbl on average in our lower-demand scenario in 2021 (Chart 7). Securing additional production cuts – to push average prices to $65/bbl as in our base case – from other OPEC 2.0 member states, including Russia, would be a difficult task. Chart 7Lower-Demand Price Scenarios Lower-Demand Price Scenarios Lower-Demand Price Scenarios Chart 8Falling US Rig Counts … Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery In the US, we believe most of the previously shut-in wells have been brought back on line. Going forward, legacy production declines rates will push onshore production down as new production from new completed wells remains below the level required to keep production flat (Chart 8). We expect production will bottom in June 2021 at ~ 8.1mm b/d before slowly moving up in 2H21 (Chart 9). The small uptick in production will come mainly from the completion of drilled-but-uncompleted (DUC) wells in the US shales, which expand and contract with the level of drilling activity, and function as a ready source of incremental lower-cost supply (Chart 10). DUCs will provide a cheap source of new production. We expect producers will begin developing this source of supply during the first half of next year, as the only expense left to bring oil to market from them are completion costs. Chart 9… And Falling US Production ... And Falling US Production ... And Falling US Production Chart 10Expect DUCs To Be Developed In 2021 Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery   Oil’s Capex Dilemma The IEA estimated oil and gas investment will fall by close to $244 billion y/y in 2020 which will reduce supply by ~ 2mm b/d by 2025. The combination of OPEC 2.0’s low-cost production and high spare capacity; parsimonious capital markets and the growing appeal of ESG-driven investment decisions; and concerns over peak oil demand will continue to limit funding to all but the most profitable producers, which will continue to limit E+P ex-OPEC 2.0.4 Consequently, new oil production in non-OPEC countries risks falling below the level needed to cover legacy wells’ decline rates, which we estimate at ~ 8% for non-OPEC ex-US shale production. This will be mostly apparent in The Other Guys – our moniker for all producers excluding Gulf OPEC, US shales, Canada, and Russia – which account for ~ 40% of global oil supply. In our view, the decline rates of The Other Guys currently are being overlooked, while the prospect of so-called “peak oil demand” is receiving a disproportionate amount of attention, and could be discouraging needed investment in new E+P. Keeping production flat in The Other Guys and US onshore production will require ~ 7mm b/d of new oil production between 2022 and 2025 (Chart 11). In the US, most of the added upstream capex will be dedicated to replacing legacy production declines. The IEA estimated oil and gas investment will fall by close to $244 billion y/y in 2020 which will reduce supply by ~ 2mm b/d by 2025. The sluggish rebound in capex could remove another 2-4mm b/d. According to IHS Markit, for supply to meet the expected demand over the next 5 years, close to $4.5 trillion in capex and opex is needed. The capital-constrained Other Guys’ supply growth, and a similar paucity of funding in the US and Canada will barely suffice to offset the decline rates in non-OPEC producing countries. This implies OPEC 2.0’s role will increase over the coming years as its spare capacity – which allows the group to move production to market more rapidly than shale producers – and ability to grow its productive capacity at low costs will disincentivize investments in major oil projects outside of these regions. Chart 11"The Other Guys" Production Remains In Decline Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery Investment Implications We expect the combination of OPEC 2.0 production discipline, parsimonious capital markets, and increasing decline rates will tighten the supply side of the market. In the near term, the recent upgrade in global GDP growth estimate from the OECD points to a stronger-than-expected recovery in oil demand, owing largely to massive fiscal and monetary support around the world. We expect the combination of OPEC 2.0 production discipline, parsimonious capital markets, and increasing decline rates will tighten the supply side of the market. As a result, we expect markets to continue to tighten (Chart 12), and for inventories to continue to draw this year and next (Chart 13). Chart 12Markets Will Continue To Tighten ... Markets Will Continue To Tighten ... Markets Will Continue To Tighten ... Chart 13... And Storage Will Continue To Draw ... And Storage Will Continue To Draw ... And Storage Will Continue To Draw We will continue to monitor growth estimates, but for the present, we are keeping our forecast for Brent at $46/bbl for 2H20 and $65/bbl on average for 2021. WTI will trade $2 - $4/bbl below Brent over this time. Longer term, producers outside the core OPEC 2.0 states are being starved for capital. The combination of continued production discipline and a paucity of capital available for producers outside this coalition are pointing toward a lower rate of supply growth going forward.    Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight  The recent announcement by Eastern Libyan commander Khalifa Haftar that the LNA would lift its blockade on oil output for a month does not meaningfully impact our previous Libyan oil production forecast. We continue to forecast a gradual recovery in the country’s production to 600k b/d and 900k b/d by December 2020 and 2021 (Chart 14). The news signals production could resume at a slightly higher pace than in our forecasts. However, we still believe risks to an export recovery are elevated, as the underlying conflicts in the country remain unresolved. Thus, we are keeping our projections largely unchanged (see Table 1). Base Metals: Neutral  World copper markets ended 1H20 with an apparent refined copper deficit of 278k MT, after adjustments for changes in Chinese bonded stocks. according to the International Copper Study Group. World ex-China refined copper usage declined ~ 9%, led by declines of 12% in Japan, 10% in the EU and ~ 8% in Asia (Ex-China). A 31% increase in net refined copper imports lifted Chinese apparent usage 9% offsetting, which offset declines in the rest of the world (Chart 15). China accounts for ~ 50% of refined copper consumption and ~ 40% of refined copper production. Precious Metals: Neutral  The sell-off in silver took prices below our trailing stop of $26/oz, leaving us with a gain of 40.5% since inception July 2, 2020. Our views for silver and gold remain positive, as the Fed continues to signal it will look through any pick-up in inflation, which we believe will keep real rates in the US low for the foreseeable future, and lead to a weaker USD. Ags/Softs:  Underweight  Soybean and corn futures paired back their gains, falling roughly 3.5% since last week. The USDA crop progress report for the week ending September 21, 2020, indicated that the deterioration in the condition of soybean and corn crops has stalled. The sharp rise in the US dollar Index has been another headwind. Given these factors and the precarious level of current prices, we recommend staying underweight agricultural products at this juncture.    Chart 14LIBYA CRUDE PRODUCTION SET TO REBOUND LIBYA CRUDE PRODUCTION SET TO REBOUND LIBYA CRUDE PRODUCTION SET TO REBOUND Chart 15Strong Chinese Copper Imports Strong Chinese Copper Imports Strong Chinese Copper Imports       Footnotes 1     Please see OECD Interim Economic Assessment, “Coronavirus: Living with uncertainty,” published September 16, 2020.   2     Following the JMMC meeting, Saudi Energy Minister Prince Abdulaziz bin Salman Al-Saud said OPEC 2.0 could hold an extraordinary meeting to address weaker demand, and warned traders against shorting the market.  Please see Saudi energy minister warns oil price gamblers ‘make my day’ published by aljazeera.com September 17, 2020. 3    Please see KSA VAT rate to increase to 15% from 1 July 2020 published by Deloitte Touche Tohmatsu Limited July 1, 2020.  See also Russian lawmakers give initial nod to hefty tax hike for mining, oil published by reuters.com September 22, 2020. 4    We opened our examination of the longer-term consequences of the contraction of supply growth last week in Oil's Next Bull Market, Courtesy Of COVID-19.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control

Highlights We present a thought experiment for the next eight years. 7000 constitutes a reasonable long-term target for the S&P 500. A doubling of the S&P 500 over the coming eight years is in line with the historical experience. Monetary policy is unlikely to tighten meaningfully, which will allow multiples to remain elevated Earnings per share can rise to $310 by 2028. Market technicals are also consistent with significant long-term gains for stocks. Feature Chart II-1Prolonged ZIRP Neither Eliminates Corrections... Prolonged ZIRP Neither Eliminates Corrections... Prolonged ZIRP Neither Eliminates Corrections... Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart II-1). Seven years. As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart II-1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart II-2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart II-3). Chart II-2...Nor Mini Economic Cycles ...Nor Mini Economic Cycles ...Nor Mini Economic Cycles Chart II-3"Lowflation"/Disinflation Has Been The Story Of The Past 30 Years "Lowflation"/Disinflation Has Been The Story Of The Past 30 Years "Lowflation"/Disinflation Has Been The Story Of The Past 30 Years   Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart II-2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart II-3). Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. Table II-1 October 2020 October 2020 With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table II-1). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart II-4). Chart II-4Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart II-5). Chart II-5EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table II-2 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table II-2SPX EPS & Multiple Sensitivity October 2020 October 2020 With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart II-5). A few words on presidential cycles are relevant given our structural bullish equity market view. We first noticed Tables II-3 & II-4 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies1 dating back to Hoover. Table II-3Every Presidency Experiences Drawdowns October 2020 October 2020 Table II-4S&P 500 Returns During Presidential Terms October 2020 October 2020 What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart II-6). Chart II-6Of Megaphones And Diamonds Of Megaphones And Diamonds Of Megaphones And Diamonds Chart II-7Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart II-7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Anastasios Avgeriou US Equity Strategist Footnotes 1 By term presidencies we are referring to the different duration of Presidents staying in office.

Highlights Portfolio Strategy We opt to stay patient and refrain from deploying fresh capital especially in the tech sector in the near-term; a better entry point will likely materialize between now and the end of the year. The softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and the risk of a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. A balanced outlook keeps us on the sidelines in the S&P home improvement retail (HIR) index. Recent Changes There are no changes to the portfolio this week. Table 1 Churning Churning Feature Equities tried to regain their footing last week, but risks still lingering on the (geo)political front should sustain the tug of war between bulls and bears and rekindle volatility. While monetary and fiscal policies will remain loose, the intensity of easing is waning as both the Fed’s impulse (i.e. second derivative) of asset purchases has ground to a halt and Congress has hit a stalemate over the next round of stimulus. Crudely put, the thrust of monetary and fiscal policies is at heightened risk of shifting from stimulative to contractive (Chart 1). As a result, we remain patient with fresh capital and will wait to deploy it when the dust settles hopefully by the end of the year. Turning to equity market internals and other high frequency financial market data is instructive in order to get a clearer picture of the direction of the broad equity market. The value line arithmetic and geometric indexes and small cap stocks that led the March 23 SPX trough are emitting a distress signal (Chart 2). Chart 1Running Out Of Thrust Running Out Of Thrust Running Out Of Thrust Chart 2Market Internals... Market Internals... Market Internals... Drilling deeper on a sector basis, hypersensitive chip stocks, energy shares, and discretionary versus staples equities will likely weigh on the prospects of the broad equity market (Chart 3). The VIX index, the vol curve and the yield curve, all excellent leading indicators of the S&P 500, have crested and warn that the shakeout phase has yet to run its course (VIX shown inverted ,Chart 4). Chart 3...Say It Is Prudent... ...Say It Is Prudent... ...Say It Is Prudent... Chart 4...To Remain On The Sidelines ...To Remain On The Sidelines ...To Remain On The Sidelines Trying to quantify the SPX drawdown, we turn to CBOE’s equity put/call (EPC) ratio. The EPC ratio is nowhere near recent extreme readings. SPX pullbacks since the early-2018 “Volmageddon” have corresponded to significantly higher EPC ratio readings. In the past 10 such iterations, the median EPC ratio has been 0.86, the mean 0.93, with a range of 0.77 to 1.28 (Table 2). Currently, the EPC ratio is hovering near 0.58 suggesting that downside risks persist (EPC ratio shown inverted, Chart 5). Chart 5Downside Risks Persist Downside Risks Persist Downside Risks Persist Table 2Equity Put/Call (EPC) Ratio During Pullbacks Since 2018 Churning Churning Finally, the commodity complex is also firing warnings shots. Lumber has collapsed nearly $300/tbf from the recent peak, oil is trailing gold bullion and silver is also cresting versus the yellow metal, iron ore is petering out and the Baltic dry index is wobbling. True, copper and materials stocks are holding their own, but overwhelmingly commodity market internals are waving a yellow flag (Chart 6). Chart 6Commodity Yellow Flags Commodity Yellow Flags Commodity Yellow Flags Netting it all out, we opt to stay patient and refrain from deploying fresh capital especially in the tech space in the near-term; a better entry point will likely materialize between now and the end of the year. This week we reiterate our underweight stance in a niche technology index and shed more light on our recent downgrade to neutral of a key consumer discretionary subgroup. Chip Equipment Update: Tangled Up In The Trade War We remain committed to our intra-tech strategy of preferring defensive software and services tech names to aggressive hardware and equipment tech stocks. In that light, we reiterate our underweight stance in the niche S&P semi equipment index. Recent news of the Trump administration’s potential tightening of the noose on Chinese chip company SMIC (the country’s largest foundry) was a net negative for US semi cap names, similar to export restrictions of American technology to Huawei was a net negative for US semi cap names. As a reminder, these manufacturers count China as one of their largest export market alongside Taiwan and South Korea. Thus, this flare up in the US/Sino trade war bodes ill for semi cap companies’ future sales and profit growth projections (Chart 7). There are high odds that relative share prices have plateaued earlier this month and a fresh down cycle has commenced. Under such a backdrop, this hyper-sensitive manufacturing group will likely overshoot to the down side as is evident in the historical tight correlation with the ISM manufacturing survey: these violent oscillations are warning that a cooling off in the ISM will be severely felt in this niche manufacturing intense index (Chart 8). Chart 7Lofty Expectations Lofty Expectations Lofty Expectations Chart 8Violent Oscillations Violent Oscillations Violent Oscillations On the global demand front, there is an element that COVID-19 is stealing sales from the future and bringing demand forward. Already global semi sales are rolling over, and a couple of industry pricing power proxies are deflating at an accelerating pace: Asian DRAM prices are topping out in the contraction zone and Taiwanese export prices are sinking like a stone, warning that a deficient demand down cycle will squeeze semi cap profit margins (Chart 9). Importantly, Taiwanese tech capex, which TSMC dominates, has crested, warning that all the euphoria behind 5G deployment and uptake is likely baked in the relative share price ratio. The implication is that semi cap names remain vulnerable to any global 5G-related hiccups (top panel, Chart 10). Chart 9Waning Selling Price Backdrop Waning Selling Price Backdrop Waning Selling Price Backdrop Chart 10Cresting Cresting Cresting Finally, the tight positive correlation between Bitcoin prices and the relative share price ratio remains intact. Were a knee-jerk rebound in the US dollar to knock down Bitcoin, at least temporarily, it would serve as a catalyst to shed chip equipment stocks (bottom panel, Chart 10). Moreover, 90% of the industry’s sales originate abroad, thus a rise in the greenback would eat into their P&L via FX translation losses. Adding it all up, a softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. Bottom Line: Stay underweight the S&P semiconductor equipment index. The ticker symbols for the stocks in this index are: BLBG S5SEEQ – AMAT, KLAC, LRCX. Home Improvement Retailers: Stay On The Sidelines Two weeks ago our trailing stop was triggered in the S&P home improvement retail index (HIR) and we monetized gains of 15% since the mid-April inception and moved to the sidelines. Today we reiterate our benchmark allocation in this consumer discretionary sub group. Clearly, HIR was a major beneficiary of the lockdown as the US and Canadian governments deemed these retailers “essential” and allowed them to stay open during the peak of the pandemic. These Big Box retailers saw their sales soar as the fiscal easing package replenished consumers’ wallets, and coupled with the lockdown, caused a surge in DIY remodeling activity. Our portfolio also greatly benefited from the stellar performance of the S&P HIR index, as existing home sales staged a significant comeback and inventories of homes for sale receded substantially thus further tightening the residential real estate market (top & middle panels, Chart 11). As reminder, historically a vibrant housing market is synonymous with handsome returns in relative share prices and vice versa. But now a number of stiff headwinds, which our HIR model encapsulates, signal that a lateral digestive move is in store in the coming months (Chart 12). Chart 11Unsustainable Front Running Unsustainable Front Running Unsustainable Front Running Chart 12Stiff Headwinds Stiff Headwinds Stiff Headwinds First, a repeat of the spike in demand for home improvement projects is highly unlikely, especially given that demand was brought forward. Also during the autumn and winter months there is a natural slowdown in the take-up of remodeling projects until the spring home selling season arrives. Second, the industry’s sales-to-inventories (S/I) ratio is literally off the charts (bottom panel, Chart 11). An inventory build-up and easing in demand will bring back the S/I ratio back to a more reasonable level. Lastly, lumber prices have taken a beating of late collapsing from over $900/tbf to below $600/tbf. This drubbing of this economically hypersensitive commodity directly cuts into HIR earnings. These Big Box retailers make a set margin on lumber sales so as prices fall they take a big bite out of profits (bottom panel, Chart 13). Nevertheless, a few offsets prevent us from turning outright bearish in this early cyclical retailers. Namely, the industry’s profit growth bar is on a par with the broad market and thus does not pose a large hurdle to overcome. Importantly, given that HIR earnings have kept pace with the massive run-up in stock prices (second panel, Chart 14), they have kept relative valuations at bay. While, the S&P HIR 12-month forward P/E trades at a market multiple, the relative forward P/E changes hands at a 20% discount to the historical mean. Thus, HIR enjoy a significant valuation cushion (bottom panel, Chart 14). Chart 13Timber! Timber! Timber! Chart 14But There Are Powerful Offsets But There Are Powerful Offsets But There Are Powerful Offsets Finally, the Fed just explicitly committed to stay on the zero interest rate line until 2023! This easy monetary policy as far as the eye can see is a powerful tonic to early cyclical and interest rate-sensitive home improvement retailers (fed funds rate shown inverted, top panel, Chart 14). Netting it all out, a balanced outlook keeps us on the sidelines in the S&P HIR index.  Bottom Line: Stick with a benchmark allocation in the S&P home improvement retail index. The ticker symbols for the stocks in this index are: BLBG S5HOMI – HD, LOW.     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

“Based on a broad set of indicators, it is hard not to see a certain amount of daylight between risky asset prices and economic prospects” – Claudio Borio, Head of Monetary and Economic Department, BIS, September 14, 2020 A pandemic, the resulting sharpest downturn in modern times and soaring government debt have made 2020 an annus horribilis for the US and world economy. Growth has rebounded strongly as economic lockdowns have ended, but most forecasts suggest that the level of activity will not return to its pre-virus level before the end of next year. That implies a lingering problem of high unemployment and there will be ongoing concerns about the eventual consequences of policymakers’ extreme monetary and fiscal actions. The long-run outlook for the US economy was already challenging before Covid-19 appeared on the scene. And this year’s events cannot have improved prospects relative to pre-crisis expectations. Thus, it is reasonable to wonder why the S&P500 hit a new all-time high in early September and currently is only slightly below that level. Is it a classic case of irrational exuberance or a sign that the economic outlook is much better than generally assumed? If we cannot come up with a convincing case for the latter then irrationality is left as a likely explanation. The sharp decline in interest rates certainly supports higher equity valuations, but a bull market that depends largely on stimulative monetary policy is problematic. The Stock Market Is Not The Economy, But… Finance theory states that equity prices should reflect the discounted long-run stream of expected dividend payments. In turn, those payments should be correlated with earnings growth which one would expect to have a close relation to underlying economic conditions. While prices often deviate significantly from so-called fundamentals, it is perfectly reasonable to assume a long-run correlation between the stock market and the performance of the economy. In practice, there is a loose relationship with occasional large deviations. Chart 1The US Economy vs. The Market The US Economy vs. The Market The US Economy vs. The Market Chart 1 shows the five-year annualized growth in US real GDP versus both real total returns from the S&P500 and real earnings.1 In making these comparisons, there are a few issues to consider. The stock market only represents quoted companies while GDP also includes the economic contribution of unincorporated businesses and the government. The sectoral composition of the S&P 500 is different from that of businesses at large. Many large US companies earn a significant share of their earnings from overseas operations that may be uncorrelated with domestic economic conditions. The price performance of stocks can reflect large swings in valuations driven by investor sentiment rather than fundamentals. Starting with the first point, corporate sector GDP accounts for only slightly more than half of total GDP, moving within a range of around 55% to 60% for the past 50 years (Chart 2). Yet the real growth in corporate GDP has moved in lockstep with that of total GDP. And aggregate sales of S&P500 companies have broadly tracked the swings in GDP. Thus, it cannot be argued that quoted companies can somehow miraculously avoid the ups and downs of the overall business cycle. The economy is based on a complex set of interconnected relationships and it would be remarkable if the performance of the country’s major corporations could deviate significantly from the economy at large for any length of time. Chart 2The Corporate Sector And Total GDP The Corporate Sector And Total GDP The Corporate Sector And Total GDP There certainly is an issue with the second point because the sectoral breakdown of the S&P500 does not exactly match that of the overall economy. While that does not always protect the stock market from general economic trends, it can help explain occasional large equity price moves. Table 1 shows the sector composition of the S&P500, weighted by market capitalization, sales and earnings, versus the composition of GDP. It is difficult to break down GDP exactly in line with the sector classifications of the market, but we have done as close a job as the data allows. Notable differences between the structure of the market and GDP are the relative weightings of the health care, industrials and information technology sectors. The following explanations seem plausible. Table 1Sector Composition: A Comparison The US Economy vs. The Stock Market: Is There A Disconnect? The US Economy vs. The Stock Market: Is There A Disconnect? For health care, the GDP weighting shown in the table is understated because it also is a significant part of the government sector’s contribution via Medicare and Medicaid. Other data show that total spending on health care accounts for around 18% of US GDP, broadly in line with the S&P index weighting. The large weighting of industrials in GDP compared with its share of the equity index probably reflects the fact that this broadly-defined group has a very large number of small and unquoted companies. On that point, it should be noted that unincorporated businesses account for 21% of national income – a non-trivial share. Last, but not least, there is the huge discrepancy in the weightings of information technology. This is a bit harder to explain, but two reasons come to mind. First, the S&P index market cap weighting has been boosted by the strong share price performance of these companies and high valuations thus flatter their index importance relative to underlying business activity. The IT weights based on sales and earnings are much lower, but still significantly exceed that in GDP. Secondly, some of these companies (Apple being a prime example) produce very little in the US relative to what they sell in the country. As GDP measures domestic output, this affects the relative weightings. Chart 3Growth In Overseas vs. Domestic Profits Growth In Overseas vs. Domestic Profits Growth In Overseas vs. Domestic Profits Let’s explore the issue about overseas earnings more closely. According to national income data, 45% of the corporate sector’s after-tax profits come from overseas earnings. And that is broadly consistent with the overseas share of sales for S&P500 companies. While the relationship is not perfect, the growth of overseas profits roughly tracks that of domestic profits (Chart 3). And where there have been large divergences, such as in 2009, that often has reflected large swings in oil prices. Overall, it hard to make the claim that the large share of earnings coming from overseas has been a factor supporting the strong performance of stocks relative to the underlying economy. This is especially true given that the US has performed better than most other economies in recent years and the dollar has been a strong currency. In sum, our analysis does not give compelling support to the idea that the fundamental performance of large quoted companies can sustainably diverge from that of the underlying economy. But that does not mean that share prices cannot deviate because of large swings in valuation. Is The US Equity Market Overvalued? This should be a simple question to answer, but often is not. Alternative approaches to valuation are sometimes in conflict and that is the current situation. Various valuation measures are shown in Chart 4 with the following observations. Chart 4AMeasures Of US Equity Valuation Measures Of US Equity Valuation Measures Of US Equity Valuation Chart 4BMeasures Of US Equity Valuation Measures Of US Equity Valuation Measures Of US Equity Valuation All the measures based on earnings (trailing, forward and cyclically-adjusted) suggest that the market is very expensive. While current earnings are affected by the economy’s second-quarter collapse, there remains considerable uncertainty about the speed of recovery. The current forward price-earnings ratio (PER) assumes that earnings will increase by around 30% over the next 12 months and that could prove to be optimistic. The market also looks significantly overvalued based on the ratios of price-to-book, price-to-sales and total market capitalization to GDP. While the valuation of the aggregate index has been boosted by the exceptional performance of the technology sector, it is important to note that the ratios of price to trailing earnings and to sales also are very elevated using the medians of 58 sub-groups, as calculated by BCA’s US Equity Strategy Service (Chart 5). In other words, this is not a story about overvaluation simply reflecting the hot technology sector. Chart 5Overvaluation Is Not Just About Technology Overvaluation Is Not Just About Technology Overvaluation Is Not Just About Technology The market looks much more attractive when comparing dividend and earnings yields with the returns available on cash and bonds. This is the so-called TINA argument (there is no alternative). It is hard not to prefer stocks when the dividend yield is above the yield on long-term government bonds. During the market overshoot of the late 1990s, the dividend yield was 500 basis points below the 30-year Treasury yield, highlighting that stocks were in a very risky phase. Moreover, the current environment of unusually low interest rates is unlikely to end any time soon. The Federal Reserve’s newly-released projections indicate that interest rates are expected to remain at current levels at least through the end of 2023. The Fed has made it abundantly clear that it is prepared to take risks with inflation in order to support a revival in economic activity. It is relatively straightforward when the different valuation metrics are all giving the same message, as was the case in the late 1990s. Even then, the market overshoot lasted longer and became more extreme than generally expected. Our composite valuation indicator takes account of 10 different measures and currently supports the idea that the market is indeed very expensive (Chart 6). Chart 6BCA Equity Valuation Indicator BCA Equity Valuation Indicator BCA Equity Valuation Indicator It currently is very difficult for institutional investors to favor fixed-income instruments over a higher-yielding equity market. However, there is no free lunch here. We cannot ignore the argument that low interest rates reflect a very bleak long-run outlook for economic growth and thus for earnings and stock prices. The secular stagnation view put forward by Larry Summers looks even more apposite today than when he outlined it several years ago. We are fortunate to have Larry as the opening speaker for our virtual Investment Conference on October 6th and it will be extremely interesting to hear his latest thinking. Some Thoughts On The Economic Outlook Equities are a long-duration asset so it makes sense to consider valuations in the context of the long-run economic outlook rather than the near-term ups and downs of activity. Of course, short-run economic moves do affect investor sentiment so cannot be ignored. The near-term outlook is extremely cloudy because of uncertainty about the future path of the pandemic. While the virus appears to have become less virulent, infection rates could climb sharply over the winter months as schools re-open and people spend more time indoors. In addition, there are doubts about the scale and timing of much-needed additional government stimulus. Chart 7Mixed Data On The US Economy Mixed Data On The US Economy Mixed Data On The US Economy Some recent data have been impressively strong. The value of retail sales has surpassed pre-virus peaks as have new and existing home sales (Chart 7). On the other hand, manufacturing and construction output and overall employment remain far below previous peaks. And we have yet to see the impact of the ending of the $600 a week income support. There are legitimate concerns that early 2021 will see a surge in home evictions and a marked increase in small business bankruptcies. Most likely, the economy will experience a bumpy and moderate recovery after its post-lockdown strong third-quarter growth. The Fed forecasts US growth of 4% in 2021 after a 3.7% drop this year and the OECD’s latest projections are similar. That still means that it will take until the end of 2021 before real GDP gets back to its end-2019 level. And there are downside risks to that forecast if the virus remains a lingering problem. Our conference on October 6th will have what is sure to be a lively debate about the US economic outlook between Ed Yardeni and Dave Rosenberg. These two very smart economists have a very different take on how things are likely to play out and what it means for the markets. This debate will follow the presentation by Larry Summers and after that, Peter Berezin, our Chief Global Strategist, and myself will discuss our views and will be open for audience questions. Should be very interesting! Let’s talk about the longer-run economic outlook. As noted at the outset, it was less than inspiring even before the virus arrived on the scene. The two drivers of long-run economic performance are demographics and productivity and the growth in both has been trending lower. Chart 8Demographics Are A Problem Demographics Are A Problem Demographics Are A Problem The demographics story is straightforward and essentially locked in place. A falling birth rate means that the working-age population will rise at a meager 0.2% a year over the next ten years compared with more than 1% a year in the 1980s, 1990s and 2000s. Moreover, growth is projected to remain low in subsequent decades (Chart 8). And even these forecasts may be optimistic if the current antipathy toward immigration leads to a more closed-door stance. Demographic trends not only imply a slow-growing workforce (impacting potential GDP) but also create a worsening picture for government finances. An aging population boosts spending on health care and pensions when the number of taxpayers is growing very slowly. This shows up in a dramatic drop in the ratio of the working-age population (i.e. potential taxpayers) to those aged 65 and above.2 This is happening when government finances are already in dire straits and implies that future tax rates can only go higher, regardless of which political party is in power. The issue of productivity is more contentious because it is hard to measure, and future trends are less predictable than for demographics.3 Nevertheless, the data present a relatively clear picture: the growth of output per hour in the non-financial corporate sector has slowed markedly after a tech-driven spurt in the second half of the 1990s (Chart 9). We show the trend as a five-year growth rate to smooth out the short-term noise in the series. Chart 9Productivity Growth Has Slowed Productivity Growth Has Slowed Productivity Growth Has Slowed We discussed the outlook for productivity in a recent Special Report and highlighted some worrying trends.4 These include weak growth in business investment, a retreat from globalization, increased government involvement in the economy and friction caused by new pandemic-related protocols to protect the safety of customers and workers in several industries. On a more positive note, the virus has forced many businesses to streamline their operations and the move to remote working should boost productivity in some cases. What about the issue of technological advances such as artificial intelligence (AI) and autonomous vehicles? These clearly have the potential to boost productivity in many areas but with a caveat. Previous major technological breakthroughs (often called general purpose technologies or GPTs) such as steam power, the internal combustion engine, electricity, and the internet had major impacts on both supply and demand. Generally, they were associated with creating completely new activities. For example, steam power led to the locomotive which in turn allowed the opening of the country and the movement of goods to distant markets. Similarly, the automobile led to the development of the suburbs and the associated demand for housing and related services. More recently, the internet boosted the demand for a wide range of tech goods and services. While that is still ongoing, its peak effect has passed, helping to explain the decline in productivity growth from late-1990s level. In contrast, a lot of current ‘new’ technologies simply are associated with doing existing tasks more efficiently (3-D printing would be an example). That is still important but not on the same scale as GPTs. There is no doubt that AI will be a big disruptor in many sectors but its impact on demand is less clear. Maybe one day all households will have a domestic robot but that is still far enough away to be in the realm of science fiction. The bigger near-term impact will be job displacement. And the same can be said for autonomous vehicles. The demand for new self-driving cars will rise, but these will simply replace gas-powered ones and perhaps the overall number of vehicles on the road will decline. In sum, there will be both positive and negative forces acting on future productivity growth and any predictions need to be treated with caution. Nonetheless, a base case should probably assume any improvements will be relatively modest. Finally, any discussion of long-run economic prospects cannot ignore the alarming rise in government debt. The US was already running $1 trillion federal deficits before this year’s crisis led to a further extraordinary explosion of red ink (Chart 10). Chart 10Soaring Government Debt Soaring Government Debt Soaring Government Debt Current large deficits are not fazing investors. In the past, the spread between 30-year and 10-year Treasurys widened as the deficit rose, but this relationship has weakened recently (second panel Chart 10). Fed buying of bonds may have had some impact, but it also reflects the weak economy and low inflation. It is hard to know at what point investors will take fright at US fiscal trends. The experience of other countries that faced sovereign debt crises suggests problems can arrive with little advance notice. One day investors seem complacent and the next they are running scared. The dollar’s status as the world’s main reserve currency gives the US more protection than other countries had when facing debt problems. And central banks’ willingness to be the bond buyers of first and last resort gives debt burdens more room to grow than in the past. However, debt arithmetic is relentless and will turn very ugly when bond yields eventually rise. It is futile to try and pin a date on when bond vigilantes might reassert themselves in the US. But it will happen at some point. Moreover, even before that happens, there will be political pressure to do something about soaring debt levels. Even without a market revolt, the burden of increased spending on entitlements and debt servicing will force the government to pursue austerity. Taxes will rise and spending growth will be curtailed. That is a further reason to be cautious about economic prospects. Increased debt is a way to bring spending forward but unless the money is used to invest in productive assets, the process eventually goes into reverse. Unfortunately, the surge in US government borrowing has been used to prop up consumption rather than to finance capital spending. The short- and long-run economic outlook would have been worse if there had not been a powerful fiscal response. Consumption would have suffered an even sharper decline with a catastrophic impact on employment, profits and capital spending. In that sense, the government really had no choice: the health of government finances becomes irrelevant in the midst of a pandemic-related economic collapse. Market Implications There are several explanations for the remarkable strength of the US equity market. Prime place goes to the Fed’s hyper-easy monetary stance. A policy of zero interest rates with a stated intention to keep them there for a long time has the desired effect of boosting risk-taking. A second factor has been excitement about technology that has created a bubble in that sector. And then there is the view that novice retail investors have been seduced into the market by online applications such as Robinhood that make day trading very easy. Missing from the above list is the suggestion that investors expect the economy to be strong enough to validate the market’s current level. That just does not seem plausible because it is not credible that earnings could grow strongly enough to lower valuations to more reasonable levels over the next five to ten years. If the bull case for stocks rests simply on the TINA argument, then it implies equities will remain in a bubble over the medium term. That certainly is possible but not the foundation for a sound investment strategy. It is not easy to come up with an investment strategy when no asset is cheap. BCA’s House View is still to prefer equities on a cyclical basis and the challenge will be timing when to jump off the train. In conclusion, my answer is that there is indeed a disconnect between the economy and equity market. This may persist for quite a while but does not appear sustainable. I am reminded of the late 1990s when the bull market lasted much longer and moved far higher than I and many others expected. Yet, fundamentals eventually did matter with the S&P500 dropping by almost 50% over the space of 30 months. I am not suggesting that a similar decline is imminent and if the 1990s example is relevant, then the market can continue to rise for quite a while, and I am sure the BCA view will prove to be correct. However, ever the skeptic, my bias is to err on the side of caution rather than try to maximize returns. Let me end by giving our upcoming conference another plug. The outlook for US equities will be discussed by Liz Ann Sonders and Ned Davis, two highly-respected market analysts and we will have a separate important session on coming up with the ideal investment strategy from three different perspectives: the buy side, the sell side and independent research In addition, over the four days of the event, we will have high-level discussions of all the other key issues that will drive markets including China, geopolitics, the US election, currencies, and policy challenges. Find out more at https://www.bcaresearch.com/conference2020.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com   Footnotes 1Total returns and earnings were deflated using the corporate price deflator. 2Obviously, not everyone of working age pays much in the way of taxes and there are many aged 65 above who pay lots of taxes. But that does not abstract from the dramatic change in the ratio.  3If you want to know how many 70-year old people there will be in 10 years’ time, simply count the number of 60-year olds today and apply an appropriate mortality rate. 4Please see BCA Special Report "Beyond the Virus," dated May 22, 2020, available at bca.bcaresearch.com

Dear Client, We will be working on our Fourth Quarter Strategy Outlook next week, which will be published on Tuesday, September 29th. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors should favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term and vulnerable to a further correction.  Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. While we ultimately expect a deal to be reached, it may take a stock market sell-off to force Republican leaders to accede to Democratic demands for more spending. US monetary policy will stay accommodative for at least the next two years, a view that this week’s FOMC meeting further validated. Investors should pivot into cheaper areas of the stock market – in particular, deep cyclicals and financials, non-US stocks, and value stocks. Value stocks are especially appealing, as they are now trading at the biggest discount on record relative to growth stocks. The “pandemic trade” will give way to the “reopening trade.” The latter will benefit value stocks. In addition, stronger global growth, ongoing Chinese stimulus, a weaker US dollar, and modestly steeper yield curves all favor value indices. Value investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Market Commentary Chart 1Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments We continue to favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term despite correcting modestly over the past few weeks. Tech stocks rallied hard into September. Aggressive buying of out-of-the-money call options helped fuel the rally. While some big institutional players such as Softbank have reportedly scaled back their positions, many retail investors remain unfazed. The triple leveraged long Nasdaq 100 ETF, TQQQ, experienced the largest weekly inflow on record in September. In addition to being technically stretched, equities face near-term risks from the impasse in the US Congress over a new stimulus bill. Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. Chart 1 shows that weekly unemployment payments have fallen by $15 billon since the end of July, representing a drop of more than 50%. At an annualized rate, this amounts to 3.7% of GDP in fiscal tightening. On top of that, the funds in the small business Paycheck Protection Program have run out, while many state and local governments face a severe cash crunch. BCA’s geopolitical strategists expect a fiscal deal to be reached over the next few weeks. The fact that Speaker Nancy Pelosi has said that Congress will stay in session until both sides agree on an aid package is good news in that regard. Nevertheless, given all the acrimony in Washington in the run up to the November election, there is still a non-negligible chance that a deal falls through. Why, then, are we still bullish on stocks on a 12-month horizon? Partly it is because voters want more stimulus, which means that fiscal policy is likely to be loosened again, even if this does come after the election. It is also because the pandemic seems to be receding. While the number of new cases is rising again in the EU and some other regions, fatality rates remain much lower than during the first wave. Progress also continues to be made on developing a viable vaccine. According to The Good Judgment Project, about 60% of “superforecasters” expect a mass-distributed vaccine to be available by Q1 of 2021, up from 45% just four weeks ago. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 2). Chart 2High Odds Of A Vaccine Within 6-To-12 Months Pivot To Value Pivot To Value Lastly, monetary policy remains exceptionally accommodative. The Fed this week formally incorporated its new flexible average inflation targeting strategy into its post-meeting statement. The FOMC promised to keep rates at rock-bottom levels until the economy has reached “maximum employment” and inflation “is on track to moderately exceed two percent for some time.” The dot plot indicated that the vast majority of FOMC members did not expect rates to rise until at least the end of 2023. As Chart 3 shows, the global equity risk premium remains quite elevated. This favors stocks over bonds. Not all stocks are equally attractive, however. Four weeks ago, in a report titled “The Return of Nasdog,” we made the case that investors should pivot away from growth stocks towards value stocks. The report generated quite a bit of interest from readers. Below, we review and elaborate on some of the issues raised in a Q&A format. Q: Being long value stocks relative to growth stocks has been a widowmaker trade for more than a decade. Why do you think we have reached an inflection point? A: Value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 4). Chart 3Global Equity Risk Premium Remains Quite Elevated chart 3 Global Equity Risk Premium Remains Quite Elevated Global Equity Risk Premium Remains Quite Elevated Chart 4Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks     Admittedly, valuations are not a good timing tool. One needs a catalyst to unlock those valuations. Good news on the virus front may end up being such a catalyst. The “pandemic trade” benefited tech stocks, which are overrepresented in growth indices. It also favored health care stocks, which are similarly overrepresented in growth indices, at least globally (Table 1). The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. Table 1Breaking Down Growth And Value By Sector Pivot To Value Pivot To Value Chart 5 shows that retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels. Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 6). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. Chart 5Are Brick-And-Mortar Retailers Coming Back To Life? Are Brick-And-Mortar Retailers Coming Back To Life? Are Brick-And-Mortar Retailers Coming Back To Life? Chart 6The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge     Q: How are investors positioned towards value versus growth? A: According to the September BofA Global Fund Manager Survey, tech and pharma were the two sectors with the largest reported overweights. Thus, there is significant scope for money to shift out of these sectors. Q: What about the overall macro environment underpinning growth and value? A: While the relationship is far from perfect, value stocks tend to outperform growth stocks when the US dollar is weakening (Chart 7). Recall that growth stocks did very well during the late 1990s, a period of dollar strength. In contrast, value stocks outperformed between 2001 and 2007, a period during which the dollar was generally on the back foot. As we have spelled out in past reports, we expect the dollar to weaken over the next 12 months, which should benefit value stocks. Value stocks also tend to do best when global growth is accelerating (Chart 8). Provided that governments maintain adequate levels of fiscal support and a vaccine becomes available by early next year, global GDP should bounce back swiftly. Chart 7Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Chart 8Value Stocks Also Tend To Do Best When Global Growth Is Accelerating Value Stocks Also Tend To Do Best When Global Growth Is Accelerating Value Stocks Also Tend To Do Best When Global Growth Is Accelerating   Q: Won’t lower real bond yields favor growth stocks? A: By definition, growth companies generate more of their earnings further in the future than value companies. As such, a decline in real yields will tend to increase the present value of cash flows more for growth companies than for value companies. We do not expect real yields to rise significantly over the next two years. However, given that real yields are already deeply negative in almost all countries, they probably will not fall either. Q: You seem to be making the cyclical case for the outperformance of value stocks. But what about the secular case? It appears to me that the stronger earnings growth displayed by growth stocks will ultimately translate into higher long-term returns. A: Historically, that has not been the case. As Chart 9 and Table 2 illustrate, value stocks have outperformed growth stocks by a wide margin over the past century. In particular, small cap value has clobbered small cap growth. Chart 9Value Stocks Have Outperformed Growth Stocks By A Wide Margin Over The Past Century Pivot To Value Pivot To Value Table 2Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Pivot To Value Pivot To Value How did value stocks manage to triumph over growth stocks if, as you say, growth stocks usually experience faster earnings growth? The answer has to do with what is priced in and what is not. If everyone expects a company’s earnings to grow next year, this will already be reflected in its share price. It is only unanticipated earnings growth that should move share prices. For the most part, both analysts and investors have tended to overextrapolate near-term earnings growth. As we discussed in a special report titled “Quant-Based Approaches To Stock Selection And Market Timing,” while analysts are generally able to predict which companies will display superior earnings growth over the next one-to-two years, they systemically overestimate earnings growth on longer-term horizons (Chart 10). As a result, investors tend to overpay for growth, causing growth stocks to lag value stocks. Chart 10A Mug’s Game Pivot To Value Pivot To Value Q: That may have been true historically, but it seems that more recently, investors have been guilty of underpaying for growth. A: Yes and no. If one looks at the period between 2007 and 2017, the superior performance of growth stocks was broadly matched by their superior earnings growth. As a result, relative P/E ratios did not change much. Since 2017, however, the P/E ratio for growth indices has soared relative to value indices (Chart 11).  Chart 11AThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion Chart 11BThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion   Q: What has happened since 2017 that has caused growth stocks to become so much more expensive? A: FANG, FAANG, FANGMAN, whatever acronym you want to use, it was mainly a story about investors becoming infatuated with mega cap tech stocks. After seeing these companies beat earnings estimates quarter after quarter, investors decided that they deserve to trade at much higher valuation multiples. Q: What about other tech companies? A: For the most part, they were left in the dust. Our proprietary Equity Analyzer system allows us to sort companies based on all types of fundamental and technical factors. Chart 12 shows that “value tech” companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales have gotten completely clobbered by “growth tech” companies trading in the top quartile of these valuation metrics. Chart 12Value Tech Versus Growth Tech Pivot To Value Pivot To Value Interestingly, the opposite pattern was true among financials: “Value financials” – financials that trade cheaply based on the valuation measures listed above – have outperformed “growth financials.” The net result is a bit surprising: Since “value tech” underperformed the average tech stock, while “value financials” outperformed the average financial stock, the average “value tech” stock has delivered a return over the past decade that was almost identical to the average “value financial” stock. Chart 13There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years Q: This seems to suggest that value managers would not have made any money by shifting exposure from financials to tech? A: Correct. Consider the iShares MSCI USA Value Factor ETF (ticker: VLUE). It is structured to have the same sector weights as the overall US market. It currently has 27% of its assets in technology and 10% in financials. Compare that to the Vanguard Value Index Fund ETF Shares (ticker: VTV). It has 10% of its assets in technology and 19% in financials. As Chart 13shows, VTV has actually outperformed VLUE over the past five years. Year to date, VTV is down 10%, while VLUE is down 15%. Q: While value managers would not have made money by shifting capital from financials to tech, I presume the same thing could not be said for growth managers. A: You can say that again. “Growth tech” outperformed the average tech stock, while “growth financials” underperformed the average financial stock. Thus, shifting money from “growth financials” to “growth tech” would have supercharged returns. Q: This still leaves open the question of why mega cap stocks were able to grow earnings so rapidly? A: Two explanations come to mind. First, tech companies often gain from so-called network effects: The more people there are who use a particular tech platform, the more attractive it is for others to use it. Second, tech companies benefit from scale economies. Once a piece of software has been written, creating additional copies costs nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner-take-all environment where success begets further success. Q: It seems this process could go on indefinitely? A: Not indefinitely. No company can control more than 100% of its market. There is also a limit to how big the overall market can get. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. Q: These companies have plenty of cash. Can’t they try to enter new types of businesses if they want to keep growing? A: They can try, but there is no guarantee they will succeed. Kodak was one of the pioneers in digital photography. However, it could never really reinvent itself and ended up fading into oblivion. Moreover, while first-mover advantage is a powerful force, it is not invincible. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Q: And I suppose government policy could also turn less friendly towards tech? A: That is a definite risk. Republicans have been cheap dates for tech companies. Republican politicians have showered tech companies with tax cuts and allowed them to exploit a variety of loopholes in the tax code. They also kept tech regulation to a minimum. All this happened despite the fact that many tech leaders have publicly panned conservative viewpoints, while tech company employees have rewarded Democratic politicians with the lion’s share of campaign donations (Chart 14). Chart 14Tech Company Employees Donate Heavily Towards Democrats Pivot To Value Pivot To Value Going forward, Republicans are likely to sour on big tech. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). Tucker Carlson, a leading indicator for where the Republican party is heading, has frequently lambasted tech companies on his highly popular television show. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies Pivot To Value Pivot To Value For their part, the Democrats are moving to the left. Alexandria Ocasio-Cortez, a leading indicator for the Democratic party, has voiced her support for Senator Elizabeth Warren’s calls to break up big tech. She has also accused Amazon of paying starvation wages, adding that "If Jeff Bezos wants to be a good person, he'd turn Amazon into a worker cooperative." Q: The political climate for tech companies may be souring. But couldn’t one say the same thing about banks and energy companies, which are overrepresented in value indices? A: One difference is that tech companies trade at premium valuations, while banks and energy companies trade near book value (Chart 16). Another difference is that banks have already felt the wrath of regulators. Thanks to Dodd-Frank and pending Basel III regulations, banks today function more like utilities than like the casinos of yesteryear. While private credit growth is unlikely to return to its pre-GFC pace, banks will still profit from a revival in global growth and increasing consolidation within their industry. Stronger global growth should also allow for modestly higher nominal bond yields and somewhat steeper yield curves. This will benefit bank shares (Chart 17). Chart 16Tech Firms Trade At Premium Valuations Tech Firms Trade At Premium Valuations Tech Firms Trade At Premium Valuations Chart 17Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares     As far as energy stocks are concerned, again, we need to benchmark our views to what the market expects. Oil is not going back above $100 per barrel anytime soon, but it does not need to for energy stocks to go up. Bob Ryan, BCA’s chief commodity strategist, sees Brent averaging $65/bbl in 2021, $19 above what is currently priced in forward markets. Q: What about materials and industrial stocks? They are also overrepresented in value indices. A: Both materials and industrials tend to outperform the broader market when global growth accelerates (Chart 18). To the extent we expect global growth to rise, this is good news for these two sectors. They also trade at attractive valuations. Q: How does China figure into this value/growth debate? A: As we saw during the 2001-2007 period, strong Chinese demand for commodities and industrial goods benefits value indices. Even though trend Chinese GDP growth has decelerated over the past decade, the Chinese economy is five-times as large as it was back then. In absolute terms, Chinese consumption of most metals continues to increase (Chart 19). Chart 18Materials And Industrials Usually Outperform When Growth Accelerates Materials And Industrials Usually Outperform When Growth Accelerates Materials And Industrials Usually Outperform When Growth Accelerates Chart 19Chinese Consumption Of Most Metals Continues To Rise Chinese Consumption Of Most Metals Continues To Rise Chinese Consumption Of Most Metals Continues To Rise   Chart 20 shows that Chinese GDP would need to grow by about 6% per year over the next decade to keep output-per-worker on track to converge with, say, South Korea by the middle of the century. Thus, Chinese demand for natural resources and machinery is unlikely to weaken anytime soon. Chart 20China Still Has Some Catching Up To Do China Still Has Some Catching Up To Do China Still Has Some Catching Up To Do Q: Let’s wrap up. What final tips would you give investors who want to pivot towards value? A: There are a number of ETFs that track value indices. We expect them to outperform the broad indices over the coming years. For investors who want even higher returns, a selective approach would help. Distinguishing between value stocks and value traps is not easy. True value stocks have often congregated in the shadows of the market, where there is limited analyst coverage and thin institutional ownership. The small-cap sector offers more opportunities for finding such mispriced stocks. Hence, it is not surprising that historically, the value premium has been greater in the small cap realm. The same is true for emerging markets and smaller developed economies (Chart 21).1 Thus, investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Chart 21AHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Pivot To Value Pivot To Value Chart 21BHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Pivot To Value Pivot To Value   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes   1 Please see Global Asset Allocation Special Report, “Value? Growth? It Really Depends!” dated September 19, 2019. Global Investment Strategy View Matrix Pivot To Value Pivot To Value Current MacroQuant Model Scores Pivot To Value Pivot To Value