Sectors

Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q:  And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around   Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Stocks That Are Popular With Retail Investors Are Outperforming Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Equity Risk Premium Is Still Quite High Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Day Trading Is Back In Vogue These Days Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3  For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017.   Global Investment Strategy View Matrix Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Current MacroQuant Model Scores Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A

Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 5India Attracts Investment As Supply Chains Diversify From China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.

Overweight (Downgrade Alert) Home Improvement Retailers Are On Downgrade Watch Home Improvement Retailers Are On Downgrade Watch In mid-April we boosted the S&P consumer discretionary index to overweight via assigning an above benchmark allocation to both internet and home improvement retailers (HIR). Our thesis to overweight consumer discretionary stocks during the recession remains intact, however, weakness in our HIR macro model (see chart), a hook down in existing home sales and tick up in inventories compelled us to institute an HIR stop at the 10% relative return mark. Bottom Line: While we remain overweight the S&P HIR index it is now on downgrade alert. We also set a stop at the 10% return mark in order to protect profits for our portfolio. Stay tuned. For additional details please refer to our June 15 Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.  

Dear client, It was my pleasure to join Dhaval Joshi, BCA’s Chief European Investment Strategist, this past Friday June 12, 2020 on a webcast he hosted titled: “Sectors To Own, And Sectors To Avoid In The Post-Covid World”. You can access the replay of the lively webcast here, where Dhaval and I debate how investors should be positioned in different time horizons. I hope you will find it both insightful and informative. Kind Regards, Anastasios Highlights Portfolio Strategy While we cannot time the exact equity market top, our sense is that we are more than fairly valued at the current juncture and the equity market has entered a speculative phase; thus the risk/reward tradeoff is poor in the near-term. We are compelled to put the S&P home improvement retailers index (HIR) on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year. Recent Changes Our rolling 10% stop got hit last Tuesday and we monetized 32% gains since the reinstatement of the long S&P oil & gas exploration & production / short global gold miners pair trade.1 Feature Equities briefly erased all losses for the year early last week, but the Fed’s June meeting lacked any additional easing measures and served as a catalyst for a much needed breather – the fifth 5.3-7.3% pullback since the March 23 bottom – as the week drew to a close. While extremely easy monetary and fiscal policies remain the key macro drivers for the SPX, any hiccups in passing a new fiscal spending bill once the money runs out on July 31, carry enough risk to short circuit the equity market’s momentum and result in a shakeout phase. Importantly, given the recent speculative overshoot in equities, the cyclical return potential has diminished, and that is cause for concern. The ongoing COVID-19 catalyzed recession that the NBER last week confirmed commenced in February, the “second wave” risk, a flare up in the US/Sino trade war and more recently, civil unrest have dominated the news flow. However in all this chaos, the November election has slowly moved into the background, especially the SPX return implications during the 4th year of a Presidency. Chart 1 shows the profile of the S&P 500 during Presidential Election calendar years, going back to the 1950s. The solid green line shows the historical mean, and shaded areas denote the 10th and 90th percentiles of SPX performance. If history rhymes, the average profile of these 17 iterations suggests that more cyclical gains are in store for the S&P 500. Chart 1Do Not Ignore… Do Not Ignore… Do Not Ignore… Nevertheless, before getting carried away, a word of caution is in order. As we highlighted last week, a Biden win represents a risk to the SPX’s euphoric rise from the March lows, and could serve as a catalyst for a much needed pullback (Chart 2).2 Thus, according to our analysis if the 90th percentile proves accurate, then the SPX could trace this lower bound and fall 640 points or 20% (Chart 1). This is a key tail risk to our cyclically sanguine equity market view. Chart 2…(Geo)Political Risks Exit Stage Right Exit Stage Right Turning over to the reopening of the economy, while the SPX has now discounted a near fully functioning economy for the rest of the year and beyond (bottom panel, Chart 3), fixed income investors are not in total agreement. In fact, the missing ingredient in giving the green light for equities is a selloff in the bond market, which financials/banks are currently sniffing out on the back of the reopening of the economy. Until fixed income investors get on the same page as equity investors, the SPX will remain on shaky ground (top panel, Chart 3). We first turned positive on the cyclical prospects of the equity market in mid-March3 and cemented our conviction in our March 23 report presenting 20 reasons to buy stocks.4 Since then, the SPX has rocketed higher by 1000 points and overshot our 3,000 SPX target that we recently derived from three methods.5 While we cannot time the exact top and equities may have a bit more upside, our sense is that today, stocks are more than fairly valued and they have entered a speculative phase (Chart 4). Thus the risk/reward tradeoff in the near-term has shifted to the downside. Once these (geo)political risks get appropriately repriced via a higher risk premium, then the broad equity market will resume its cyclical upside march. Chart 3Bond Market Is Not Buying Stock Market’s Euphoria Bond Market Is Not Buying Stock Market’s Euphoria Bond Market Is Not Buying Stock Market’s Euphoria Chart 4Lots Of Good News Is Priced In Lots Of Good News Is Priced In Lots Of Good News Is Priced In This week we update one consumer discretionary subgroup and put it on our downgrade watch list. Put Home Improvement Retailers On Downgrade Alert We are putting the S&P home improvement retailers index (HIR) on downgrade alert and setting a stop at the 10% return mark in order to protect handsome gains for our portfolio since the mid-April overweight inception. HIR have catapulted to all-time highs both in absolute terms and relative to the broad market. Granted, this has been an earnings-led propulsion (top panel, Chart 5), however, we are uneasy that HD is a top ten holding in the S&P growth index (middle panel, Chart 5).6 Importantly, the first print in the real GDP release for Q1/2020 in late-April made for grim reading, with one notable exception: real residential investment. Business capex took it to the chin, but housing related outlays spiked over 20% on a quarter-over-quarter annualized basis, and signal that DIY same-store retail sales will likely prove resilient this summer (bottom panel, Chart 6). Chart 5An Earnings-Led Advance… An Earnings-Led Advance… An Earnings-Led Advance… Chart 6…Buttressed By Resilient Residential Investment… …Buttressed By Resilient Residential Investment… …Buttressed By Resilient Residential Investment… As a reminder, these Big Box retailers are highly levered to the ebbs and flows of residential investment and the latest GDP print should sustain the recent bid under S&P HIR prices (top & middle panels, Chart 6). Tack on the roughly $75/tbf jump in lumber prices since the early-April trough (not shown), and profits benefit from a dual lift: rising volumes and firming selling prices. The DIY avalanche is real and not likely to dissipate any time soon as a consequence of the coronavirus-induced working from home pervasiveness. Yet, HIR has run too far too fast and is due for a consolidation phase. One yellow flag is the recent fall in existing home sales, despite the all-time lows in mortgage rates brought back by the Fed’s ZIRP. The middle panel of Chart 7 shows that if the home sales decline continues in the summer months, then HIR sales will face stiff headwinds as remodeling activity suffers a setback. In addition, in previous recessions the inventory of homes for sale has surged, but at the current juncture only a small jump in inventories is visible (inventories shown inverted, top panel, Chart 7). Were that trend to gain steam, it could put downward pressure to high-flying HIR equities. Chart 7…But Soft Home Sales Are An Issue… …But Soft Home Sales Are An Issue… …But Soft Home Sales Are An Issue… Chart 8…And The Tick Down In Our HIR Model Is A Yellow Flag …And The Tick Down In Our HIR Model Is A Yellow Flag …And The Tick Down In Our HIR Model Is A Yellow Flag The industry’s net earnings revision ratio has climbed to multi-year highs and warns that analyst optimism is excessive, which is contrarily negative (bottom panel, Chart 7). Our macro driven HIR model does an excellent job in encapsulating all the moving parts and its recent tick down is worrisome (Chart 8). Nevertheless, given that this has been a profit-led advance, HIR have a large valuation cushion. The relative forward P/E is trading near a market multiple and below the historical mean (bottom panel, Chart 5). Netting it all out, we are compelled to put the S&P HIR index on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year (middle panel, Chart 5). Bottom Line: While we remain overweight the S&P HIR index it is now on downgrade alert. We also set a stop at the 10% return mark in order to protect profits for our portfolio. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Insight Report, “Pocketing Gains In Oil/Gold Pair Trade” dated June 10, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Don’t Turn A Blind Eye To Geopolitical Risks” dated June 8, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    Please see BCA US Equity Strategy Weekly Report, “New SPX Target” dated April 20, 2020, and “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com. 6    https://us.spindices.com/indices/equity/sp-500-growth#data-constituents   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Exit Stage Right Exit Stage Right Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Equities hit an air pocket last week after making another recovery high: Investors seemed to reassess the economy’s direction following official forecasts that ranged from sober to grim. “Whatever we can, and for as long as it takes”: The FOMC’s outlook may have dampened investors’ mood now, but it contained the promise of an extended period of easy policy. Further fiscal help is on the way: The White House supports additional spending and some new Republican proposals offered a hint of what the next phase of fiscal relief might look like. Bank stocks quailed at the prospect of lower rates: The SIFI banks sold off sharply as investors feared that falling rates and a flatter yield curve would crimp net interest margins. We are undeterred from our bullish stance on the group. Feature Coming into last week, the gap between the effervescence of the stock market and the gloom of the pandemic-stricken economy was Topic A for investors and the financial media. We have interpreted the gap as a vote of confidence for policymakers. The Fed and Congress have thrown nearly everything they have at shielding the economy from the virus’ depredations and investors have concluded that they’ll succeed, bidding equities higher and corporate bond spreads tighter (Chart 1). Chart 1Spreads Are Back To The Middle Of Their Post-GFC Range ... Spreads Are Back To The Middle Of Their Post-GFC Range ... Spreads Are Back To The Middle Of Their Post-GFC Range ... Through last Monday, the benchmark Bloomberg Barclays Investment Grade and High Yield Corporate Bond Indexes had generated total returns of 17% and 24%, respectively, since their March 20-23 lows, while the S&P 500 was up 45% peak-to-trough on a total return basis. Equities’ torrid run had the S&P in the black year-to-date and within just 5% of its mid-February peak (Chart 2). Given that the economic projections have only worsened since late March, and the virus toll has been worse than the consensus expected, policy has had to shoulder the entire load. Chart 2... And Equities Made It All The Way Back To Their 2019 Close ... And Equities Made It All The Way Back To Their 2019 Close ... And Equities Made It All The Way Back To Their 2019 Close In the monetary sphere, the Fed swiftly cut the fed funds rate to zero, purchased Treasuries and agency MBS at a faster rate than it did during the global financial crisis, revived several GFC initiatives and announced it would lend money directly to investment-grade-rated corporations1 for the first time. The medley of measures quickly gained traction. Though the new issuance market initially seized up upon the arrival of the pandemic, record amounts of corporate bonds were issued in both March and April. All-out stimulus efforts from Congress and the Fed have produced a remarkable market turnaround. From the fiscal side, Congress passed several measures to speed aid to vulnerable parts of the economy, crowned by the CARES Act. As we detailed last week,2 its expansion of state unemployment insurance benefits has made two-thirds of the unemployed eligible to earn more than they did at their jobs. Bolstering unemployment insurance and sending direct $1,200 payments to nearly two-thirds of taxpayers has allowed households to service their debt and pay their rent, preventing wider contagion. Although several fiscal hawks cited May’s way-better-than-expected employment situation report as evidence that Congress can relax its fiscal efforts, we expect that another phase of assistance will follow by the end of July. The potential vulnerability in financial markets stems from the prevailing certainty that policymakers have already won. But things could still go wrong, as highlighted by last week’s bracing economic projections from the OECD and the Fed. US financial markets are generally unaware of the OECD’s semi-annual outlooks, but this one’s probability assessments were striking: it sees a 50-50 chance that an infection second wave will require new lockdowns before the end of the year. The Fed Has The Economy’s Back … Chart 3Take All This ZIRP And Call Me In 2023 The Fed, Congress And The Yield Curve The Fed, Congress And The Yield Curve “At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, and for as long as it takes, to provide some relief and stability, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.” As Chair Powell stated at the beginning of his prepared remarks, whatever it takes was the theme of last week’s FOMC meeting press conference. He made it very clear that the Fed intends to err to the side of providing too much accommodation as it confronts the highly uncertain environment. Asked how long the Fed would stick with zero interest rates if the economy surprises to the upside, he said, “we’re not even thinking about thinking about raising rates.” The first Summary of Economic Projections (SEP) since December validated his statement. Every voter projected that the fed funds rate will remain at its current near-zero level for all of 2020 and 2021, and only two voters foresaw rate hikes in 2022 (Chart 3). After Powell described the new round of QE purchases as a necessary measure to support the smooth functioning of financial markets and ensure credit access, a reporter asked if they were still needed, given how market disruptions have dissipated amidst the recovery rally. He replied that the FOMC did not want to take anything for granted and risk prematurely withdrawing its support. As he said in his prepared remarks, “We will continue to use [our emergency lending] powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery.” The Fed is not even thinking about thinking about raising rates. Powell’s pledges to keep applying the Fed’s full range of tools to support the economy went to the heart of our rationale for overweighting equities over the cyclical timeframe: the Fed will maintain hyper-accommodative policy settings even after they’re no longer necessary. Every rose has its thorn, however, and the Fed would not be on an emergency footing if conditions weren’t dire. Though Powell and the committee expect a recovery to take hold over the next two quarters, the median SEP participant expects the unemployment rate to exceed 9% at the end of this year and does not see GDP returning to its 2019 level until the second half of 2022. The glum projections dampened investors’ enthusiasm and halted equities’ upward march. … And Congress Eventually Will, Too In testimony before a Senate committee on Wednesday, Treasury Secretary Mnuchin touted the budding recovery but made it clear that the administration wants additional stimulus measures. “I definitely think we are going to need … to put more money into the economy,” he said. He expressed a preference for programs that get people back to work and voiced concern that the first round of enhanced unemployment benefits may encourage people to stay out of work, but left the door open to some form of extension. He also indicated that the administration would consider another round of direct payments to taxpayers. Unemployment benefits well in excess of median wages may not be extended beyond July 31st but Republican senators and representatives have begun to put forth appealing alternative proposals like a temporary $450 weekly bonus or an additional two weeks of the existing $600 supplement for those returning to work. The bottom line is that events are validating our geopolitical strategists’ view that another fiscal stimulus package is inevitable. Senate holdouts caught between the House’s and the White House’s desire for more aid will be unable to thwart another round. Banks And The Yield Curve Just a week ago, when the animal spirits sap was rising and a range of indicators suggested that growth may be bottoming, the 10-year Treasury yield surged 26 basis points (bps) in six sessions, from 0.65% to 0.91%, and the 2s/10s segment of the curve steepened by 20 bps. Bank stocks surged, and the SIFIs gained an average of 22% (Table 1). Then the 10-year yield reversed field, tumbling 25 bps in just three sessions from Tuesday to Thursday, and the curve flattened by 23 bps. The SIFI rally evaporated across the three midweek sessions, and the group fell 18% to end the nine-day round trip 30 bps from where it began. Table 1Back So Soon? The Fed, Congress And The Yield Curve The Fed, Congress And The Yield Curve The violent back and forth reinforced the conventional wisdom that banks are joined at the hip with long yields and the slope of the curve. If the 10-year doesn’t go anywhere, the thinking goes, and the curve doesn’t steepen, bank stocks can’t make any significant headway. We beg to differ. The link from the curve to bank earnings runs through net interest margin (NIM), the difference between the banks’ weighted-average lending yield and cost of funds. It makes perfect sense that NIM would expand and contract as the yield curve steepens and flattens, and it did into the early nineties. But by then banks had learned the lesson of the savings and loan debacle – borrowing short and lending long can be fatal if inflation and/or the Fed drive short rates much higher – and they became fastidious about matching the duration of their assets and liabilities. In the new duration-matched regime, NIM has become insensitive to the slope of the curve (Chart 4). With the NIM link broken, the yield curve has no influence on bank earnings (Chart 5). There is no doubt that banks regularly trade with long yields, but any link with the yield curve is easily severed (Chart 6) by earnings surprises. If the policy outlook doesn’t change between now and mid-July, we expect the SIFI banks will get a boost from smaller than expected loan-loss reserve builds. Taking our cue from the way monetary and fiscal largess will hold down defaults, we reiterate our overweight on the SIFI banks. Chart 4There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... Chart 5... Or Bank Net Income And The Yield Curve ... Or Bank Net Income And The Yield Curve ... Or Bank Net Income And The Yield Curve Chart 6Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Investment Implications A client asked us last week how investors who have built up cash holdings over the last few months should approach re-entering the equity market. Patiently, we replied, in line with the qualms we’ve had about the magnitude and speed of the rally from the March lows. We are only neutral equities over the tactical 0-to-3-month horizon because the S&P 500’s forward P/E multiple is elevated (Chart 7) and investors don’t seem to be assigning a high enough probability to the possibility that the virus, Congress, or geopolitics could create a bump in the road. We are still looking for a double-digit correction. Our SIFI banks thesis doesn't require a steeper curve or higher long yields; it'll work as long as loan-loss reserve builds fall short of investors' fears. Chart 7Stocks Are Expensive Stocks Are Expensive Stocks Are Expensive Table 2Downside Insurance Is Awfully Expensive The Fed, Congress And The Yield Curve The Fed, Congress And The Yield Curve We suggested that the client get 15-20% of the desired allocation deployed that day (Thursday, fortuitously) and parcel the rest out at lower limits all the way down to 2,875 (10% below the recent peak around 3,200) or some lower target like 2,700 or 2,800. With the revival in the VIX, we also suggested considering writing out-of-the-money put options on the SPY ETF. As of Thursday’s close, an investor could be compensated handsomely for agreeing to get hit down another 6.7% (280) or 10% (270) any time between now and the third Friday of July (Table 2). Writing puts is a way to get paid to wait to deploy capital, and with the VIX in the 40s, an investor can earn 20-30% annualized on the notional amount of capital s/he is committing by writing the option.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Corporations downgraded to junk ("fallen angels") after the lending facility was announced subsequently became eligible to participate. 2 Please see the June 8, 2020 US Investment Strategy Weekly Report, "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)", available at usis.bcaresearch.com.

Software: The Crown Jewel Software: The Crown Jewel Overweight While we are neutral the S&P tech sector, we continue to employ a defensive over aggressive tech strategy and prefer software and services to hardware and equipment. The S&P software index in particular has proven its resilience during the COVID-19 sell-off and recovery and has now broken out to fresh all-time highs both in absolute and relative terms. Upbeat profit fundamentals underpin software buoyancy. Relative capex spending remains in a secular uptrend, spring-boarding the share price ratio. Our relative macro earnings growth model is also gaining steam highlighting that the earnings driven outperformance phase has staying power. Bottom Line: Stay overweight the S&P software index.  

A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus compelled us to examine S&P sector performance during inflationary periods. Specifically, health care stocks have consistently outperformed during inflationary periods (see chart). Over the long haul, it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is on a secular rise around the globe, and most recently further catalyzed by the COVID-19 pandemic: in the developed markets driven largely by the aging population and in the emerging markets by the accelerating adoption of health care safety nets and higher standards. As a reminder, we are currently overweight the S&P health care sector. For more details on S&P GICS1 sector performance during inflationary periods, please refer to our recent Special Report. Health Care & Inflation Health Care & Inflation

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... In 2008, Tech Behaved Like A Cyclical... In 2008, Tech Behaved Like A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend Chart I-10Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Sector Relative Performance Drives... Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance ...Regional And Country Relative Performance ...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP ZAR/CLP ZAR/CLP   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

The SPX catapulted to fresh recovery highs, on the back of optimism surrounding the successful reopening of the economy along with the ongoing support of easy fiscal and monetary policies. Sentiment is not as extended as in February or during previous SPX tops in the past few years, as we highlighted in recent research.1 Equity market internals signal that there is likely a bit more gas left in the tank, despite the roughly 1000 point rise since the March 23 lows. The S&P deep cyclicals/defensives share price ratio, has led the broad equity market bottom and continues to herald additional gains for the SPX (not shown). Deep cyclicals include tech stocks, but even if IT were excluded, the cyclicals ex-tech/defensives ratio still troughed prior to the SPX and is gaining steam. Importantly, the turn in our Global Trade Activity Indicator corroborates the message that the cyclicals/defensives ratio is emitting (see chart). Further, the recent breakout in the JPM EM currency index along with budding evidence of China’s economic recovery and likelihood of a stimulus package (not as large as the GFC, but bigger than the early-2016 manufacturing recession one) suggest that global growth is slated to recover in the back half of the year. Bottom Line: We remain constructive on the broad market’s prospects  over the coming 9-12 month time horizon. For more details, please refer to this Monday’s Weekly Report.   There's A Bit More Gas Left In The Tank There's A Bit More Gas Left In The Tank Footnotes 1  Please see BCA US Equity Strategy Weekly Report, “There’s No Limit” dated May 26, 2020, available at uses.bcaresearch.com.

Highlights Duration: Investors should keep portfolio duration close to benchmark, but continue to hold yield curve steepeners (on both the nominal and real yield curves) as well as overweight TIPS positions versus nominal Treasuries. These tactical trades will profit from higher Treasury yields in the near-term. Healthcare: We recommend an overweight allocation to investment grade Healthcare bonds relative to the overall investment grade corporate index. But we also recommend an underweight allocation to high-yield Healthcare relative to the high-yield corporate index.  Pharmaceuticals: Investors should underweight Pharmaceutical bonds in both the investment grade and high-yield credit universes. How Much Higher For Bond Yields? Two weeks ago, we warned that bonds would struggle in the near-term as the re-opening of the US economy led to an improvement in economic data.1 However, we definitely didn’t anticipate the magnitude of the positive data surprise that has occurred since then. The US Economic Surprise Index was -55 one week ago and today it sits at +66 (Chart 1)! The bulk of that jump occurred after Friday’s employment report revealed that 2.5 million jobs were added in May when Bloomberg’s consensus estimate had called for a contraction of 7.5 million. Against this back-drop, it shouldn’t be too surprising that bond yields jumped sharply. The 30-year Treasury yield rose 27 bps last week to 1.68% and the 10-year yield rose 26 bps to 0.91% (Chart 2). The 2-year yield rose a more modest 6 bps to 0.22%, as the Fed maintains its tight grip on the front-end of the curve. Chart 1Back In Business Back In Business Back In Business Chart 2Yields Have Room To Move Higher Yields Have Room To Move Higher Yields Have Room To Move Higher For investors, the first relevant question is: How high can yields go? Our view is that if last week does indeed represent the cyclical economic trough, then forward rates at the long-end of the curve will revert to levels consistent with market expectations for the long-run neutral fed funds rate. The median estimate of that rate from the New York Fed’s most recent Survey of Market Participants is 2%, but with an unusually wide interquartile range of 1.3% to 2.5% (Chart 2, bottom panel). At the very least, we’d expect the 10-year and 30-year Treasury yields to re-test their respective 200-day moving averages of 1.38% and 1.91%, respectively. However, we are not ready to declare last week the economic trough for three reasons: First, we cannot rule out a re-acceleration in the number of confirmed COVID cases as the economy re-opens. This could lead to the re-imposition of lockdown measures come fall. Second, last week’s positive economic data might cause some members of Congress to question the need for further fiscal stimulus. This would be a mistake. In last week’s report we showed that fiscal measures have done a good job propping up household income so far, but these measures are temporary and will need to be renewed.2  Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak (Chart 1, bottom panel). This is by no means a fully healed economy that can withstand policymakers taking their feet off the gas. Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak. Finally, US political risks are heightened with anti-police protests occurring daily in most major cities. Added to that, President Trump is now the underdog heading into November’s election and he will need to develop a reelection bid that doesn’t hinge on the economy. Our geopolitical strategists think a doubling down on “America First” foreign and trade policies makes the most sense.3 A significant move in that direction would certainly send a flight to quality into US bonds. Investment Strategy As we advised two weeks ago, nimble investors should tactically reduce duration as yields still have more upside in the next month or two. However, we are not yet sufficiently confident in the sustainability of the economic rebound to recommend reducing portfolio duration on a 6-12 month horizon. Rather, we continue to recommend keeping portfolio duration close to benchmark while holding several less risky positions that will profit from higher yields. Specifically, investors should hold duration-neutral curve steepeners along the nominal Treasury curve. We advise going long the 5-year note and short a 2/10 barbell.4 We also like holding TIPS over nominal Treasuries and positioning for a steeper real Treasury curve.5 In terms of spread product, we also recommend staying the course. This entails overweighting corporate bonds rated Ba and higher, Aaa consumer ABS, Aaa CMBS (both agency and non-agency) and municipal bonds, while avoiding corporate bonds rated B and below and residential mortgage-backed securities. Appendix A at the end of this report shows how these positions have performed since the March 23 peak in spreads. The remainder of this report focuses on the Healthcare and Pharmaceutical sectors of both the investment grade and high-yield corporate bond markets. Investment Grade Healthcare & Pharma Risk Profile When assessing the risk profiles for investment grade-rated Healthcare and Pharmaceutical bonds, we first consider the credit rating distributions of both sectors relative to the overall Bloomberg Barclays corporate index (Chart 3). Chart 3Investment Grade Credit Rating Distribution* Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Immediately, we see that the Healthcare sector has a lower credit rating than the benchmark: 71% of the Healthcare index is rated Baa, compared to 48% for the corporate index. Meanwhile, the Pharmaceuticals sector has slightly higher credit quality than the corporate benchmark: 12% of the Pharmaceuticals index is rated Aa or Aaa, compared to 8% for the corporate index. Credit rating alone suggests that Healthcare should trade cyclically relative to the corporate index. That is, it should outperform during periods of spread tightening and underperform during periods of spread widening. However, this turns out to not be the case. Chart 4 shows that healthcare has outperformed the corporate benchmark during each of the last five major bouts of spread widening and underperformed during periods of spread tightening. Clearly, despite its low credit rating, Healthcare trades like a defensive corporate bond sector. Healthcare’s historically defensive nature is confirmed by its duration-times-spread (DTS) ratio, which has tended to be below 1.0 (Chart 4, top panel).6 Though recently, the DTS ratio climbed above 1.0 due to a lengthening of the sector’s duration (Chart 4, bottom panel). This suggests that Healthcare, while historically defensive, might trade more cyclically during the next 12 months. Neither the Healthcare nor Pharmaceuticals sectors offer a spread advantage over the corporate index. Pharmaceuticals, on the other hand, are a much more cut and dry defensive sector (Chart 5). The DTS ratio is almost always below 1.0 and the sector has a strong track record of outperforming the corporate index during periods of spread widening (Chart 5, panels 2 & 3) Chart 4IG Healthcare Risk Profile IG Healthcare Risk Profile IG Healthcare Risk Profile Chart 5IG Pharma Risk Profile IG Pharma Risk Profile IG Pharma Risk Profile   Valuation Turning to valuation, we find that neither sector offers a spread advantage compared to the corporate index or its comparable credit tier (Table 1). This is true whether we look at the raw option-adjusted spread or if we control for duration differences by looking at the 12-month breakeven spread.7  It is interesting to note that the Healthcare index offers a spread advantage compared to the A-rated corporate index. On the one hand, this is not surprising because the Healthcare index carries an average Baa rating. On the other hand, we have seen that Healthcare tends to trade more defensively than its average credit rating implies. This arguably makes its spread advantage over A-rated debt somewhat compelling. Table 1IG Healthcare & Pharma Valuation Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Balance Sheet Health Both the Healthcare and Pharmaceuticals sectors loaded up on debt during the last recovery. The amount of Healthcare debt in the corporate index grew 8.8 times since 2010. Meanwhile, total debt in the corporate index grew 2.4 times. The result is that Healthcare’s weight in the corporate index increased from 1.1% in 2010 to 4.3% today (Chart 6). The Pharma sector also increased its debt load at a faster pace than the overall corporate universe since 2010 (3.2 times versus 2.4 times), but the boom in Pharma debt has been much milder than in Healthcare. The weight of Pharmaceuticals in the corporate index increased from 4.1% in 2010 to 5.5% today (Chart 7). Chart 6IG Healthcare Debt Growth IG Healthcare Debt Growth IG Healthcare Debt Growth Chart 7IG Pharma Debt Growth IG Pharma Debt Growth IG Pharma Debt Growth Despite rapid debt growth during the past few years, credit quality in both the Healthcare and Pharma sectors appears quite solid. Appendix B lists the issuers in the Healthcare index, grouping them by credit tier and indicating whether they carry a positive, stable or negative ratings outlook from Moody’s. Of the 56 issuers in the Healthcare index, only six currently have a negative ratings outlook. The two largest issuers in the Healthcare index are Cigna and CVS Health. Both carry Baa ratings, but Moody’s just confirmed Cigna’s ratings outlook at stable in mid-May. CVS Health, on the other hand, has carried a negative ratings outlook since 2018. Appendix C lists issuers in the Pharmaceuticals index. Of the 17 issuers, only four carry a negative ratings outlook. None of the Baa-rated Pharmaceutical issuers currently has a negative ratings outlook. The two biggest issuers in the index are Bristol-Myers Squibb and Abbvie. Bristol-Myers Squibb is A-rated with a negative outlook, while Abbvie is Baa-rated with a stable outlook. Macro Considerations In a typical demand-driven recession, consumers tend to prioritize healthcare spending while they cut back on more discretionary outlays. This dynamic is probably what causes healthcare bonds to trade defensively relative to the overall corporate index. However, the unique nature of the COVID recession has thrown this traditional pattern into reverse. Consumer spending on health care services is down 40% since February while overall consumer spending is 19% lower (Chart 8). Oddly, healthcare bonds shrugged off this year’s massive drop in spending and continued to behave defensively – outperforming the corporate index when spreads widened and underperforming since the March 23 peak in spreads. Despite the plunge in spending, pricing power in the health care industry remains strong. Health care services prices continue to accelerate even as overall inflation has dropped sharply (Chart 8, bottom panel). Unlike healthcare, pharmaceutical spending has held firm during the past couple of months (Chart 9). Consumer spending on pharmaceuticals is only down 4% since February, while overall consumer spending is down 19%. But despite firm spending, medicinal drug prices have decelerated in concert with the overall headline CPI (Chart 9, bottom panel). Chart 8Healthcare Demand & Pricing Power Healthcare Demand & Pricing Power Healthcare Demand & Pricing Power Chart 9Pharmaceutical Demand & Pricing Power Pharmaceutical Demand & Pricing Power Pharmaceutical Demand & Pricing Power Investment Conclusions Putting everything together, we are inclined to recommend an underweight allocation to Pharmaceuticals and an overweight allocation to investment grade Healthcare. Pharmaceuticals are simply too expensive and too defensive for the current environment. Given our positive outlook on investment grade corporate bonds, we should target cyclical sectors with elevated spreads that have more room to compress. Healthcare is slightly more interesting. It has behaved like a typical defensive sector so far this year, but there are some indications that it is becoming more cyclical. The DTS ratio recently shot above 1.0 and consumer spending on healthcare services is poised for a rapid snapback. In terms of valuation, healthcare is expensive relative to other Baa-rated bonds but cheap versus the A-rated universe. This would seem to make healthcare a good risk-adjusted bet. Even if the sector continues to behave defensively, its spread advantage over A-rated bonds makes it an attractively priced defensive sector. High-Yield Healthcare & Pharma Risk Profile Considering the risk profile of high-yield Healthcare and Pharmaceuticals, we first notice that both sectors have significantly lower credit ratings than the overall junk index (Chart 10). Ba-rated credits account for 29% and 24% of the Healthcare and Pharma indexes, respectively, compared to 54% for the High-Yield index as a whole. Chart 10High-Yield Credit Rating Distribution* Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic The fact that significant portions of the Healthcare and Pharmaceutical indexes are rated B and lower immediately raises alarm bells. This is because we do not expect that many B-rated or lower issuers will be able to take advantage of the Fed’s Main Street Lending Program. This lack of Fed support for the lower-rated junk tiers has led us to recommend underweighting junk bonds rated B & below.8 High-yield Healthcare and Pharmaceuticals sectors have significantly lower credit ratings than the overall junk index. Interestingly, despite low credit ratings, a look at both sectors’ DTS ratios and historical excess returns reveals that they tend to trade defensively relative to the high-yield benchmark index. Healthcare outperformed the high-yield index by 473 bps from the beginning of the year until the March 23 peak in spreads and has underperformed the index by 123 bps since (Chart 11). Similarly, Pharmaceuticals outperformed the junk index by 670 bps from the beginning of the year until March 23 and have since underperformed by 136 bps (Chart 12). Chart 11HY Healthcare Risk Profile HY Healthcare Risk Profile HY Healthcare Risk Profile Chart 12HY Pharma Risk Profile HY Pharma Risk Profile HY Pharma Risk Profile Valuation Turning to spreads, we would characterize both high-yield Healthcare and Pharmaceuticals as expensive (Table 2). Despite both sectors carrying average credit ratings of B, they offer spreads that are below both the overall junk index average and the average for other B-rated credits. Tight option-adjusted spreads are at least partially attributable to low average duration for both sectors. If we adjust for duration differences by looking at 12-month breakeven spreads, we see that Pharmaceuticals look somewhat cheap versus other B-rated credits while Healthcare remains expensive. Table 2HY Healthcare & Pharma Valuation Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Balance Sheet Health Healthcare debt has grown less quickly than overall high-yield index debt since 2010 (Chart 13). Healthcare debt has grown 1.7 times since 2010 while the overall index has grown 1.8 times. This has caused Healthcare’s weight in the index to fall from 6.2% to 5.7%. In contrast, the high-yield Pharmaceuticals sector has grown rapidly during the past decade (Chart 14). Pharma debt has increased 10.3 times since 2010 compared to 1.8 times for the overall index. This has brought the sector’s weight in the index up to 2.3% from 0.4% Chart 13HY Healthcare Debt Growth HY Healthcare Debt Growth HY Healthcare Debt Growth Chart 14HY Pharma Debt Growth HY Pharma Debt Growth HY Pharma Debt Growth Looking beyond debt growth, in the current environment we are mostly concerned with the number of issuers in each index that will be able to access Fed support through the Main Street Lending facilities. In this regard, neither sector fares particularly well. Appendix D lists all high-yield Healthcare issuers along with their ratings outlooks, number of employees, 2019 revenues and total debt-to-EBITDA ratios. To qualify for the Fed’s Main Street Lending facilities, issuers must have either less than 15000 employees or less than $5 billion in 2019 revenues. Additionally, they must be able to keep their Debt-to-EBITDA ratios below 6.0. We estimate that all but three of the Ba-rated Healthcare issuers are eligible for the Main Street program, but only one of the B-rated issuers is eligible. High-yield Pharmaceuticals issuers are listed in Appendix E. Here, we once again find that only one of the B-rated issuers is likely to qualify for the Main Street lending facilities. Of the two Ba-rated issuers, one is likely to qualify. The other is Bausch Health, a Canadian firm that is by far the largest issuer in the Pharma index. It would need to turn to the Canadian authorities for help in an emergency lending situation. Investment Conclusions We recommend underweight allocations to both the high-yield Healthcare and Pharmaceuticals sectors. In the current environment we prefer to focus our high-yield credit exposure on the Ba-rated credit tier where issuers are more likely to have access to Fed support. The large concentration of B-rated and lower issuers in both the Healthcare and Pharma sectors, along with their generally expensive valuations, makes us wary about both sectors. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix B Table 4Investment Grade Healthcare Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix C Table 5Investment Grade Pharmaceuticals Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix D Table 6High-Yield Healthcare Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix E Table 7High-Yield Pharmaceuticals Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “Filling The Income Gap”, dated June 2, 2020, available at usbs.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, “Spheres Of Influence (GeoRisk Update)”, dated May 29, 2020, available at gps.bcaresearch.com 4 For more details on this recommended yield curve position please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on these recommendations 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 6 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. 7 The 12-month breakeven spread represents the spread widening that must occur for a sector to underperform a duration-matched position in Treasury securities during the next 12 months. It can be proxied by option-adjusted spread divided by duration. 8 For more details please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification