Sectors

S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight As a follow up to our yesterday’s Insight where we outlined some of our reasons to go underweight the S&P technology sector, today we focus on two defensive sub-sectors that will benefit from the spreading cracks in the U.S. economy: S&P hypermarkets and S&P soft drinks. Both sub-sectors enjoy deteriorating macroeconomic conditions, which are currently reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. treasury yield, melting inflation and rapidly contracting ISM PMI numbers (see chart) Bottom Line: Stick with defensive consumer stocks. For a more detailed discussion on S&P hypermarkets and S&P soft drinks, please see our July 15 Weekly Report and “Bubbling Up” Insights,1 respectively. For the complete list of our recent moves, please see our Monday’s Weekly Report. ​​​​​​​   1      Please see BCA U.S. Equity Strategy Insight Reports, “Bubbling Up (Part I)” and “Bubbling Up (Part II)”, dated July 24, 2019 available at uses.bcaresearch.com.

Special Report

Highlights China’s infrastructure investment growth rate could rebound moderately from its current nominal 3% pace, but will remain well below the double-digit rate it has registered for most of the past decade.  A lack of funding for local governments and their financing vehicles will somewhat cap the upside in infrastructure fixed-asset investment (FAI) in the next six to nine months. Special bond issuance will be insufficient to ensuring a major recovery in infrastructure spending. Investors should tread cautiously on infrastructure plays in financial markets. Feature Chart I-1Chinese Infrastructure Investment: Double-Digit Growth Again? Nominal infrastructure investment growth in China has slowed from over 15% in 2017 to 3% currently (Chart I-1). This is the weakest growth rate since 2005 excluding the late 2011-early 2012 period. Over the past decade, each time the Chinese economy experienced a considerable slowdown, infrastructure construction was ramped up to revive growth. Infrastructure spending growth skyrocketed in 2009 and was also boosted in 2012. In 2015-2016, it was not allowed to decelerate with the issuance of nearly RMB 2 trillion of special infrastructure bonds. This time the government has also reacted. Since mid-2018, the Chinese authorities have dramatically raised local governments’ special bonds balance limits, prompted local governments to front-load their issuance this year, and also encouraged the private sector to participate in public-private partnership (PPP) infrastructure projects. Will Chinese infrastructure FAI growth accelerate over the next six to nine months from its current nominal 3% pace to double digits? The short answer is no. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. For purposes of this report, the composition of “infrastructure” includes three categories – (1) Transport, Storage and Postal Service, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas & Water Production and Supply. Chart I-2 presents the breakdown of the nominal infrastructure FAI by category. Funding Constraint Preceding both the 2011-2012 and 2018 infrastructure investment slumps, the Chinese central government increased its scrutiny on local government debt and tightened funding conditions for infrastructure projects. As a result, all three categories of infrastructure spending experienced a sharp deceleration (Chart I-3). Overall, financing and qualitative limitations that Beijing imposes on local government infrastructure spending hold the key to the outlook. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. Looking forward, without a considerable recovery in available financing, there will be no meaningful rebound in Chinese infrastructure investment and construction activity. For now, we are not very optimistic on financing. Chart I-4 shows the breakdown of the major funding sources of Chinese infrastructure investment. All of them are likely to face considerable funding constraints over the next six to nine months. Chart I-3Chinese Infrastructure Investment Growth Has Decelerated Across The Board   1. Self-Raised Funds Self-raised funds contribute nearly 60% of overall infrastructure funding. They include net local government special bond issuance, PPP financing and government-managed funds’ (GMFs) revenues excluding proceeds from special bond issuance. A. Local government special bond issuance, which is exclusively used to fund infrastructure projects, has been the major source of financing for local governments in the past 12 months. The authorities significantly boosted net local government bond issuance to RMB 1.2 trillion in the first six months of this year from only RMB 361 billion in the same period in 2018. However, the amount of special bond issuance in the second half of this year will unlikely be significant enough to boost infrastructure FAI greatly. First, the central government has not only set a limit on the aggregate local government special bond balance, but it also set limits for each of the 31 provinces/provincial-level cities.1 In the past three years, nearly all provinces did not use up their special bond issuance quotas. This resulted in an outstanding aggregate amount of special bonds of only about 85% of the limit.2 In both 2017 and 2018, local governments were left with RMB 1.1 trillion special bond issuance quota unused for that year. Second, based on the limit on outstanding amount special bonds set by the central government for the end of 2019, local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of this year. In comparison, in 2018, the issuance was heavily concentrated in the second half of the year with RMB 1.6 trillion. Our estimate shows there will be only RMB 400-600 billion increase in net total special bond issuance in 2019 versus 2018.3 This will translate into a merely 2-3% growth in Chinese infrastructure investment. Third, net local government special bond issuance made up only 15% of overall infrastructure FAI over the past 12 months. Hence, there is still a huge financing gap to be filled (Chart I-5). B. Public-private partnerships (PPP) are unlikely to meet the financing shortage either. PPPs have become an important financing model for Chinese local governments to fund infrastructure investments since 2014. Nevertheless, to control rising local government debt risks, the central government has tightened regulations on PPP projects since early last year. A series of tightened rules have resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPPs contributions to total infrastructure FAI have plunged from over 30% in 2017 to 10% currently (Chart I-6). Chart I-5Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Chart I-6Public-Private Partnerships: Too Small To Meet The Financing Shortage   So far, the rules on PPP projects on local governments remain tight. In March, the central government tightened its rule on local government participation in PPP projects. The new rule states that, if a local government has already spent more than 5% of its overall general expenditures on PPP projects excluding sewage and waste disposal PPP projects, it will not be allowed to invest in any new PPP projects. Before March, the threshold was over 10%. In early July, the National Development and Reform Commission (NDRC) demanded all PPP projects undertake a thorough feasibility study. The NDRC emphasized that PPP projects that do not follow standard procedures will not be allowed. Chart I-7Government-Managed Funds: Headwinds From Falling Land Sales C. Government-managed funds (GMF) excluding special bond issuance accounts, which contribute about 15% of overall infrastructure financing, are also facing constraints. According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures of the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. Land sales by local governments are one major revenue source for GMFs. Contracting property floor space sold is likely to depress real estate developers’ land purchases, further reducing local governments’ revenues from selling land (Chart I-7). This will curb local governments’ ability to finance their infrastructure projects through GMFs. 2. Domestic Loans Domestic loans contribute to about 15% of overall infrastructure financing. Infrastructure projects are generally long term in nature. Presently, the impulse of non-household medium- and long-term (MLT) lending has stabilized but has not yet improved (Chart I-8). While not all of MLT loans are used for infrastructure, sluggish MLT lending reflects commercial banks’ reluctance to finance infrastructure projects. We believe a decelerating economy, mounting local government debt, and often-low returns on infrastructure projects will continue to constrain loan funding of infrastructure projects from both banks and the private sector. 3. General Government Budget The general government budget (which includes central and local governments) accounts for about 15% of overall infrastructure financing. The general budget is also facing headwinds from declining revenue due to recent tax cuts and lower corporate profit growth (Chart I-9). Chart I-8Sluggish Medium/Long-Term Bank Lending Chart I-9Government General Budget: Large Deficit   Bottom Line: Funding constraints will likely linger, making any recovery in Chinese infrastructure investment growth moderate over the next six to nine months. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. While local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of 2019, it would be well below the RMB 1.4 trillion of special bond issuance that was rolled out in the second half of 2018. FAI In Transportation: In Nominal Terms… The transportation sector accounts for about 31% of total Chinese infrastructure investment. It includes railway, highway, urban public transit, air and water transport. Table I-1 shows the 13th five-year (2016-2020) transportation investment plan released by the government in February 2017,4 which excludes urban public transit. The authorities planned to invest RMB 15 trillion in the transportation sector over the five-year period between 2016 and 2020, with highways accounting for over half of the investment, followed by railways (23%), air transportation (4.3%) and water transportation (3.3%). The table also shows our calculation of the realized investment amount in these four sub-sectors for the period of January 2016 to June 2019. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. Table I-1 suggests the remaining FAI for the transportation sector for the July 2019 to December 2020 period will be considerably smaller than the FAI amount over the past 18 months. This entails a major drag on infrastructure investment at least over the next 18 months. It is important to emphasize that this is conditional on the central planners in Beijing sticking to their five-year plan for infrastructure FAI. As of now, there has been no announcement of revisions to these five-year FAI targets. Bottom Line: China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. …And Real Terms Table I-2 summarizes the 2020 targets for major Chinese infrastructure development (urban rail transit, railway, highway and airport) in real terms. Chart I-10Transportation 2020 Targets: Not Far Away In real terms, the annual growth of transportation infrastructure will likely be 4.2% in both 2019 and 2020. We illustrated in the previous section that the five-year budget plan had been front-loaded, leaving a very small budget for transportation investment over the next 18 months. This may suggest that without considerably exceeding the budget, transportation infrastructure will fail to achieve the 4.2% annual growth in real terms both this year and next. In brief, more funding should be dispatched/allowed by the central planners in Beijing for infrastructure FAI not to shrink. Second, urban rail transit, high-speed railways, highways and airports will reach their respective 2020 targets, while non-high-speed railway construction will likely be a little bit off its 2020 target. Third, based on the 2020 targets, urban rail transit will enjoy very fast growth over the next one and a half years. Fourth, the growth of high-speed railways and highways will be very low, at around 1-2% in real terms (Chart I-10). Finally, while the number of airports will increase at a faster pace, their contribution to overall infrastructure investment will remain insignificant as they only account for about 1.4% of overall infrastructure investment. Bottom Line: In real terms, transport infrastructure growth will likely be only about 4% over the next six to nine months. Future Infrastructure Investment Focus Urban rail transit, environmental management and public utility management will likely be the major driving forces for Chinese infrastructure investment over the next 18 months. Urban rail transit line length will likely register fast growth of around 10% over the next six to nine months. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management will likely experience continued growth acceleration (Chart I-11). China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. Meanwhile, as the country’s urbanization continues and more townships and city suburbs become urbanized,5 public utility management investment will also grow moderately. Public utility management investment, contributing a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels in the city. Investment Implications Investors should not hold their breath expecting a major upswing in infrastructure FAI and a major rally in related financial markets. Chinese steel demand is sensitive to construction of railways and urban rail transit lines (Chart I-12, top panel). In turn, mainland cement demand is dependent on highway construction (Chart I-12, bottom panel). Chart I-11Environment Management: Will Continue Booming Chart I-12Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand...   Chart I-13...And Steel & Cement Prices At The Margin The infrastructure sector accounts for about 10-15% of total Chinese steel use, and about 30-40% of Chinese cement consumption. Nevertheless, given that we believe Chinese infrastructure spending will only have a moderate recovery, the positive effect on steel and cement prices will be muted as well (Chart I-13). The same holds true for spending on industrial machinery, equipment, chemicals and various materials. Notably, risks to this baseline scenario of a muted recovery are to the downside because of the lack of funding. Barring a substantial increase in the special bond issuance quota this year or a major credit binge, infrastructure FAI growth could in fact stall. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1  Please note that the central government only set the special bond balance limit (not the quota) for local governments. The often-cited “quota” in the news is derived by calculating the difference between the current limit and the previous year’s limit. The “quota” used in this report is the difference between the current special bond balance limit and the actual special bond balance of the previous year end. 2  At the end of 2018, Chinese special bond balance was RMB 7.4 trillion, only 85.8% of the special bond balance limit of RMB 8.6 trillion. This ratio was 84.6% in 2017 and 85.5% in 2016. On average, the ratio was 85.3% in the past three years. 3  Given that the central government is aiming to somewhat stimulate infrastructure spending by increasing special bond issuance, we assume special bond balance at the end of 2019 to reach 88%-90% of the limit (RMB 10.8 trillion) that it has set for 2019. This will be higher than the 85% average of the past three years. In turn, this means that the special bond balance at the end of this year will likely be RMB 9.5-9.7 trillion. Since the balance at the end of last year was RMB 7.4 trillion, this results that net special bond issuance will be around RMB 2.1-2.3 trillion in 2019. Given the net special bond issuance last year was RMB 1.7 trillion, it follows that there will only be a RMB 400-600 billion increase in total special bond issuance in 2019 versus 2018. 4  Please see www.gov.cn/xinwen/2017-02/28/content_5171576.htm, published February 28, 2017, by the Chinese central government website. 5  Please see Emerging Markets Strategy/China Investment Strategy Special Report “Industrialization-Driven Urbanization In China Is Losing Steam,” dated January 2, 2019, available on ems.bcaresearch.com

Feature GAA DM Equity Country Allocation Model Update Chart 1GAA DM Model Vs. MSCI World The GAA DM Equity Country Allocation model is updated as of July 31, 2019.  The quant model reversed its abnormal upgrade of Sweden in the previous model update. In hindsight, the model’s behavior when a bond yield moves close to zero needs to be watched closely. Currently, the model still favors Spain, Italy, Germany, Netherland and Australia at the expenses of U.S., Japan, U.K., France and Canada, as shown in Table 1.  As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed the MSCI World benchmark by 94 bps in July, largely driven by 146 bps of underperformance from the Level 2 model, and 26 bps of underperformance from the Level 1. Directionally, 7 out of the 12 choices generated positive alpha. However, the overweight in Sweden and Spain generated outsized underperformance. Since going live, the overall model has outperformed by 94 bps, with 297 bps of outperformance by the Level 2 model, offset by 42 bps of underperformance from the Level 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. 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 too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of July 31, 2019. Chart 4Overall Model Performance The model’s tilts between cyclicals and defensives have changed compared to last month. Following the Fed’s decision to cut interest rates yesterday, the liquidity component shifted its inputs to phase 4 – a period in which the central bank is cutting rates, while simulative monetary conditions persist. Although this should favor most cyclical sectors, the lack of evidence of global growth bottoming is tilting the model to favor a mixed bag of sectors. The valuation component continues to remain muted across all sectors. The model is now overweight 4 sectors in total, 2 cyclical and 2 defensive sectors. These are Consumer Discretionary, Information Technology, Consumer Staples, and Healthcare. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   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, Research Associate amrh@bcaresearch.com Footnotes

Neutral Downgrade Alert This Monday we published a summary of our portfolio allocation changes that we made over the past couple of months. They key underlying theme running through most of our recent moves was to reduce our cyclical exposure and pocket in some profits. Today we highlight one of the major moves we are preparing to make: downgrade the S&P technology sector. The downgrade will be executed via the S&P software index. As a reminder, we have a stop at the 27% relative return mark and once it’s triggered, we will go neutral on software pushing the overall tech sector to a below benchmark allocation. Our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a seemingly invincible U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). Bottom Line: We reiterate our defensive stance on the U.S. equity market as the risk/reward remains to the downside. For the full summary of our recent moves, please see this Monday’s Weekly Report.  

Special Report

Highlights A decade after the financial crisis, yield remains scarce: The global count of bonds trading at negative yields seems to grow every week, squeezing a broad swath of investors who are desperate for coupon income. Increasingly accommodative monetary policy is not on income investors’ side, … : Dovish pivots from the Fed and the ECB ensure that low-to-negative yields won’t go away soon. … but it is quite friendly for maturity transformation strategies in the near term: Borrowing short to lend long is far from a fail-safe strategy, but it should dovetail nicely with reflationary Fed policy for at least the rest of the year. The time is ripe for returning to the agency mortgage REITs: Among public securities, agency mortgage REITs offer the most direct exposure to maturity transformation. Feature Economic data and corporate earnings releases remain mixed enough to provide both bulls and bears with ample support for their leanings. The debate within BCA remains spirited, and is emblematic of the debate among investors. Per the financial media, it seems as if the scolds are getting the most attention,1 even as the S&P 500 keeps setting new highs. One thing that both camps agree on, however, is that nothing is cheap. Equities are not terribly expensive, but bonds appear to have little chance of matching their historical return profile. Investors seeking income, from individuals and advisors, to pension funds, life insurers and endowments needing to meet a fixed schedule of liabilities, are under siege a decade into ZIRP and NIRP. With rate cuts on the horizon in the U.S., and the ECB preparing to ramp up accommodation, the pressure on income-seeking investors to throw caution to the wind and ignore credit quality shows no sign of abating. Maturity transformation – borrowing short to lend long – fits the Fed’s reflationary goals like a glove, and offers an alternative to abandoning credit standards. Contrary to popular belief, banks no longer pursue maturity transformation. Chastened by the savings-and-loans’ demise in the ‘80s, they make heavy use of swaps to keep a tight rein on asset-liability mismatches. Maturity transformation is agency mortgage REITs’ raison d’être, however, and aside from some hedging to ensure survival in the face of adverse interest-rate moves, they actively embrace it. The Agency mREIT Formula Mortgage REITs (“mREITs”) finance real estate investment, either by lending directly to property owners or by purchasing mortgages and/or mortgage-backed securities (“MBS”). Agency mREITs invest solely or predominantly in instruments issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. MBS issued by these entities are explicitly backed by the full faith and credit of the United States and bear little to no credit risk. The agency mortgage REITs stumbled ahead of all four of the yield curve inversions they’ve experienced, and six years of flattening has ground down their share prices. Despite the negligible credit risk in their investment portfolios, agency mREITs themselves are far from riskless – leveraged carry trading strategies are not for the faint of heart – but they have performed much better than non-agency mREITs, some of which go bust in every cycle. The agency mREITs are a much purer play on the term structure of rates than their non-agency peers. Their borrow-short-to-lend-long model is intentionally designed to exploit the yield curve’s typical upward slope. Though they stumble ahead of inversions (Chart 1), they are an attractive portfolio component when the fed funds rate outlook is benign and the curve is poised to steepen. Chart 1The Steeper The Better Banks are happy to lend against pristine collateral for short timeframes, allowing agency mREITs to build RMBS portfolios 10 times the size of their equity capital. Figure 1 illustrates the mechanics of building an agency mREIT portfolio. A new mREIT first raises equity in a public offering and uses the proceeds to purchase a portfolio of agency-backed residential MBS (“agency RMBS”). It then uses the portfolio as collateral for a secured repurchase (“repo”) loan, typically with a 30-, 60- or 90-day term, the proceeds of which it recycles into more agency RMBS.  With banks and brokers lending 95 cents on the dollar against agency collateral, an agency mREIT can easily amass asset portfolios several times the value of its equity capital. As long as portfolio income exceeds the sum of repo interest and operating expenses, it will be profitable. Table 1 lists all of the constituents of our Agency Mortgage REIT Index since its 1998 inception, along with the current constituents’ price-to-book multiples, dividend yields, betas versus the S&P 500 and leverage ratios. As a group, the agency mREITs have high dividend yields, low equity betas and considerable leverage. Table 1Agency Mortgage REIT Index Constituents Low beta and high leverage could be a nice mix when the economy is mushy and the Fed and other major central banks are ramping up accommodation. Then And Now The last time we recommended the agency mREITs (June 2011 through September 2012), they handily outperformed the S&P 500 and the Bloomberg Barclays High Yield Index on a total return basis (Chart 2). Uninspiring growth and easy monetary policy proved to be a potent mix for agency mREIT outperformance. The backdrop looks similar to us now, and we expect that the agency mREITs will outdistance high-yield corporate bonds over the rest of the year. They may be hard-pressed to top the S&P 500 under more constructive economic and market scenarios, but they should help protect other equity exposures in the event that economic growth and equities slump. Chart 2The Agency Mortgage REITs Boosted Our Returns In 2011-12, ... The Incredible Shrinking Stock Price Agency mREITs trade on their price-to-book multiples, but REIT rules leave the companies with little chance to grow book value. REITs have to distribute 90% of their annual income to shareholders to maintain their tax-preferred status, and they pay no income tax at the corporate level if they distribute all of it. The upshot is that mREITs have no retained earnings, which stymies them from growing book value.   In exchange for optimal tax efficiency, REITs give up the potential to compound their way to growth. Chart 3...But They've Run Into Headwinds Since Price-to-book multiples swung wildly in the group’s first decade, but have settled into a tight post-crisis range (Chart 3). If book value can’t grow, and multiples are capped around 1, stock price appreciation is unlikely to contribute to total returns. History suggests that investors should actually expect some modest drag from capital losses; all but one of the stocks in our Agency mREIT Index have declined since their inclusion2 (Chart 4). The drag follows from the constraints of the REIT rules; companies that can’t retain earnings and have already reached their borrowing capacity can only grow by issuing stock, but companies only receive about 95% of the proceeds from offerings after underwriting fees.3 The practical takeaway is that the agency mREITs are not a through-the-cycle play, and investors should only add them to their portfolios when they are comfortable that price declines are not likely to undermine dividend distributions. Honey, I Shrunk The Share Price. Agency mREIT Vulnerabilities The agency mREIT model has three inherent vulnerabilities: it relies on maturity transformation, it employs copious amounts of leverage, and it has convexity working against it. None is likely to prove fatal for entities that are reasonably prudent about hedging rate exposures, limiting leverage, and guarding against prepayments, but double-digit annual returns are not pre-ordained. Each management team makes its own hedging choices, but all agency mREITs maintain considerable duration mismatches. Unexpected changes in the term structure of rates have the potential to upend shareholder returns. Chart 5Repo Funding Is Reliable Our index constituents have a considerable amount of leverage. With 5-cent haircuts on agency repo financing, mREITs can theoretically build an agency MBS portfolio equivalent to 20 times the value of its equity capital. Maximal leverage would leave very little room to maneuver under duress, but leverage around ten times has not historically posed a problem. Given that agency MBS is gilt-edged collateral, we expect that the agency mREITs will be able to roll over their repo financings in a stress scenario, just as they were able to amidst the crisis (Chart 5). Interest rate volatility is also a headwind, independent of the level of rates. Under standard U.S. mortgage terms, MBS investors implicitly grant options to borrowers by allowing them the unlimited right to prepay their obligations without penalty (see Box). Options increase in value as the volatility of their underlying reference asset increases, so MBS values move inversely with changes in interest rate volatility. The good news for the mREITs is that increasingly accommodative Fed and ECB policy should act to tamp down rate volatility in the near term. The agency mREIT model proved its resiliency at the height of the crisis. Even in times of peak stress, it’s possible to borrow against the best collateral.   Box An Equity Investor’s Guide To Negative Convexity Even for fixed income lifers, mortgages can be a dauntingly complex product, largely because of borrowers’ ability to prepay their loans, without penalty, at any time.  This prepayment option gives mortgages and MBS what fixed income professionals call “negative convexity.” Long-duration, non-callable bonds are said to be positively convex.  That is, their value increases at an increasing rate as interest rates fall and decreases at a decreasing rate as interest rates rise.  Mortgage borrowers’ prepayment option prevents mortgage lenders from enjoying the full effect of convexity because the more the present value of a mortgage’s future payment stream rises as rates fall, the less likely lenders will realize it as savvy borrowers refinance into one offering a lower interest rate. This effect is called negative convexity and it is why mortgage investors must be compensated with higher yields.  Fannie, Freddie and Ginnie securities therefore yield more than Treasuries, even though both are backed by the full faith and credit of the U.S. Treasury.   With the exception of 2018’s backup, mortgage rates are where they’ve been since late 2014. There may not be many more loans worth refinancing. An unexpected rash of refinancings (“refis”) would squeeze agency mREIT income via mark-to-market losses and unwelcome exposure to reinvestment risk. More borrowers refi when rates decline, squeezing earnings, and cutting into, or even potentially wiping out, the benefit of lower funding costs. Although refi application activity has not always exhibited a tight correlation with agency mREIT returns, refis are a threat to agency mREIT earnings. Although we expect rates to remain in a fairly narrow range consistent with mushy growth and quiescent inflation expectations, it is our sense that they have bottomed and that refi activity, in turn, has already peaked (Chart 6). Chart 6Prepayments May Be Ready To Taper Off   Why Now? An equally-weighted basket of agency mREITs has outperformed both the S&P 500 and the Bloomberg Barclays High Yield Corporate Bond Index by two-and-a-half percentage points (“ppt”) on an annualized total return basis over its 21-plus-year history (Chart 7). They do not always outperform, however, and since we closed our position at the beginning of October 2012, the agency mREITs have lagged large-cap equities and high-yield bonds by ten-and-a-half and three ppt, respectively, on an annualized total return basis. Chart 7The Agency REITs Have Had A Strong Career, But The Last Seven Years Have Been Rough Rising rates and curve-flattening normally spell the end of agency mREIT outperformance, but we feared in the fall of 2012 that the Fed was killing the group with kindness. Ultra-accommodative policy encouraged refis while the Fed itself was actively bidding up agency MBS prices with QE3. Refis impaired the value of the legacy portfolios because they triggered losses on positions that had been marked-to-market above par. Higher prices helped the legacy portfolio holdings but forced the mREITs – in the midst of an epic three-year run of capital raising via secondary equity offerings – to put new capital to work at the top of the market. The policy backdrop appears more conducive to relative agency mREIT outperformance now. Faced with sluggish global growth and stubbornly low inflation expectations, the Fed is poised to cut rates for the first time since 2008. We expect the Fed will deliver a 25-basis-point cut at the conclusion of tomorrow’s FOMC meeting, and another one in September, and then refrain from hiking again until at least the first quarter. Nothing outperforms forever. The agency mREITs make a much better cyclical investment than a structural investment. Reflationary monetary policy should produce a steeper curve as growth and inflation expectations revive (Chart 8). A steeper curve will boost agency mREITs’ earnings by widening their net interest margins, allowing for increased dividend payments and fatter total returns. Given that we expect curve steepening, we do not worry that rate cuts will spark a wave of prepayments. As Chart 6 showed, 2018-vintage mortgages would seem to be the only ones issued over the last five years that are worth refinancing. Chart 8Rate Cuts Typically Promote A Steeper Curve Investment Implications Reflationary policy is a good backdrop for agency mREIT performance because it’s likely to promote a steeper curve. A steeper curve is manna from heaven for maturity transformation strategies, and it would boost mREIT income while reducing the potential for the capital losses that eat away at double-digit dividend yields. We are not counting on capital gains, but if peak inversion is behind us, the group’s multiple has a chance to expand. The bottom line is that several factors may have come together to bring the curtain down on the agency mREITs’ extended underperformance. We recommend that investors stick to the constituents in our index basket if they choose to add agency mREIT exposure to their portfolios. The leading mREIT ETFs, REM and MORT, provide one-stop access to the mREIT universe, but they come with considerable non-agency and commercial exposure. We are constructive on credit performance, but we think the best opportunities reside in the pure-play maturity transformation offered by the agency mREITs. We recommend funding agency mREIT exposure in balanced portfolios by diverting allocations from equities and high-yield positions. We plan on holding the mREITs for six months for now, but we’re open to staying with them longer. We expect that agency mREITs will boost risk-adjusted returns at least until the Fed first hikes again, and possibly even longer if inflation expectations revive. We therefore intend to maintain agency mREIT exposure through the end of the year, and are open to holding onto it for longer if conditions remain supportive. Our initial six-month recommendation in June 2011 remained in place for sixteen months, and we’d be pleased if this one had similar staying power.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com     Footnotes 1      De Aenlle, Conrad, “Is It Time to Fight the Fed?” New York Times, July 14, 2019, p. BU13. The experts quoted in the lead article in the Times’ latest quarterly mutual fund and ETF section were uniformly bearish on U.S. equities, in keeping with the author’s “iffy-to-awful” characterization of the economic backdrop. 2      Dynex (DX) is only included in our index from the beginning of 2001, when it switched to a pure agency strategy after nearly capsizing. Since its 1988 IPO, DX’s stock price has shrunk at an annualized rate of 3.9%. 3      The built-in drag from issuance is exacerbated by the lamentably common industry practice of issuing stock at a discount to book value, which dilutes incumbent shareholders’ investments.

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Chart 5...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps