Sectors

Special Report

Highlights Energy Bond Model: This report presents models for both investment grade and high-yield Energy bond excess returns. The models are based on overall corporate bond index spreads and the oil price. They can be used to generate Energy bond excess return forecasts for investment horizons up to 12 months. IG Energy Bonds: Our model suggests that investment grade Energy bond excess returns will be strong during the next 12 months under likely economic scenarios. We recommend an overweight allocation to investment grade Energy bonds.  HY Energy Bonds: Our models imply positive excess return outcomes for high-yield Energy bonds, but we remain concerned about near-term default risk for lower-rated issuers. We advise a cautious (neutral) allocation for now. Part 2 of this Special Report, to be published next week, will dig further into the high-yield Energy index on an issuer-by-issuer basis. Feature Table 1Energy Bond Excess Return* Scenarios (12-Month Investment Horizon) During the past couple of months we’ve published several reports that take more detailed looks at specific industry groups within both the investment grade and high-yield corporate bond markets. So far, we’ve published reports on: Banks1 Healthcare & Pharmaceuticals2 Technology3 This week and next week, we continue our series with a deep dive into Energy bonds that is split between two Special Reports. This week’s report develops a model for Energy bond excess returns based on overall corporate bond index excess returns and the oil price. In next week’s report, we look more deeply into the characteristics of the investment grade and high-yield Energy indexes. We also consider the outlooks for the five sub-categories of Energy debt: Independent, Integrated, Oil Field Services, Refining and Midstream. A Model Of Energy Bond Excess Returns A good starting point for modeling the excess returns of any corporate bond sector is to combine the sector’s Duration-Times-Spread (DTS) ratio with the excess returns of the overall corporate bond index.4 Please note that “excess returns” refers to returns relative to a duration-matched position in Treasury securities. The DTS-only model explains 86% of the variance in monthly investment grade Energy excess returns. Considering only a sector’s DTS ratio, we can define the following model for monthly investment grade Energy excess returns: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP Where: EXSENRG = Monthly investment grade Energy excess returns versus duration-matched Treasuries (DTSENRG / DTSCORP) = The investment grade Energy sector’s DTS ratio EXSCORP = Monthly investment grade corporate index excess returns versus duration-matched Treasuries For example, the current DTS for the investment grade Energy sector is 18. The DTS for the overall corporate index is 12. This means that the DTS ratio for the Energy sector is 18/12 = 1.5. According to our simple model, we would expect Energy sector excess returns to be 1.5 times corporate index excess returns in any given month. It turns out that our simple model performs quite well. Chart 1 shows monthly investment grade Energy sector excess returns versus our model’s prediction. Our sample period spans from 1997 to the present. Specifically, we find that our model explains 86% of the variance in monthly investment grade Energy excess returns. Chart 1Investment Grade Energy Monthly Excess Returns*: DTS-Only Model** The simple (DTS-only) model’s performance is admirable, but we can do slightly better if we also incorporate the oil price. Chart 2 shows a statistically significant relationship between the residual from the DTS-only model and the monthly change in the Brent crude oil price. Chart 2Residual From DTS-Only Model* Versus Oil Price Combining the models shown in Charts 1 and 2, we get a model for investment grade Energy monthly excess returns based on both corporate index excess returns and the oil price: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP + (376.84 * ∆ ln Oil) – 1.0587 Where excess returns are measured in basis points and (∆ ln Oil) = the monthly change in the natural logarithm of the Brent crude oil price. Chart 3 shows the historical performance of this complete model. Note that the model now explains 91% of the historical variance of investment grade Energy excess returns, 5% more than the initial DTS-only model. Chart 3Investment Grade Energy Monthly Excess Returns*: Complete Model (DTS & Oil)** Robustness Checks We performed the same analysis for 3-month, 6-month and 12-month excess returns and found very consistent results (Table 2). The oil price adds significant explanatory power to the model in each case, but the bulk of variation in investment grade Energy excess returns is determined by trends in the overall corporate index spread. Table 2Investment Grade Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) We also find consistent results when looking at high-yield Energy returns (Table 3). Once again, the bulk of excess return variation is explained by multiplying the DTS ratio and the benchmark index’s excess returns. The oil price also adds a statistically significant amount of extra explanatory power. Table 3High-Yield Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) One final observation is that oil explains a greater proportion of the variation in Energy sector excess returns if we limit our sample period to the past few years. Specifically, we re-ran the monthly iterations of both the investment grade and high-yield models from July 2014 to present. We found that the DTS component of the model explains the same amount of excess return variation as it did for the full sample. However, we also found that the oil price has a much greater impact if the sample is limited to the past six years (Table 4). Table 41-Month Excess Return* Models: Full Sample (1997 - Present) Versus Recent Sample (2014 - Present) Energy Excess Return Scenarios Finally, using our 12-month excess return models for investment grade and high-yield Energy, we can project likely outcomes for Energy excess returns versus Treasuries for the next 12 months. All we have to do is assume different outcomes for the overall benchmark index spread (either the investment grade or High-Yield index, depending on the model) and the oil price.5 The results of this scenario analysis are shown in Table 1. Starting with investment grade Energy, we see that all scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. This is true even in a scenario where the oil price falls by $20 during the next year. Our model also suggests that a $10-$20 increase in the oil price during the next 12 months will keep Energy excess returns positive, even in a modest “risk off” scenario where the corporate index spread widens by 25 bps. All scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. The story is similar in high-yield, though returns are much more variable. For example, high-yield Energy is projected to lose money relative to Treasuries in a scenario where the junk index spread tightens 50 bps and the oil price falls by $20. There are no scenarios where benchmark index spread tightening coincides with negative Energy excess returns in the investment grade model. Chart 4Watch For Falling Inventories In terms of likely scenarios for the next 12 months, we anticipate further spread tightening for corporate bonds rated Ba & above. But we also view B-rated and lower spreads as too tight given the default outlook for the next 12 months and the fact that these lower-rated issuers usually can’t access the Fed’s emergency lending facilities.6 With that in mind, we would confidently bet on investment grade index spread tightening during the next 12 months, but can envision high-yield spread widening driven by the lower credit tiers. On oil, our Commodity & Energy Strategy service forecasts an average Brent crude oil price of $65 in 2021, a sizeable increase relative to the current price of $43.27.7 Our strategists expect a significant supply contraction in the second quarter of this year that will cause the oil market to enter a physical deficit in the second half of 2020. Investors can look for falling storage levels in the coming months to confirm whether that forecast is playing out (Chart 4). Escalating tensions between the US and Iran pose an additional near-term upside risk to oil prices. This risk increased during the past few weeks as a string of mysterious explosions struck several Iranian military and economic facilities.8 However, with major oil producers now operating significantly below capacity, any net impact on oil prices from a supply disruption in the Persian Gulf would likely be short-lived. Investment Conclusions All in all, our bullish outlook for both investment grade corporate bond spreads and the oil price makes us inclined to overweight investment grade Energy bonds on a 12-month horizon. Within high-yield, our model also suggests that we should have a bullish bias toward Energy, but we remain concerned about default risk for lower-rated (B & below) Energy issuers during the next few months. We will dig into the high-yield Energy index on an issuer-by-issuer basis in Part 2 of this report, to be published next week. For now, we advise a more cautious stance toward high-yield Energy.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 5 We translate changes in benchmark index spread into 12-month excess returns using the formula: excess return = option-adjusted spread – (duration * change in option-adjusted spread) 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, “Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks”, dated June 18, 2020, available at ces.bcaresearch.com 8 Please see Geopolitical Strategy Special Alert, “Cyber-Rattling In The Middle East”, dated July 10, 2020, available at gps.bcaresearch.com

Special Report

Dear Client, Next Monday, July 20, we will be hosting our quarterly webcast, one at 10am EST for our US and EMEA clients and one at 9pm for our Asia Pacific, Australia and New Zealand clients; our regular weekly publication will resume on Monday July 27, 2020. Kind Regards, Anastasios Highlights A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. A Biden presidency would lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. Democrats would remove the Senate filibuster. Yet the macro agenda is reflationary. A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps. While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Feature Online political betting markets are still not fully pricing our “Blue Wave” scenario for the US election this year. The odds are closer to 50%-55% than 35%. Hence the equity market, especially the NASDAQ, is complacent about rising political risks to US equity sectors (Chart 1). The immediate risk to the rally is not politics but the pandemic, namely the COVID-19 resurgence in the United States, which is causing governors of major states like Texas, California, and Florida to slow down the economic reopening. The US’s failure to limit the spread of the virus has not yet led to a spike in deaths in aggregate, but it is leading to a spike in major states like Texas and Florida (Chart 2). Deaths are ultimately what matter to politicians and financial markets, since governments will not shut down all of society for less-than-lethal ailments. Fear will weigh on consumer and business confidence, including fear of a deadly second wave this winter. Near-term risks to the equity rally are elevated. Chart 1Blue Wave Expected, Equities Unconcerned Chart 2COVID-19 Outbreak Still A Risk Beyond this risk, the driver of the cyclical rally is the gargantuan monetary and fiscal stimulus – and more is on the way. President Trump wants another $2 trillion coronavirus relief package, while House Democrats already passed a $3 trillion package to demonstrate their election platform that government should take a greater role in American life. Senate Republicans (and reportedly Vice President Mike Pence) want a smaller $1 trillion bill but will capitulate in the face of a growing outbreak and any financial turmoil. Congress is highly likely to pass a new relief bill before going on recess on August 10. If COVID-19 causes another swoon in financial markets and the economy, then this congressional timeline will accelerate. America’s total fiscal stimulus for 2020 is rapidly approaching 20% of GDP, or 7% of global GDP (Chart 3). Thus it is understandable that the market has not reacted negatively to an impending blue wave election. Bipartisan reflation is overwhelming the Democratic Party’s market-negative agenda of re-regulation, tax hikes, minimum wage hikes, energy curbs, price caps, and anti-trust probes. Moreover the Democrats’ agenda also includes social and infrastructure spending, cheap immigrant labor, and less hawkish trade policy ex-China, which are all reflationary. Chart 3US Stimulus Greater Than Global – And Rising In short, over the next year, the US is not lurching from massive stimulus to a mid-term election that imposes budget controls and “austerity,” as occurred in 2010, but rather from massive stimulus to a likely Democratic sweep that will be fiscally profligate (Charts 4A & 4B). After all, Democrats are openly flirting with modern monetary theory. Chart 4ADeficits Would Soar Under Democrats Chart 4BDemocrats Would Be Ultra-Dovish On Fiscal Debt monetization is the big change, regardless of the election, which makes investors cyclically bullish. China is also bound to provide massive fiscal-and-credit stimulus because its first recession since the 1970s is threatening the Communist Party’s source of legitimacy (Chart 5). The European Union is uniting under a banner of joint debt issuance to fend off deflation. Bottom Line: Near-term risks to the exuberant post-lockdown rally abound, but the cyclical view remains constructive due to the ultimate policymaker stimulus put. Chart 5China Loosens Credit And Fiscal Taps Pre-Election Volatility And Post-Election Equity Returns Volatility normally rises ahead of US elections and it could linger in the aftermath given extreme polarization and the risk of vote recounts, contested results, Supreme Court interventions, and refusals by either candidate to concede. This is a concern in the short run but not the long run. US equities will grind higher over the long run regardless of the election outcome. Stocks normally rise by 10% in the 12 months after a presidential election that yields single-party control, though the upside is smaller and the initial downside is bigger than is the case with a gridlocked government (Chart 6, top panel). In cases of gridlock – which is virtually assured if Trump wins – the equity pullback after the election is just as deep but tends to be later in coming. On average stocks rise by the same amount after 12 months in either case (Chart 6, bottom panel). Thus political risks are primarily relevant in their regional or sectoral effects, though investors should take note that a Democratic sweep probably limits next year’s upside. Chart 6Equities Have Less Upside Under Democratic Sweep There are two likely scenarios. The first is the risk that President Trump makes a historic comeback and wins re-election, with Republicans retaining the Senate. Subjectively we put Trump’s odds at 35% though our quantitative model suggests they could be as high as 44%. The second scenario is our base case that the Democratic Party wins the Senate as well as the White House. In this scenario, the Democrats will prove more left-wing and anti-corporate than the market currently expects. Bottom Line: A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. However, history shows that a clean sweep limits the market’s upside risk. And full Democratic rule entails major political risks that have a regional and sectoral character. Biden And The Blue Wave Our expectation of a blue sweep is not based only in polling – which is uniformly disastrous for Trump as we go to press – but in the surge in unemployment. The basis for investors to view Biden as a risk-on candidate is driven by the macro and market views outlined above, not political fundamentals. From the political point of view, Biden may prefer to govern as a centrist, but victory in the Senate would remove constraints on his party’s domestic agenda. He would move to the left. Indeed, a Democratic sweep would mark a paradigm shift in domestic economic policy that is negative for corporate profits and the capital share of national income. It would unleash pent-up ideological and generational forces in favor of redistributing wealth and restructuring the economy. Progressivism would have the tendency to overshoot and create negative surprises for investors (Chart 7). Unlike 2008-10, when Republicans were last out of power, Republicans this time would be divided over Trump and populism and would be unlikely to recuperate as quickly. Chart 7Democratic Party Would Focus On Inequality Biden would end up governing to the left of the Obama administration, promoting Big Government while restricting Big Business and re-regulating Wall Street banks. A sharp leftward turn would be in keeping with the trend in the Democratic Party and the generational shift in the electorate (Chart 8). Only if Republicans pull off a surprise and keep the Senate despite losing the White House (~10% chance) would Biden be forced to govern as a true centrist. Even then Biden would oversee a large re-regulation of the economy through executive powers alone (Chart 9).1 Chart 8Generational Shift Favors Wealth Redistribution Chart 9Biden Would Re-Regulate The Economy Additional reasons to expect a left-wing policy overshoot:  · Presidents tend to succeed in passing their initial legislative priority after an election. This is incontrovertible when they control both chambers of Congress, as Obama showed in 2009 and Trump showed in 2017.2 · Biden will have huge tailwinds. He will not be launching a new agenda so much as restoring a policy status quo in most cases (laws and agreements that Trump either revoked or refused to enforce). He will also benefit from majority popular opinion and support of the bureaucracy and media (Chart 10). · Biden and the Democrats will be even more determined not to “let a good crisis go to waste” after having witnessed the Obama administration’s frustrations the last time the party took over in a sweeping victory on the back of a national disaster. · Democrats will not hesitate to use the budget reconciliation process to pass their first priority legislation with a mere 51 votes in the Senate. This is how Trump passed the Tax Cut and Jobs Act (TCJA). This is also how progressive stalwart Howard Dean believed the party should have passed a public health insurance option in 2009. This means Biden will be capable of increasing the corporate tax rate higher than 28%, pass a minimum 15% tax rate for corporations, and raise the capital gains tax and individual taxes. Chart 10Popular Opinion Would Boost Biden Administration · Contrary to consensus, Democrats are likely to remove the filibuster in the Senate – enabling bills to pass with a simple majority rather than the 60/100 votes required to close off debate. Yes, some moderate Democrats have already spoken out against “going nuclear” and changing such a critical norm. But populism and polarization are the driving forces in US politics today and we would advise investors not to bet heavily on “norms.” If Republicans prove capable of obstructing major legislative initiatives in the Senate, then Democrats, remembering obstructionism in the Obama years, will go nuclear to enact their progressive agenda. This would mark a massive increase in uncertainty for investors on everything from taxes to wages to anti-trust laws. Bottom Line: Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. If Republicans are obstructionist, Democrats will remove the filibuster. Biden’s Legislative Priorities First, Biden would seek to restore and expand the Affordable Care Act (Obamacare). The party has fixated on health care since 1992. Investors are complacent about Biden’s plan. A public health insurance option will be a major new progressive initiative that would undercut private health insurers over time (Chart 11). The bill will also impose caps on pharmaceutical prices and allow imports, reducing Big Pharma’s pricing power (Chart 12). Chart 11Health Insurers Will Be Undercut By Biden Public Option Investors are also complacent about taxation. Biden will pay for health care reform by partially repealing the Tax Cut and Jobs Act. He has proposed raising the corporate rate from 21% to 28%, but this could go higher and still fall well below the 35% that Trump inherited in 2017. Chart 12Big Pharma Faces Price Caps A rate above 28% would be a major negative surprise for financial markets and yet it is an obvious way for Democrats to raise much-needed revenue. Biden also intends to pass a 15% minimum tax that would hit large firms adept at paying lower effective taxes. Capital gains taxes and individual income taxes for high-earners could also rise by more than is expected (Table A1 in Appendix). Second, Biden will seek to offset the negative growth impact of falling stimulus and rising taxes by enacting large “Great Society” fiscal spending on infrastructure, the Green New Deal, education, and other non-defense discretionary spending (Table A2 in Appendix). Even defense spending will be largely kept flat due to rising geopolitical conflicts. As mentioned, this part of the agenda is reflationary, especially relative to a scenario in which fiscal largesse is normalized more rapidly by a Republican Senate. The redistribution effects would be marginally positive for household consumption, but marginally negative for corporate investment. On immigration, Biden will follow the Obama administration in pursuing a path to citizenship for “Dreamers” (illegal immigrants brought to the US as children) and taking executive action to allow more high-skilled workers and refugees, defer deportation of children and families, and reduce border security enforcement. There will be some constraints due to the risk of provoking another populist backlash, but comprehensive immigration reform is possible. This would be positive for potential GDP, agriculture, construction, and housing demand on the margin (Chart 13). On trade, Biden will have to steal some thunder back from Trump if he is to win the election and maintain the Rust Belt. He will concentrate his protectionist policy on China, while removing virtually all risk of a trade war with Europe, Mexico, or other partners. China may get a reprieve at first but Biden will ultimately prove hawkish (Chart 14). Investors are underrating the use of import duties to punish countries like China for carbon-intensive production. Chart 13Biden Lax Immigration Policy A Boon For Housing Biden will take a multilateral approach and restore international agreements that Trump revoked. Joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) is not a massive change given that even Trump agreed to trade deals with Canada, Mexico, and Japan. But it is marginally positive for the US-friendly trade bloc while contributing to the US economic decoupling from China (Chart 15). Chart 14Watch Out, Biden Won’t Be Too Dovish On China In Office! Chart 15Biden Eliminates Risk Of Global Trade War Ex-China On foreign policy, Biden will face the ongoing US-China cold war. He will also seek to restore the Iranian nuclear deal of 2015. The removal of Iran risk is positive for European companies with a beachhead in Iran as well as for the euro more generally, since regional instability ultimately threatens the EMU with waves of refugees (Chart 16). Chart 16Biden Removes Tail-Risk Of Iran War Bottom Line: A Biden presidency will lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. But Biden’s agenda is mostly reflationary in other respects. Blue Wave Equity Market And Sector Implications The most profound implication of a blue sweep of government is an SPX profit margin squeeze that will weigh heavily on EPS. Importantly, there are two clear avenues through which net profit margins will suffer: An increase in the corporate tax rate. A rise in labor’s share of national income. As a reminder these are two of the four primary profit margin drivers we discussed in detail in our “Peak Margins” Special Report last October (Chart 17). The other two are selling price inflation and generationally low interest rates. Odds are high that all four drivers are slated to dent S&P 500 margins. With regard to corporate tax rates, the mirror image of the one time fillip that SPX EPS enjoyed in 2018, owing to Trump’s 1.2% increase in fiscal thrust that year, is a drop in S&P 500 profits given that a Biden presidency will boost the corporate tax rate from 21% to 28% or higher. In early-December 2017 we posited that SPX EPS would jump 14% on the back of that fiscal easing package, which is very close to what actually materialized. Chart 18 compares S&P 500 EBIT growth with S&P 500 net profit growth. The 2018 delta hit a zenith of 16%. Chart 17Profit Margin Drivers Chart 18Spot Trump's Tax Cut Assuming a blue wave, the opposite would happen, i.e. net profit growth would suffer an 11% one-time contraction according to our calculations (Table 1). The bill would pass in 2021 and take effect in 2022. Importantly, Table 1 reveals that the hardest hit GICS1 sectors are real estate, tech and health care, and the ones faring the best are consumer staples, industrials and energy. Table 1What EPS Hit To Expect? Table 2S&P 600/S&P 500 Sector Comparison Table The second way SPX margins undergo a squeeze is via climbing labor costs. Labor costs have been increasing since 2008/09 (labor’s share of income shown inverted, second panel, Chart 17), coinciding with the apex of globalization (third panel, Chart 17). A Biden presidency would also more than double the federal minimum wage to $15 per hour for all workers over six years. These policies would take a bite out of corporate profits by knocking down profit margins. While S&P 500 EPS maybe recover back to trend near $162 in 2021, they would gap lower in 2022 which is not at all priced in sell side analysts’ EPS expectations of $186. A blue sweep would produce some other US equity sore spots. Small caps would suffer disproportionately compared with their large cap brethren as would banks, health care, and parts of tech (see below). Chart 19 shows that according to the National Federation of Independent Business (NFIB) survey, small and medium enterprise (SME) owners grew extremely concerned about higher taxes and red tape by the end of the Obama presidency. When President Trump got elected, he cut back these fears drastically. Today concerns about taxes and regulation are probing multi-decade lows, which implies that SMEs are not prepared for the regulatory shock that a Biden administration has in store for them (Chart 19). These small business concerns will resurface with a vengeance if there is a blue sweep this November. The implication is that at the margin small caps would underperform their large cap peers, especially given that small cap indexes sport 1.5x the financials sector market cap weight compared with the SPX (Table 2). Bottom Line: A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps as they will have to vehemently contend with rising red tape and taxes. Chart 19Re-Regulation Will Weigh On Small Business Sentiment Historical Parallel Of Blue Sweeps And Select Sector Performance A more detailed discussion on banks, health care, and technology sectors is in order, as they are the likeliest candidates to be at the forefront of Biden’s regulatory, wage, and tax policies. There are two recent episodes when US presidential elections resulted in a blue sweep, namely in 1992 and 2008. Both times, Democrats took control of both chambers of Congress and the White House but eventually surrendered this trifecta two years later during the 1994 and 2010 mid-term elections.3 Charts 20 & 21highlight the S&P banks, S&P health care, and S&P IT sectors’ performance during the last two blue waves. In both cases, banks remained flat to down; health care equities went down sharply; while tech stocks had mixed results. Tech took off in 1993-1994, but remained flat in 2009-2010 (excluding the recovery rally off the recessionary trough). Armed with this general roadmap, we now dive deeper into each of these three sectors for a more detailed discussion. Chart 20Not Everyone Is A Fan... Chart 21...Of The Blue Sweeps Banks Face High Risk Of Re-Regulation There is little doubt that Biden will re-regulate Wall Street, especially after the recent COVID-19-related watering down of the Dodd-Frank Act. Big banks are popular scapegoats. In fact, Biden already moved to the left on bankruptcy reform by adopting Massachusetts Senator Elizabeth Warren’s progressive proposal after a long drawn-out battle over this issue between them. Both of the earlier blue wave elections proved challenging for the banking sector. In addition, banks are already under pressure from the recent Fed stress tests. There are high odds that a number of banks will further cut or suspend dividend payments in coming quarters in line with the Fed’s guidance, especially if profits take a big hit, as we expect. Currently, the market is underestimating the Biden threat to the banking sector as a substantial divergence has materialized between the banks’ relative performance and the blue sweep probability series (Chart 22). As the election draws closer, a repricing in the banking sector is likely looming. Chart 22Mind The Divergence Health Care Stands To Lose The Most From A Blue Sweep The health care sector was the only sector we analyzed that clearly underperformed in both 1992 and 2008 blue waves. Health care reform will be Biden’s top priority, as outlined above. Biden will also go after pharma manufacturers. As a reminder, while Medicare has substantial bargaining power with hospitals and other drug providers due to the number of Americans enrolled, it has no leverage when it comes to pharma manufacturers leaving them free to set prices at will. Biden intends to end such practices, enabling Medicare to bargain for prices. He also wants to link the rise in drug prices to inflation and allow foreign imports. These actions will put a cap on pharma manufacturers’ pricing power. Importantly, the S&P pharmaceuticals index is the dominant player within the S&P health care universe comprising 29% of the entire health care sector. A direct hit to pharma earnings will be a hard pill to swallow, especially if the S&P biotech index (comprising 17% of the S&P health care market cap weight) is included that are similar to Big Pharma as they manufacture blockbuster drugs. In fact, as the American electorate is getting more interested in Biden’s campaign, the market is pricing in a tougher environment for US pharmaceuticals (Chart 23). Markets can rely on the fact that Biden has rejected a single-payer government health system (“Medicare For All”) – this policy position helped him beat Vermont Senator Bernie Sanders for the Democratic nomination. However, he is proposing a public insurance option, which will have the ability to absorb losses indefinitely and will have the insurance regulators at its side. Thus private health insurers will be undercut. Chart 23Beginning Of The End A public option is also seen even by promoters as a “Trojan Horse” that will increase the odds that Democrats will move toward a single-payer system in 2024 or thereafter. Thus the risk/reward ratio skews further to the downside for the S&P health care sector. Will Technology Escape Unscathed? In the wake of COVID-19, and facing geopolitical competition in cyber space, a Biden administration will also seek a much stronger regulatory handle on Big Tech. Social media companies are already buttering up to the Democrats to ensure that Biden maintains the Obama administration’s alliance with Silicon Valley and does not pursue extensive anti-monopoly and anti-trust investigations. Yet the tech sector cannot avoid heightened scrutiny due to its conspicuous gains in the midst of an economic bust – this is what normally prompts anti-trust actions (Chart 24). The Democrats will pursue probes into data privacy and excessive market concentration and will demand stricter patrolling of the ideological space in battles that will be adjudicated by the courts. Chart 24How Much Is Too Much? Should the monopolistic tech stocks – including FB and GOOGL, which are now classified under the GICS1 S&P communication services index – be forced to sell their crown jewel assets, then a hit to earnings is a given. The S&P technology sector plus FB & GOOGL commands more than one third on the SPX index, meaning that a dent in tech earnings will have negative ramifications for the entire market. In previous research, we drew a parallel with the chemicals industry and the regulatory shock that came in 1976 when the Toxic Substance Control Act (TSCA) was introduced.The bill pushed chemical stocks off the cliff as investments in the index became dead money for a whole decade – until 1985 when chemicals finally troughed (Chart 25) In the near future, a similar shock might come as a result of privacy-related regulation. A series of anti-monopoly or anti-trust probes, whether by the US or the EU, would make investors cautious about their tech exposure. While the probes may not result in a break-up, the heightened uncertainty would dampen the allure of tech stocks. The pattern of anti-trust probes in US history is that a probe first causes a selloff in the stock of the company investigated; then another selloff occurs when it is clear that a break-up is a real option under consideration; then a buying opportunity emerges either when the company is cleared or when the long dissolution process is completed. Bottom Line: While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Chart 25Will History Rhyme?     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Appendix Table A1Biden Would Raise $4 Trillion In Revenue Over Ten YearsTable A2Biden Would Spend $6 Trillion In Programs Over Ten Years   Footnotes 1     Republicans have 13 Senate seats at risk this cycle while Democrats have only four. More conservatively, Republicans have nine at risk while Democrats have two. Opinion polling has Democrats leading in seven out of nine top races, and tied in the other two – including states like Kansas where Democrats should have zero chance. Most of these races are tight enough that they will hinge on whether the election is a referendum on Trump. If so, Democrats will likely win the net three seats they need to control the chamber. Most likely they will have a 51-49 majority if Biden wins, though a 52-48 balance is possible.   2     The Republican failure to repeal and replace Obamacare in 2017 but success in passing the Tax Cuts and Jobs Act reflects the fact that political constraints are higher on taking away an entitlement than they are on giving benefits (tax cuts). 3    As noted above, however, investors today cannot be assured that Republicans will come roaring back in 2022 to impose constraints. Trump’s populism threatens to divide the party if he loses and delay its ability to regroup and recover.  

Bob Farrell famously remarked “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.” This could not be truer than today’s market, especially the NASDAQ. Not only are the top five SPX stocks comprising roughly 23% of the index, but the same five tech titans carry a 40% weight in the NASDAQ composite. This seems excessive and carries a lot of risk in case of even a mild disappointment. True, the collapse in interest rates has boosted the NASDAQ forward P/E to the stratosphere, but the longer these high flying stocks defy gravity the more painful the eventual snap will be (bottom panel). Already there are tentative signs of trouble brewing beneath the surface. NASDAQ breadth is sinking like a stone and this has proven a reliable leading indicator in the recent past, warning that a pullback is looming (top panel). Finally, the hypersensitive chip stocks are suffering from exhaustion, unable to outperform the tech titan led NASDAQ (middle panel). Any hiccups in the tech space will negatively reverberate in the SPX: currently the S&P tech sector plus the FANG (FB, AMZN, NFLX & GOOGL) comprise 40% of the S&P 500. Thus as tech goes so does the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.    

Special Report

Highlights The underperformance of value versus growth has been a reason behind the dollar bull market rather than a consequence of it. The rationale is that the catalyst for any sector to outperform is return on capital rather than the cost of capital. The outperformance of health care and technology has been on the back of rising profits, rather than just investor exuberance and/or low bond yields. Cyclical currencies with a high concentration of value sectors have tracked the relative performance of their representative bourses. A reversal will require value sectors to start outperforming on a sustainable basis. It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to take place every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. An outperformance of value versus growth will favor cyclical currencies. We are long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Feature The usual market narrative is that for non-US stocks to outperform, the dollar has to decline. This also applies to value stocks that have a higher weighting outside the US, compared to growth stocks. At the center of this premise is that the dollar is a reserve currency. As a result, three reasons emblem the view. First, a fall in the dollar eases financing costs for non-US corporations borrowing in dollars. Second, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. And finally, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. On the surface, this makes sense. But digging deeper into the thesis, it appears that a lower US dollar is a necessary but not sufficient condition for non-US (or value) stocks to outperform. The reason is that profit growth (the ultimate driver of stock prices) is more contingent on productivity gains rather than translation effects. As such, the value-versus-growth debate is important, not only for the sectors involved, but for currency strategy as well. A Two-Decade Postmortem Chart I-1Value/Growth Turns Before The Dollar Chart I-1 plots the MSCI global value index versus its growth counterpart, superimposed against the US dollar. Two trends become apparent: The relative performance of value versus growth typically bottoms or peaks ahead of turns in the US dollar. The relationship between the value/growth ratio and the US dollar is not always in sync. There was a period of decoupling after the financial crisis, and, more recently, in 2015-2016. This was also the case in the ‘80s and around the Asian crisis in the late ‘90s. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Meanwhile, both equity and currency relative performances tend to be in sync (Chart I-2A and Chart I-2B). Chart I-2ACurrencies Follow Relative Equity Performance Chart I-2BCurrencies Follow Relative Equity Performance According to the MSCI classification, information technology and health care are the biggest components of the growth index – a whopping 49%. This is in stark contrast to financials and industrials, which make up 33% of the value index. Not surprisingly, currencies with a heavy value weighting in their domestic bourses (Table I-1) have suffered indiscriminately compared to their growth counterparts, over the last decade. Table I-1Sector Weights Across G10 Take the US and Switzerland, which have the highest equity concentration in traditional growth sectors, at over 60%. Both the US dollar and Swiss franc have held up remarkably well in trade-weighted terms since the onset of the dollar bull market (Chart I-3). Likewise, it would have been a miracle for petrocurrencies (CAD, NOK and AUD) to hold up amid the recent underperformance in energy and financials. Chart I-3Style Tilt Drives Currency Performance This suggests that at minimum, the underperformance of value versus growth has been a reason for the dollar bull market rather than a consequence of it. Chicken And Egg Problem? What about the narrative that a decline in the dollar greases the engine of non-US stocks? Yes, but not entirely. It is certainly the case that most global trade and financing is conducted in US dollars, and so a fall in the US dollar (commensurate with lower interest rates) leads to easier global financial conditions. As Chart I-4 clearly illustrates, corporate spreads abroad have been tightly correlated to dollar volatility. A lower dollar also eases repayment costs for non-US borrowers. Chart I-4The Dollar And Funding Stresses A lower dollar also boosts resource prices through the numeraire effect (Chart I-5). Meanwhile, rising commodity prices flatter industries tied to the resource value chain such as industrials, materials, and energy. Second-round economic effects also buffet other cyclical industries such as retail and hospitality, which help boost the domestic equity index. That said, the rally in commodities, value stocks, and emerging market share prices in 2016-2017 occurred despite a dollar that was flat-to-higher – so the causality versus effect link is not always trivial. Part of the reason is that, over the past few years, both emerging market and other non-US corporates have diversified their sources of debt funding. Euro- and yen-denominated debt have been surging (Chart I-6), which has kept their cost of capital low, even as the dollar has risen. Chart I-5Tied To The Hip Chart I-6Lots Of Non-US Debt It is also important to note that in commodity bull markets, prices tend to rise in all currencies, including domestically (Chart I-7). This is crucial for sector outperformance since the translation effect for profits will otherwise be negative, given local-currency fixed and variable costs. This suggests that demand is the driving force behind bull markets in commodity prices and cyclical stocks, rather than a lower greenback. Chart I-7Commodity Bull Markets In Different Currencies This demand has come in the form of Chinese stimulus. Chart I-8 shows a close correlation between excess liquidity in China (a measure of the centripetal force from Chinese credit) and resource share valuations. Ergo, a key barometer for value to outperform growth is that Chinese demand picks up, plugging the hole in exactly the sectors that have borne the brunt of deleveraging in recent years. Chart I-8China And Commodities A look at corporate balance sheets and income statements corroborates this view. Growth has outperformed value on the back of a re-rating, but also on profitability. Chart I-9A and Chart I-9B rank G10 equity bourses on the basis of return on equity and their corresponding price-to-book ratios. Not surprisingly, the winners of the last decade have had the biggest returns on equity, as was the case for the winners during the prior decade. Chart I-9AMarkets Bid Up High Returns To Capital Chart I-9BMarkets Bid Up High Returns To Capital As such, the catalyst for any sector to outperform is return on capital rather than the cost of capital. Structural Shift? There is some evidence that the underperformance of value versus growth could be structural. For one, being a value manager seems to be following the fate of telephone switchboard operators in the early 1900s. Perhaps the advent of computer trading systems has systematically eroded the value premium. As such it is becoming more and more difficult, even for the most skillful value managers, to beat their own index. An inability for value sectors to outperform will be a key risk to a dollar-bearish view. Work done on our in-house Equity Trading Strategy platform corroborates this view. Since about 2014, a long/short strategy based on the best value stocks relative to the worst in terms of a swath of fundamental valuation metrics has been flat compared to a more blended strategy (Chart I-10). According to our quantitative specialists, the best value can be found in European countries such as Sweden, Denmark, the Netherlands, and Germany (Chart I-11). Surprisingly, their proprietary value model rate Switzerland and New Zealand quite highly, despite a clear defensive bias in these equity markets. Unsurprisingly, some of the countries that have had the weakest currencies in the last decade such as Sweden and the Eurozone members have highly favored value sectors. Chart I-10A Dearth Of Value Managers Chart I-11Lots Of Value Outside The US Going forward, a few things could change. One of the primary reasons why growth has outperformed value has been the drop in bond yields, which has increased the appeal of companies with low payout ratios and much more backdated cash flows (Chart I-12). But as countries from Japan to Australia implement yield-curve controls at the zero bound, the capitalized dividend from low yields is bound to be exhausted. Meanwhile, any rise in yields will favor deep-value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12A Lower Discount Favors Long-Duration Assets Second, falling global trade and the proliferation of Environmental, Social and Governance (ESG) investing has hammered traditional industries such as energy and autos. Part of this trend is structural, but there is also a cyclical component. For the auto industry in particular, auto sales are strongly (inversely) correlated to the unemployment rate, and as more economies reopen, car sales should pick up. Meanwhile, traditional auto and energy companies are stepping up their electric vehicle and alternative energy strategies, meaning the first-mover advantage for the avant-gardes like Tesla and Nikola could be eroded. Finally, valuation tends to be a key catalyst near recessions. Given that over the years, one of the more consistent drivers of long-term equity returns has been the valuation starting point, this favors non-US stocks (Chart I-13A, Chart I-13B, Chart I-13C, Chart I-13D). Not surprisingly, the currencies that are the most undervalued in our models1 also have cheap equity markets. Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive, according to our Equity Trading Strategy platform (Chart I-14). This suggests some measure of convergence is due. Chart I-13AProspective Returns Higher Outside The US Chart I-13BProspective Returns Higher Outside The US Chart I-13CProspective Returns Higher Outside The US Chart I-13DProspective Returns Higher Outside The US Chart I-14Attractive Growth Stocks Outside The US It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to occur every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. Portfolio Construction Chart I-15CAD/NZD And Relative Stocks An outperformance of value versus growth will favor cyclical currencies. The catalyst will have to be improving return on capital from value sectors, but the valuation starting point is already quite compelling. Meanwhile, even traditional growth sectors are still cheaper outside the US. We are already selectively long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Should value stocks gain more widespread appeal, we will add the Eurozone and emerging market currencies to this basket. Elsewhere, a tactical trading opportunity has also opened up to go short the NZD/CAD cross. Little known is that the New Zealand stock market is the most defensive in the world (previously referenced in Table I-1). This has helped keep the New Zealand dollar higher than would have otherwise been the case. Should value start to outperform growth, this will favor the CAD/NZD cross (Chart I-15). While we commend Prime Minister Jacinda Ardern’s efforts to limit the spread of COVID-19 in New Zealand, the economy will soon start to bump against supply-side constraints. More specifically, COVID-19 has accentuated the immigration cliff in New Zealand, an important hit to the labor dividend for the economy (Chart I-16). As such, the neutral rate of interest is bound to head lower. Chart I-16A Top For NZD/CAD? This is in stark contrast to Canada, where the current government was pro-immigration even before widespread lockdowns. Meanwhile, in the commodity space, our bias is that energy will fare better than agriculture, boosting relative Canadian terms of trade. Go short NZD/CAD for a trade.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report , "Updating Our Intermediate-Term Models", dated July 3, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: The ISM non-manufacturing PMI jumped from 45.4 to 57.1 in June, with the new orders component surging from 41.9 to 61.6 and the employment component at 43.1 versus 31.8 earlier. JOLTS job openings increased from 5 million to 5.4 million in May. Initial jobless claims fell from 1413K to 1314K for the week ended July 3rd. The DXY index fell by 1% this week, alongside the outperformance of non-US equities, particularly emerging market stocks. Recent data have shown budding signs of a recovery as many countries gradually reopen their economies. As a counter-cyclical currency, this has pressured the dollar. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit services PMI increased from 47.3 to 48.3 in June. The Sentix investor confidence index rebounded from -24.8 to -18.2 in July. Retail sales fell by 5.1% year-on-year in May. However, this is a 17.8% increase on a month-on-month basis.  The euro increased by 0.6% against the US dollar this week. While recent data have been promising, the Summer 2020 Economic Forecast released by the European Union sounded quite pessimistic this week. The Summer Forecast projects that the euro area will contract by 8.7% in 2020 and grow by 6.1% in 2021, much worse than the spring forecast. That said, a mild second wave could trigger the European Union to revise these estimates higher. Meanwhile, the ECB remains committed to lowering the cost of capital for Eurozone countries. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: The current account balance surged from ¥262.7 billion to ¥1176.8 billion in May, as imports fell faster than exports. The preliminary coincident index fell from 80.1 to 74.6 in May, while the leading economic index increased from 77.7 to 79.3. Machinery orders fell by 16.3% year-on-year in May, following a 17.7% decrease the previous month. Moreover, preliminary machine tool orders in June continued to fall by 32% year-on-year. USD/JPY fell by 0.5% this week. The June Eco Watchers Survey released this Wednesday shows that the current conditions index increased sharply from 15.5 to 38.8. Moreover, the outlook index rose to 44 in June from 36.5 the previous month. The Survey sounded cautiously optimistic and indicated that while COVID-19 continues to be a downside risk, activities are starting to pick up in recent months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit services PMI ticked up marginally from 47 to 47.1 in June. The construction PMI surged from 28.9 to 55.3. Halifax house prices increased by 2.5% year-on-year in June. The British pound jumped by 1.3% against the US dollar this week. The Bank of England chief economist, Andy Haldane, has warned about second, third or even fourth wave of COVID-19 infections. However, he also acknowledged that the UK economy has received a boost since restaurants and bars have reopened. We remain bullish on the pound as an undervalued currency, but are monitoring Brexit developments closely as they continue to add more volatility to trading patterns. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: The AiG services performance index was flat at 31.5 in June. Home loans fell by 7.6% month-on-month in May, following a 4.4% decline the previous month. The Australian dollar rose by 0.6% against the US dollar this week. On Tuesday, the RBA held its interest rate unchanged at 0.25%, as widely expected. The Bank sounded optimistic about the recovery and the government’s effective measures to contain the virus. That said, with Melbourne returning into lockdown, a dose of skepticism is warranted. We continue to favor the Australian dollar as a key barometer for procyclical trades, but domestic factors could be a risk to this view. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ preliminary business confidence index recovered from -34.4 to -29.8 in July. The New Zealand dollar rose by 0.9% against the US dollar this week. The Q2 NZIER Quarterly Survey of Business Opinion (QSBO) indicated that economic activities plunged sharply in Q2. According to the survey, a net 63% of businesses expect conditions to deteriorate, compared with 70% in the previous survey. While confidence has picked up slightly, business sentiment remains downbeat with less intensions to invest and hire, particularly in the subdued construction sector. As such, a tactical opportunity is opening for short NZD trades at the crosses. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The Ivey PMI surged from 39.1 to 58.2 in June. The Markit manufacturing PMI also increased from 40.6 to 47.8 in June. Bloomberg Nanos confidence increased from 46 to 46.2 for the week ended July 3rd. Housing starts picked up from 195.5K in May to 211.7K in June. The Canadian dollar appreciated by 0.5% against the US dollar this week. The BoC Business Outlook Survey was released this week and survey results suggest that “business sentiment is strongly negative in all regions and sectors” due falling energy prices. Most firms believe that production could pick up quickly but sales might take longer to recover. That said, both interest rate differentials and recovering oil prices are bullish for the Canadian dollar for now.  Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: FX reserves increased from CHF 817 billion to CHF 850 billion in June. The unemployment rate declined from 3.4% to 3.2% in June. Total sight deposits increased from CHF 683 billion to CHF 687 billion for the week ended July 3rd. The Swiss franc appreciated by 0.7% against the US dollar this week. The Swiss franc has been quite resilient recently despite the rebound in risk sentiment since the March lows. The expensive franc remains a headache for the SNB and the Swiss economy. We are looking to go long EUR/CHF at 1.055. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Manufacturing output fell by 3% month-on-month in May. The Norwegian krone surged by 1.3% against the US dollar this week. We remain bullish on the krone due to its cheap valuation and signs of a recovery in energy prices. Our Nordic Basket is now around 10% in the money and we also went long a petrocurrency basket including the Norwegian krone last week. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industrial production fell by 15.5% year-on-year in May. Manufacturing new orders plunged by 18.4% year-on-year in May. The Swedish krona surged by 1.3% against the US dollar this week. Like the Norwegian krone, the Swedish krona is tremendously undervalued and remains one of our favorite G10 currencies at the moment. As a small open economy, Sweden relies heavily on exports and imports. While global trade was hit hard during COVID-19, signs of stabilization bode well for the Swedish krona. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Overweight Consumer discretionary stocks have been on fire of late besting the SPX by 13% since our overweight inception in mid-April. AMZN (44% market cap weight in the sector) is frequently printing two standard deviation moves on daily, weekly and monthly timeframes, as COVID-19 has been an accelerant both to consumers moving away from bricks and mortar shops and toward online retail and to businesses adopting cloud services. Easy fiscal and monetary policies underpin the relentless rally (top panel). While we are participating in the advance via key overweights in internet retail and home improvement retailers (HIR), we note signs of exuberance. Our technical indicator has crossed above the one standard deviation line entering into a danger zone (middle panel). Similarly, valuations are also climbing to extreme levels, last seen in the early 1990s (bottom panel). We will keep an eye on these developments and have recently implemented portfolio risk management tools to defend against a potential air pocket. Specifically, we have instituted two stops: one in the S&P HIR, and another in the S&P internet retailers overweights at the 10% and 20% relative return marks, respectively. Should the stops get triggered, then the consumer discretionary sector will be automatically downgraded to neutral. Bottom Line: We remain overweight the S&P consumer discretionary sector via the S&P HIR and S&P internet retailers indexes, but should our stops get triggered, we are ready to downgrade to neutral.

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

In mid-April we boosted the S&P internet retail index to overweight as it was poised to benefit from the shifting consumer spending habits due to the COVID-19 outbreak. True, the “amazonification” of the economy is not a new phenomenon, but COVID-19 acted as an accelerant to an already powerful uptrend in online retail sales (see chart). Today, our overweight in the S&P internet retail index surpassed the 29% relative return mark since the mid-April inception, which compels us to protect profits by instituting a stop at the 20% mark. Bottom Line: We remain overweight the S&P internet retail index, but from a portfolio risk management perspective today we add a stop at the 20% relative return mark in order to protect profits.   ​​​​​​​

Highlights Chart 1More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). 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 Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still 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. Ryan Swift US Bond Strategist rswift@bcaresearch.com 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. Performance Since March 23 Announcement Of Emergency Fed Facilities 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 July 3, 2020) 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 July 3, 2020) 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 57 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 57 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) 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 July 3, 2020) Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 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 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

The GAA DM Equity Country Allocation model is updated as of June 30, 2020.  The model has added another 6 points to the US overweight at the expense of the euro area, mainly Germany, Netherlands, and Spain. The driving force for this change is from the relatively favorable momentum and liquidity indicators, despite an unfavorable valuation indicator. Now the top four overweight countries are the US, Spain, Australia, and Sweden, while the biggest four underweight countries remain Japan, the UK, France, and Switzerland, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in June by 49 bps. The Level 2 model outperformed its benchmark by 162 bps, thanks largely to the underweight in Japan and the UK, as well as the overweight in Australia and Spain. The Level 1 model underperformed slightly by 3 bps due to the slight overweight in the US. Since going live, the overall model has outperformed its MSCI World benchmark by 260 bps, with 463 bps of outperformance from the Level 2 model, and 29 bps of outperformance from the Level 1 model. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1)     Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of June 30, 2020. Chart 4Overall Model Performance The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model maintains its cyclical stance driven by an improvement in its global growth proxy. The model reversed its overweight position on the only defensive sector where it was previously overweight, Healthcare, given a deterioration in its momentum component. Over the past month, the model outperformed its benchmark by 42 basis points. Year-to-date, the model has outperformed its benchmark by 109 basis points, and 108 basis points since inception.   Table 3Overall Model Performance Table 4Current Model Allocations The model’s global growth proxy improved – driven by EM currencies and rising metal prices, and therefore continues to remain positive on cyclical sectors. Global monetary easing and low rates should keep the liquidity component favoring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, multiple sectors continue to be near the expensive and cheap zones – mainly Info Tech and Consumer Discretionary (expensive), and Real Estate and Consumer Staples (cheap). The model awaits confirming momentum signals to change recommendations for those sectors.  The model is now overweight four cyclical sectors in total. These are Information Technology, Consumer Discretionary, Communication Services, and Materials. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019, available at https://gaa.bcaresearch.com.    Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy  Senior Analyst amrh@bcaresearch.com  

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