United States

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 2 Appendix  

Highlights Monetary Policy: It’s all but certain that tapering will begin next month and conclude by the middle of next year, but the FOMC is currently split right down the middle on whether it will be appropriate to lift rates in H2 2022. We present five factors to track to decide when the Fed will hike rates. Yield Curve: A bear-flattening of the nominal yield curve remains the most likely scenario for the next 6-12 months. Maintain a position short the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Investors should enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. The 2-year real yield, in particular, has a lot of upside during the next 6-12 months. EM Bonds: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling. Feature This past week was quite eventful for US bond investors. First, the Fed presented its September update on Wednesday, offering some hints about the timing and pace of asset purchase tapering alongside its updated economic and interest rate forecasts. Then, bonds sold off sharply on Thursday, Friday and Monday with the 10-year Treasury yield rising all the way to 1.49%. The first section of this week’s report looks at what we learned from last week’s FOMC meeting and opines on some monetary policy questions that remain unanswered. The second section updates our views on portfolio duration, the yield curve and TIPS in light of last week’s large market moves. Finally, we conclude with an update on the outlook for USD-denominated Emerging Market bonds. Powell Answers Some Small Questions, Avoids The Big One The Small Questions The start date for asset purchase tapering is the first small question that the Fed answered last week. A new sentence was added to the post-meeting statement saying that “a moderation in the pace of asset purchases may soon be warranted” and, in his press conference, Chair Powell clarified that the purpose of the new language is “to put notice out there that [tapering] could come as soon as the next meeting”. After this statement from the Fed, we expect asset purchase tapering to be announced at the next FOMC meeting on November 3rd. A delay until December is possible if September’s employment report is a massive disappointment, but the bar for delaying tapering beyond November appears high. Chair Powell also shed some light on a second small question related to the Fed’s balance sheet. Specifically, the pace of asset purchase tapering. In his press conference the Chair said that “participants generally view that, so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.” The information about the pace of tapering is slightly more interesting than the start date, if only because Fed policymakers have expressed a desire for net purchases to reach zero before the first interest rate increase. The fact that the Fed is planning to reach net zero purchases by the middle of next year suggests that it wants to leave the door open for a possible rate hike in the second half of 2022. This message was confirmed by the Fed’s updated interest rate projections (Chart 1). The projections revealed an even split (9 vs. 9) on the Committee between those that expect at least one 25 basis point rate increase before the end of 2022 and those that do not expect to lift rates next year. It’s also notable that, out of the 9 participants that don’t expect a rate hike in 2022, 8 anticipate lifting rates in 2023. Chart 1Rate Expectations Of course, as Chair Powell often points out, the Fed’s interest rate projections are contingent on the future state of the economy and will almost certainly be revised as the outlook evolves. What’s more important from a forecasting perspective is knowing how the Fed will react to different economic conditions. The Big Question With that in mind, we know that the Fed has promised not to lift rates until the labor market reaches “maximum employment”. However, as we noted in a recent report, the Fed hasn’t provided much detail on what “maximum employment” actually means.1 Powell’s comments last week didn’t add much clarity, but we can hunt for clues in the Summary of Economic Projections (SEP). In the SEP, we first notice that 13 FOMC participants expect the unemployment rate to be 3.8% - 3.9% or lower by the end of 2022 (Chart 2A). It is logical to assume that this group includes the 9 participants who expect to lift rates in 2022 and 4 additional ones. We also observe that 17 out of 18 participants anticipate an unemployment rate of 3.8% - 3.9% or lower by the end of 2023 (Chart 2B), exactly matching the number of participants who expect to lift rates by then. We can therefore infer that the Fed views an unemployment rate of roughly 3.8% as consistent with “maximum employment”. That is, FOMC participants tend to have rate hikes penciled into their forecasts once the unemployment rate is below 3.8%. Chart 2AFOMC 2022 Unemployment Rate Projection Distribution Chart 2BFOMC 2023 Unemployment Rate Projection Distribution The SEP’s inflation forecasts are less illuminating than the unemployment ones. All but 4 participants expect core PCE inflation to be above the Fed’s 2% target at the end of 2022 (Chart 3A) and no FOMC participant is forecasting below-2% core PCE at the end of 2023 (Chart 3B).2 The most we can take away from these forecasts is that 14 FOMC participants expect inflation to be above target in 2022, but five of those participants don’t see the labor market as being tight enough to lift rates by then. Chart 3AFOMC 2022 Core PCE Inflation Rate Projection Distribution Chart 3BFOMC 2023 Core PCE Inflation Rate Projection Distribution The revelation that FOMC participants view a 3.8% unemployment rate as consistent with “maximum employment” is illuminating, but it doesn’t tell the entire story. We don’t know, for example, what assumptions about labor force participation the different Fed officials are using. Our sense is that the following five criteria will ultimately determine when the Fed starts to lift interest rates: An unemployment rate in the neighborhood of 3.8%. Prime-age (25-54) labor force participation close to its pre-pandemic level (Chart 4, top panel). Accelerating wage growth (Chart 4, bottom 2 panels). Long-dated inflation expectations at or above target levels (Chart 5, top 2 panels). Non-transitory inflation at or above target levels (Chart 5, bottom panel). Bottom Line: The FOMC is currently split right down the middle on whether it will be appropriate to lift rates in 2022, but these forecasts aren’t set in stone and next year’s economic data – particularly the five factors listed above – will determine which group is correct. Chart 4Part Rate & Wage Growth Chart 5Inflation & Inflation Expectations Our own view is that the labor market will be sufficiently tight for the Fed to deliver its first rate hike in December 2022, and that rate hikes will proceed more quickly than what is currently priced in the yield curve. US bond investors should maintain below-benchmark portfolio duration. The Fallout In Bond Markets Bonds sold off sharply last Thursday and again yesterday morning. At the time of publication, the 30-year Treasury yield had risen from 1.81% on Wednesday to 2.02% (Chart 6). The 10-year Treasury yield had risen from 1.30% to 1.49% (Chart 6, panel 2). The 5-year yield is up to 0.98% from 0.85% on Wednesday (Chart 6, panel 3), and the 2-year yield is up to 0.28% from 0.24% (Chart 6, panel 4). The yield curve has also steepened since Wednesday, though the 2/10 slope remains well below its March peak (Chart 7). The trend during the past few months has been one of curve steepening out to the 5-year maturity point (Chart 7, panel 2) and flattening beyond that point (Chart 7, bottom 2 panels). Recent market action has led to some steepening beyond the 5-year maturity, but so far that steepening is minor compared to the flattening move we’ve witnessed since the spring. Chart 6Treasury Yield Trends Chart 7Treasury Curve Trends Nominal Curve We have been recommending a position short the 5-year bullet and long a duration-matched barbell consisting of the 2-year and 10-year notes, and we think this trade will continue to outperform. First, the 5-year/5-year forward Treasury yield is back above 2%, consistent with median estimates of the long-run neutral fed funds rate from the New York Fed’s Surveys of Market Participants (2%) and Primary Dealers (2.25%) (Chart 6, bottom panel). We think it will be difficult for the 5-year/5-year forward yield to rise much above these levels, which makes curve flattening more likely than steepening going forward.3 Second, we updated our work on yield curve scenarios to incorporate recent market action and some new information gleaned from last week’s SEP. In this analysis we estimate fair value levels for different parts of the yield curve as of the end of 2022 based on a scenario for the path of the fed funds rate. For example, if we assume that Fed liftoff occurs in December 2022 and rate hikes proceed at a pace of 75 bps per year (the median pace in the SEP) until the fed funds rate levels-off at 2.08% (consistent with a 2%-2.25% range for the long-run neutral fed funds rate), we calculate that the 2-year yield has 74 bps of upside between now and the end of 2022. This is slightly more than the 65 bps of upside in the 5-year yield and much more than the 37 bps of upside in the 10-year yield (Table 1). Comparing this expected change to what is already discounted in the forward curve, we see that both the 2-year and 10-year yields are expected to exceed their forwards by 6 bps. The 5-year yield is expected to exceed its forward by 16 bps. Table 1Treasury Curve Scenario Analysis To us, the message is clear. We want to remain short the 5-year note versus a duration-matched 2/10 barbell. Real & Inflation Curves Chart 8Real & Inflation Curves The increase in the 10-year nominal yield since last Wednesday was roughly evenly split between the real and inflation compensation components. Interestingly, inflation drove a greater proportion of the increase at the front-end of the curve, and the 2-year real yield actually fell. We maintain a neutral recommendation on TIPS versus nominal Treasuries, but this week we recommend taking advantage of recent market action by implementing some curve trades across the real and inflation curves. Specifically, we note that the cost of short-maturity inflation compensation remains well above the cost of long-maturity inflation compensation (Chart 8). Going forward, the cost of front-end inflation compensation will fall as inflation moderates from its current extremely high level. Meanwhile, the cost of long-maturity inflation compensation will remain sticky near the Fed’s target levels. This will lead to a steepening of the inflation curve (Chart 8, panel 2). The combination of a steeper inflation curve and a flatter nominal curve will lead to a much flatter real yield curve (Chart 8, bottom 2 panels). The 2-year real yield, in particular, has a lot of upside if inflation moderates, as we expect, and the 2-year nominal yield rises in line with the projections shown in Table 1. Bottom Line: Investors should remain short the 5-year bullet versus a duration-matched 2/10 barbell on the nominal Treasury curve. Investors should also enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. A Quick Update On Emerging Market Bonds The collapse of Chinese real estate behemoth Evergrande dominated headlines for most of the past week, though so far there has been little contagion into USD-denominated credit markets. Unsurprisingly, the spread on Chinese corporate and quasi-sovereign bonds has widened, and there has been some passthrough into both the High-Yield EM USD Corporate & Quasi-Sovereign Index and the High-Yield EM USD Sovereign Index (Chart 9). However, investment grade EM credit spreads have been relatively unaffected by the turmoil, as have US corporate bond spreads (both IG and HY) (Chart 9, bottom 2 panels). While the Evergrande drama – and weakening Chinese economic growth in general – could weigh on USD-denominated EM bond performance in the near-term, we see an excellent buying opportunity in investment grade EM bonds on a 6-12 month horizon. Investment grade EM Sovereigns outperformed credit rating and duration-matched US corporate bonds in the early months of the recovery but have lagged during the past few months (Chart 10). The same is true for the investment grade EM Corporate and Quasi-Sovereign index (Chart 10, panel 3). This is not to say that EM bond performance has been poor – the EM Sovereign index is still up 97 bps versus duration-matched Treasuries on the year – it has simply failed to keep pace with the stellar performance of US corporate bonds. Chart 9No Contagion Chart 10EM Bonds Versus US Corporates But that recent stellar performance of US investment grade corporate bonds has left spreads in the sector near historically tight levels. In last week’s report we ran some scenarios for US investment grade corporate bond returns during the next 12 months and concluded that excess returns versus Treasuries are probably capped at 85 bps.4 This makes the current spread advantage in EM Sovereigns (Chart 10, panel 2) and EM Corporates & Quasi-Sovereigns (Chart 10, bottom panel) very compelling. This will be especially true if Emerging Market growth accelerates in 2022 on the back of increased Chinese stimulus and a COVID vaccination campaign that is already picking up steam.5 Bottom Line: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 2 Chart 3B shows that 4 participants expect core PCE inflation of 1.9%-2.0% in 2023, but the SEP also reveals that the minimum forecast for core PCE in 2023 is 2.0%. In other words, all 4 participants in that range are forecasting 2.0%, not 1.9%. 3 For more details on the relationship between our 5-year/5-year forward yield target and the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 For a recent debate about the outlook for Emerging Market assets please see last Friday’s Webcast: https://www.bcaresearch.com/webcasts/detail/458 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights This is the second part of the publication, in which we provide an in-depth overview of Hotels, Restaurants, and Airlines, or the “travel complex” as we dubbed it. In last week’s report, we provided an overview of the macroeconomic backdrop, the Delta variant trajectory, and a “deep dive” into the hotel industry. We concluded Hotels is a sound tactical and cyclical investment, and we recommended an overweight. Airlines Less profitable trip mix and excess capacity: Domestic travel has rebounded to 2019 levels, while international and corporate travel are still lagging due to government and corporate restrictions (Chart 1). Some of the excess capacity is being redirected to domestic leisure travel, which has higher volume but is far less profitable. Airline cargo growth is a saving grace. The cost side of the airline business has its own challenges. Airlines have high fixed costs as they own or lease aircraft fleets. This creates a heavy financial burden during downturns. The price of jet fuel has increased to pre-pandemic levels. Labor costs are high due to the unionized work force and rising wages. Profitability is elusive: With airline revenues down 27% YoY in August 2021, and costs on the rise, it is hard to envision profitability without a return of international and business travel. Too much debt: Airlines’ net debt has risen significantly since the pandemic. Without positive cash flow generation, it will become harder and harder for them to meet their debt obligations. We have a negative outlook for airlines and are underweight the S&P Airlines index. Restaurants Defensive: Although the S&P Restaurant Industry resides within the pro-cyclical S&P Consumer Discretionary Index, its composition is nothing but defensive as it is dominated by fast-food chains. Profitable and resilient: Despite the havoc wreaked by Covid, the restaurant industry has not stopped being profitable (Chart 2). With any new Covid variant scare, restaurants will just go back to their “drive-throughs” playbook. Over the course of 2021, restaurant spending has risen by more than 40%. We have a positive outlook for fast-food chains and are overweight the S&P Restaurant index. Feature This is the second part of the publication, in which we provide an in-depth overview of Hotels, Restaurants, and Airlines, or the “travel complex” as we dubbed it. These industries share many drivers of profitability as each provides in-person experiences. They are also highly dependent upon public sentiment regarding the potential dangers and likelihood of Covid infections. Further, consumer confidence and financial wellbeing are at the core of this group’s profitability, as the travel complex is a quintessential discretionary spending category. The recovery of the group was coming along quite well until the Delta variant derailed it in late summer, with reports pouring in about dining rooms closing, airline bookings flagging, and hotel occupancy dipping. What is next? In last week’s report, we provided an overview of the macroeconomic backdrop, the Delta variant trajectory, and a “deep dive” into the hotel industry. We concluded that the Hotels, Resorts, and Cruise Lines industry has significant potential to return to its former “glory”: Delta is cresting, financially healthy US consumers are choosing to spend their money on services and experiences, sell-side forecasts are pointing to surging sales, and hotels have substantial pricing power. The industry is a sound tactical and cyclical investment, and we recommend an overweight. This week we will continue with a deep dive into the Restaurant and Airline industries. Sneak Preview: We like restaurants (overweight) but airlines, not so much (underweight). Chart 1Airline Majors' Traffic Still Has Not Recovered To 2019 Level Chart 2Profitability Is Resilient To Downturns Airlines “To suggest that the airlines should have better prepared for this environment seems akin to suggesting Pompeii should have invested more heavily in firefighting technology.” (JP Morgan, Mar. 22, 2020) Having avoided bankruptcy in 2020 thanks to federal payout support, US passenger airlines recorded $4.3 billion more in pre-tax losses in the first half of 2021. Clearly, this industry’s woes are far from over. Unsurprisingly, airlines have had the worst performance of any industry in the travel complex, underperforming the S&P 500 by 5% over the past year (Chart 3 & Table 1). Importantly, the performance of the industry slumped at the end of the summer, triggered by the Delta variant scare: After several months of steady increases, new ticket sales have dipped. As we noted last week, several major airlines have warned in regulatory filings that their third quarter may not look as rosy as was hoped. American Airlines, Southwest Airlines, and United all noted a deceleration in near-term customer bookings in August and elevated trip cancellations, even in leisure.1 All three have suggested that the Delta variant is having a dampening effect on business. We believe that the Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the travel complex is vulnerable to any new virus scare (Table 2), and this is a risk that investors need to keep in mind. However, unlike hotels, airlines face multiple other challenges. Chart 3The S&P Airline Industry Index Is Still Under the Pre-pandemic Level Table 1PerformanceTable 2Airline Industry Composition Competitive Landscape The US airline industry generated total operating revenues of $92.7 billion in 2020, down 48.3% from $179.4 billion in 2019. The industry is dominated by five majors, that are included in the S&P 500 index). Macroeconomic Backdrop For Airlines The airline industry is highly cyclical, and its wellbeing is tightly tied to economic growth. As economic activity improves, business travel tends to increase (except when Covid-related restrictions change the normal course of things). As economic growth translates into higher wages and stronger employment gains, leisure travel also takes off. So does the transportation of goods. As we discussed in Part 1 of the report, the economy is currently in a slowdown stage of the business cycle: Growth is slowing but off high levels. As such, even in the absence of Covid-19 or the Delta variant, Airline sales would continue to grow but at a slow pace. US consumers are financially healthy, and while most of the stimulus money has been spent, more and more people are returning to work. Recently, consumer confidence has soured on the back of a resurgence in Covid infections and rising prices (Chart 4, panel 2). However, domestic airline tickets are still cheap, and only fear of infection is keeping Americans grounded. With Delta cresting, people will go back to flying. Chart 4Airlines Are Highly Cyclical Key Drivers Of Profitability: Revenue Vs Expenses Revenue While many industries have been hit hard by the pandemic (brick-and-mortar retail, hotels, restaurants) most have turned the corner and are now profitable. Airlines, however, are still struggling (Chart 5). The good news is that losses have been declining, but the bad news is that the financial situation of most airlines is still precarious. Airlines rely on diverse sources of revenue, and thanks to that, business is starting to recover. The following are the key streams: Fares charged to customers In-flight entertainment, food, and beverages Sales of frequent-flyer credits to hotels, auto rental agencies, credit card issuers Auxiliary charges: Baggage checks, choice of seat, extra leg room Cargo and mail Chart 5Airlines' Revenue Remain Chart 6Airline Majors' Traffic Still Has Not Recovered To 2019 Level Traffic Recovery: Domestic Travel Has Rebounded, While International And Corporate Travel Are Still Lagging Budget airlines are pandemic winners: As of October 2021 compared to October 2019, scheduled available seat miles are down for all the airlines in the S&P 500 index (AAL, LUV, DAL, UAL, and ALK) (Chart 6). Only the budget airlines such as Allegiant, Spirit, and Frontier have a scheduled number of flights above the 2019 watermark. The underlying reason for such a dichotomy is easy to explain. The successful rollout of Covid-19 vaccines in the US has unleashed material pent-up demand for domestic leisure travel, benefiting domestic budget airlines. US domestic seat miles and load factors have recovered to pre-pandemic levels (Chart 7) as consumers have eagerly spent their stimulus checks on travel within the US. Chart 7Domestic Load Factor Has Fallen Below Pre-Pandemic Levels Major airlines are bleeding cash due to high exposure to international and business travel segments: In the meantime, many government and company-imposed restrictions on international and business flights are still in place. Companies are taking a very cautious approach to office re-openings and employee travel, and Zoom has become embedded as a viable corporate communications alternative and a cost-saving tool. As a result, the airline traffic of the majors with high exposure to international (Chart 8) and business travel (Chart 9), is still below the pre-pandemic level. Some of that capacity is being redirected to domestic leisure travel, which has higher volume but is far less profitable. Chart 8In August 2021, US-International Air Travel* Fell 54% Below 2019 Levels Chart 9Since Mid-July, Growth Of Overall And Corporate Ticket Sales Has Slowed Corporate and international travel are the most lucrative revenue segments and are significant in size: Before the pandemic, business travel constituted 30% of all trips. The industry can hardly recover without these segments rebounding. Until that happens, companies will stay unprofitable, and cash burn will continue. Business travel is projected to recover in 2022 at best and 2024 at worst: The US Travel Association projects US business travel to return to the 2019 level in 2024. The Airlines for America Association (A4A) concurs. It projects that airline passenger volumes will return to the 2019 level in 2022 in the best-case scenario and in 2024 in the worst. Airline cargo is a saving grace: With passenger revenues still lagging 2019 levels, many airlines are focusing on the capacity of their cargo units. With global supply chains clogged and shipping costs increasing five-fold over the past few months, this is a profitable niche. Air cargo demand reached its all-time high in 2020 and continues to grow in 2021: US airlines posted a 20.5% increase in demand for international air cargo in July 2021 from the July 2019 actuals (Chart 10). Chart 10For US Airlines, Growth In Air Cargo Continues To Outpace Air Travel By A Large Margin Airlines Compete On Volume: Airfares Are Low Despite the inflationary environment, the price of airfares is still 18% below its 2019 level (-10% annualized), and that is after 7% YoY price increases in 2021 (Chart 11). These are price levels not seen since the 1990s. With all the spare capacity, former international and business travel is now competing to attract domestic leisure passengers. Making things worse, due to prior commitments, airlines continued to grow their fleets throughout the pandemic closures (Chart 12), further increasing capacity and exacerbating competition for passengers as business and international travel are likely to lag, making peak ticket prices and peak revenue elusive (Chart 13). There is also another matter to consider, which is hardly minor. Airline taxes and fees constitute about a quarter of the price of a ticket. According to an example put together by A4A, the base airline fare of $236 has $64 in multiple taxes and fees, making tickets less affordable. Chart 11Airfares Have Fallen by 10% A Year Since The Beginning Of The Pandemic Chart 12Capacity Continues To Increase Chart 13Airfares Are Down 18% From 2019 And 29% From 2014 Sales Growth Analysts expect airline sales growth to stabilize at 60% over the next 12 months. The base effect certainly plays a significant role, but this rate will help the industry to recover. Expenses Airlines have high fixed costs as they own or lease aircraft fleets. This creates a heavy financial burden during downturns, as costs can hardly be cut. Other expenses such as labor and fuel are also sticky. Price Of Jet Fuel Has Increased To Pre-pandemic Levels The cost of jet fuel is one of the most significant input costs for airlines, constituting anywhere between 10% and 30% of revenue (Chart 14). The price of fuel can make a significant difference for an airline’s razor-thin margins. Airlines therefore tend to hedge their fuel exposure. Jet-fuel prices have rebounded to their pre-pandemic level and are up 49% from January 2021 (Chart 14), no longer giving the airline any slack on the cost side. According to Zach Research, at United Airlines the average aircraft fuel price per gallon increased by 66.9% year-over-year to $1.97 in the June quarter. Owing to the uptick in air travel demand witnessed in the June quarter following increased vaccinations, fuel gallons consumed were up 206.4%. Chart 14Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Chart 15Labor Costs Increased Again Labor Costs Are Fixed Due To The Unionized Work Force Labor is another significant line item on the expense side of the airline’s income statement. Normally labor costs constitute 30-40% of sales. During the darkest days of the lockdowns, labor expense soared to 60% of sales (Chart 15). With a highly unionized labor force, layoffs and furloughs require significant payouts. There are also many other conditions in the labor contract that must be met. As a result, as sales tanked, labor costs did not change in the same proportion. Even so, airlines reduced their workforce from 458,000 people in 2019 to 363,000 in November 2020 (Chart 15). Now, with sales growing again, airlines have started rehiring. However, with recent wage rises, new employees are more expensive. Profitability With revenue challenged by a less profitable trip mix, excess capacity, and rising fuel and labor costs, airlines have been losing money for over a year now (Chart 16). While the increase in leisure travel and cargo units is helping, it is hard to envision profitability without a return of international and business travel. With airline revenue down 27% YoY in August 2021, and costs on the rise, profitability is still a long way off (Chart 17). Chart 16Airlines Are Unprofitable… Chart 17…And Are Burning Cash Net Debt Airlines’ net debt has risen significantly since the pandemic, driven by their need to support fixed costs (Chart 18). The increase in net debt was also stimulated by large government support and a low interest-rate environment. The problem is that since airlines are unprofitable, and are burning cash, it is becoming harder and harder for them to meet their debt obligations (Chart 19). While there have not been any high-profile bankruptcies in the US, some European and Asian carriers, such as Norwegian Air and AirAsia Japan Co., had to file for bankruptcy protection. As airlines are expected to continue to burn cash through 2022 their credit ratings have been downgraded (Table 3). We would not be surprised if more bankruptcies or industry consolidations take place in the near term. Chart 18Debt Levels Have Increased Significantly Chart 19Airlines Have Difficulty With Interest Payments Table 3All Airlines Credit Ratings Have Been Downgraded When Will Airlines Thrive Again While revenue lags, the industry will remain vulnerable to shocks and cost headwinds. However, once international and business travel recovers, sales will pick up, and companies will generate positive cash flow. Cash generation is a necessary condition for financial recovery – once airlines arrest the cash burn, they can shift their efforts towards rebuilding profitability and, eventually, repairing their balance sheets. Valuations And Technicals Airlines are trading at 36x forward earnings, which is optically high. However, the Valuations Indicator suggests that airlines are not expensive relative to their own history (Chart 20). The industry is also modestly oversold (Chart 21). Chart 20Airline Are Not Expensive Relative To Own History… Chart 21…And Are Oversold  Investment Implications Airlines are slowly recovering from a malaise induced by the pandemic lockdowns. However, the road to recovery will be long. While domestic leisure and cargo traffic has picked up, it will be another couple of years before international and business travel rebounds to the pre-pandemic levels. With fuel and labor costs on the rise, profitability is elusive without those segments. And, even when airlines return to profitability, it will take them years to repair their indebted balance sheets. What is worse, with current levels of debt burden and negative interest coverage, bankruptcies may not be out of the question for some. While airlines may rally with rates rising and cyclicals outperforming, we are negative on the industry on both a cyclical and structural basis. However, if any of our clients wish to trade this industry, there are several liquid ETFs that represent this space (Table 4). If investors chose to be granular and pick individual stocks in this space, they need to be aware of the individual challenges of each airline and their levels of indebtedness vs cash burn. In short, we have a negative outlook for airlines and are underweighting the industry. Table 4Airline ETFs Are Readily Available Restaurants: Defensive Cyclicals Industry Composition Although the S&P Restaurant Industry resides within the pro-cyclical S&P Consumer Discretionary Index, its composition is nothing but defensive. In fact, a more appropriate name would have been the S&P Fast-Food Industry, with MCD and SBUX accounting for 70%+ of the industry market cap (Table 5). Table 5Industry Composition Performance Restaurant Industry performance has been tracking the performance of the S&P 500, lagging the benchmark by only 8% since January 2020 (Chart 22) Chart 22Restaurant Performed Almost In Line With The S&P 500 Restaurants Are “Defensive Cyclicals” Since fast-food prices are generally low, fast-food restaurants tend to be what economists call “inferior” goods, i.e., goods whose sales rise when the economy is in a downward spiral. Restaurants tend to outperform in the slowdown stage of the business cycle (Chart 23), are flat during contraction, and underperform during expansions. Consistent with these expectations, fast-food restaurants also came out as winners of Covid lockdowns: Although sales initially dipped, they quickly recovered as fast-food chains reoriented their business toward drive-throughs and other forms of take-out (Chart 24). Chart 23Fast-Food Restaurants Are Defensive Chart 24Sales Growth Is Recovering Covid While the restaurant business was coming along quite well, concerns emerged at summer’s end that the Delta variant would further delay industry recovery. Chains like McDonald’s and Chick-fil-A announced that they are slowing their dining room re-openings. As data from restaurant analytics firm Black Box Intelligence demonstrates, sales that had grown steadily earlier this summer have fallen.2 We believe that the reaction to the Delta variant is transitory as new infections are cresting. And, in the worst-case scenario, fast-food restaurants in the index will just switch back to their Covid “drive-through playbook,” and will maintain their level of profitability. Restaurant Spending And Profitability Over the course of 2021, US retail sales releases reveal that restaurant spending rose by more than 40%, outpacing the headline number (13%) by a wide margin (Chart 25). While restaurant spending is likely to decelerate over the coming months as pent-up demand for services is satisfied, earnings will continue to improve. This is in line with analyst expectations (Chart 26). Chart 25Restaurant Sales Skyrocketed In 2021 Chart 26Earnings Will Continue to Grow But At A Slower Pace Despite the havoc wreaked by Covid, the restaurant industry has not stopped being profitable, and although margins dipped in the midst of the lockdown, they swiftly rebounded. The 83% YoY print in restaurants FCF is nearly an all-time high reading since the history of the data going back to the 1990s (Chart 27). Debt Is Low Net debt to total assets also echoes the upbeat message highlighting that US dining stocks remain in good financial health (Chart 28). Chart 27Free Cash Flow Is At All-Time High Chart 28Debt Is Low Valuations And Technicals Valuations are not demanding while technicals suggest that the industry is oversold (Chart 29). Chart 29Restaurants Are Oversold & Undervalued Investment Implications The current slowdown stage of the business cycle is favorable for the fast-food industry. This industry is profitable and resilient in downturns. It is also attractively valued. The industry is oversold, which represents a favorable entry point for an overweight position. In short, fast-food restaurants are a sound “cyclical defensive”: They are resilient to downturns, highly profitable, and have healthy balance sheets. We have a positive outlook on the industry and are overweight. A Quick Aside: Toast IPO Before we conclude, a brief note on the new Toast (TOST) IPO is in order. While the stock became public only last week and is not a part of the S&P 500, it is an important newcomer to the stock market. The company is a market leader in cloud-based restaurant management software. Toast’s performance is tied to the health of the overall US restaurant industry. Many of the popular restaurants and fast-food chains are among Toast’s clients. Bottom Line We have a negative outlook for Airlines: This highly cyclical industry is on a long-winding path towards recovery, profitability, and deleveraging. Airlines face multiple challenges and headwinds: Fuel and labor costs are rising, while their most profitable revenue segments, international and business travel, are missing in action. Cash burn is still acute, and profitability is elusive despite all the progress made. We are much more positive on the outlook for the Restaurant Index, which represents some of the largest fast-food chains in the nation. This industry thrives during economic slowdown, is resilient to shocks, and is highly profitable.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Travel Investors Need More Drive, WSJ, Sep 12, 2021 2     Restaurants Close Dining Rooms Again as Delta-Driven Infections Spread, WSJ, Sep 13, 2021.     Recommended Allocation

Highlights Economy – We find the leading arguments for why households’ excess savings won’t be spent to be wanting: US households do not commonly demonstrate the detached foresight that Ricardian equivalence takes as given and the trauma-will-change-behavior thesis fails to account for the absence of widespread financial trauma. Markets – Public equities account for a record portion of household wealth, but their share gains are not a sign of a budding mania: Our analysis of the Fed’s Flow of Funds data argues that much of equities’ relative share gains have been driven by structural rather than cyclical factors. Strategy – It would be premature to shift to defensive asset allocation settings if monetary policy is going to remain accommodative for another three years: The rate hike progression envisioned by FOMC participants’ dot-plot projections suggests policy won’t become tight until late 2024 at the earliest. Feature The US Investment Strategy team has been at the more bullish end of the continuum within BCA, and among the broader strategist community, since the spring of 2020. Our view was premised on the idea that the fiscal and monetary policy responses to the pandemic were (and would continue to be) so large that they would overwhelm its adverse effects on the economy and markets. That view came to pass as Congress augmented the CARES Act’s fiscal largesse with two subsequent rounds of direct payments to households earning up to $100,000 per adult and a renewed federal supplement to unemployment insurance (UI) benefits. With the expiration of the UI benefit program at the beginning of the month and the Fed poised to end asset purchases by the middle of next year, clients have begun to ask if our underlying bullish premise still applies. We believe that it does, on the grounds that policy remains on an emergency footing even though the emergency has passed. The fiscal transfers may have ended, but their full effect has yet to be felt. They will support the economy on an ongoing basis as households direct their excess pandemic savings toward consumption. No one knows for sure how much of the excess savings will be spent or when, but the arguments citing Ricardian equivalence or consumer trauma as impediments to consumption are flawed. What If Today’s Income Is Taxed Tomorrow? British classical economist David Ricardo is best known to introductory economics students for comparative advantage, but he also posited that deficit spending may fail to boost aggregate demand because taxpayers, anticipating that they will be tapped in the future to repay state loans, may increase savings to cover future taxes. Despite its theoretical appeal, empirical data in support of Ricardian equivalence is elusive. Two centuries and an ocean removed from Ricardo’s England, we submit that Americans are not known for parsimony, studied caution or a tendency to see the glass as half-empty. Although American households began to rebuild savings after the global financial crisis, an additional dollar has tended to burn a hole in their pockets ever since the baby boomers began reaching adulthood (Chart 1). Chart 1The Searing Trauma Of The Depression Weighed On Consumption Decisions Even if Americans were wont to consider future tax burdens, it may be rational for the households who received the fiscal transfers to assume they will largely escape them unless their relative income surges. Per the most recent adjusted gross income (AGI) distribution data (for tax year 2018), 70% of taxpayers earn $75,000 or less (Chart 2). Single taxpayers meeting that threshold (and married taxpayers earning $150,000 or less) received the full amount of the economic impact payments authorized by the CARES Act and subsequent legislation. That bottom 70% paid just 5.1% of AGI in federal taxes (Chart 3), and the current political climate points in the direction of an increasingly progressive tax system, so they may not have to worry about being called upon to cover the expanding deficit down the road. Chart 2The Income Distribution Is Top Heavy ... Chart 3…But So Is The Tax Burden The (Not So Traumatic) Economic Trauma Of COVID-19 While we are confident that Ricardian equivalence will not act as an impediment to consumption, the ultimate disposition of households’ excess pandemic savings is unknown. Our working assumption has been that half of the savings will be spent across 2021 and 2022. Though we do not have any close antecedents for what households might do with a savings windfall equivalent to 10% of a year’s GDP amassed over a thirteen-month span, we reject the notion that those who experienced COVID-19 will behave like the many shell-shocked survivors of the Great Depression who became lifelong precautionary savers. However terrible the human cost of COVID, it did not ravage American households’ financial position; as the Fed’s latest Flow of Funds report showed, their balance sheets flourished, allowing the vast majority of them to escape any sense of financial trauma. Per the Flow of Funds, American household wealth grew by nearly $6 trillion in the second quarter, extending the last five quarters’ gains to $31 trillion since financial markets cratered when the pandemic burst forth in the first quarter of 2020. The 22% annualized five-quarter gain is nearly four standard deviations above the mean and blows away 4Q03 through 4Q04’s 14% second-place mark by two full standard deviations (Chart 4, top panel). The current run sets a record even when it’s stretched to six quarters to include 1Q20, the worst quarter in series history, and the five- and six-quarter gains are also pacesetters after adjusting for inflation (Chart 4, bottom panel). Chart 4Recessions Aren't So Bad When Congress And The Fed Throw Everything They Have At Them Changes in household net worth lead consumption growth with a two-quarter lag (Chart 5), though the four quarters before the most recent one (the red dots with negative consumption growth) were notable outliers. 2Q21 consumption was just a little more than a percentage point below the best-fit line, however, so it is closing in on its modeled value and we expect it will overshoot it in coming quarters upon the release of pent-up demand. We do not believe that the pandemic will dampen household spending simply because the broad mass of consumers did not experience financial trauma on a scale that would alter future behavior. As household wealth and income data have shown, this recession has been a boon for most Americans. Chart 5Consumption Overshoots Are On The Way Chart 6Fiscal Shock And Awe We additionally reject the notion that households have learned a lesson that will make them want to hold more savings. The financial lesson of the pandemic seems to be that policymakers will do their utmost to shelter them from calamity. Between the economic impact payments (Chart 6, top panel) and the UI benefit supplement (Chart 6, middle panel), Congress directly sent nearly $1.5 trillion to US households to offset $300 billion of lost wages (Chart 6, bottom panel). COVID-19 inflicted terrible distress on those who lost loved ones and witnessed or experienced near fatal suffering, but it boosted the lower three quartiles of households who received transfers and the top decile of households who reveled in the financial markets’ advance. Those who experienced it will not hoard their pennies and shun debt like many of the Depression’s survivors; they are more likely to have experienced post-traumatic bliss than stress when it comes to their financial outlook. Too Much Of A Good Thing? We periodically check in on the Flow of Funds for insight into the evolution of households’ asset allocations and the share of net worth accounted for by homes. Directly owned equities and mutual funds have taken share from the other major categories throughout the pandemic run (Chart 7) and now account for a record share of household financial assets after having surpassed their 2000 highs (Chart 8, top panel). It is sensible to approach any equity milestone that invokes the dot-com bubble with some trepidation, but structural factors go a long way toward explaining the new allocation peak. The financialization of the economy has steadily advanced since the Flow of Funds data began to be compiled in 1951, promoting public equity ownership, and consolidation has supported the transfer of commercial ownership from mom-and-pop operations to corporate interests, many of which are publicly traded. Overall equity in businesses as a share of household net worth is merely in line with its ‘50s levels (Chart 8, bottom panel). Chart 7The Running Of The Bulls Chart 8From Mom And Pop To Broad And Wall Home price appreciation has picked up, but it is not out of the ordinary (Chart 9). Home equity gains have outstripped home price gains, relative to each series’ history, testifying to prudent behavior on the part of borrowers and lenders. The low aggregate mortgage loan-to-value ratio (Chart 10) suggests that slowing home price appreciation, or even an outright decline, would not be a source of economic instability. Chart 9Home Price Gains Are Not Out Of The Ordinary ... Chart 10... And Leverage Levels Are Not A Concern The Fed Signals That Tapering Is Near Though the FOMC did not adjust the pace of its asset purchases last week, it indicated that tapering will most likely begin after its November meeting. Chair Powell noted that the economy has made substantial further progress toward reaching the committee’s inflation goal and expressed that “many” members feel that it has made substantial progress toward achieving its full employment objective as well, going so far as to volunteer his personal view that the employment test has been “all but met.” Per the committee’s discussions, the purchases will likely end around the middle of next year if the economy progresses in line with its expectations. The committee would not be talking about reducing the accommodation it’s providing the economy if it weren’t secure in the sense that it is on solid footing. Powell expressed satisfaction with the evolution of inflation expectations (Chart 11) and although the real GDP forecast for this year was lowered in the summary of economic projections (the “dots”), next year’s forecast was raised and slightly higher inflation expectations imply that nominal GDP growth will remain quite robust. A shift in two members’ fed funds rate projections brought the median member’s liftoff date to 2022 from 2023, in line with our view. Chart 11The Fed Has Succeeded In Firming Up Inflation Expectations The chair reiterated that tapering – slowing the pace of accommodation – and hiking the fed funds rate – slowing the economy – are distinct actions subject to separate criteria. We see liftoff as a more significant action than tapering, but much will depend on the pace at which the committee lifts the fed funds rate. It is too soon to speculate on the pace, but we stress that the big move for financial markets will occur once the policy rate exceeds the neutral rate. If the latter is somewhere around 2%, the rate hike pace embedded in the dots suggests that it may take until the end of 2024 or early 2025 before monetary policy becomes restrictive. Investment Implications If monetary policy is not going to become tight for another three years, it is premature to shift a portfolio to more defensive settings, especially for anyone sharing our three-to-twelve-month cyclical timeframe. Growth will be robust in the near term, supported by the income boost that the lower three quartiles of taxpayers received from fiscal transfers and the way wealthier households cleaned up as financial asset prices soared. We expect that a hearty portion of the newly minted wealth will be spent, as Ricardian equivalence requires a longer attention span than Americans typically exhibit, and the pandemic was largely trauma-free for most households from a financial perspective. The clearest policy lesson that a citizen should have taken from COVID is that Congress and the Fed have his/her back in a big way. We are staying the course with our risk-friendly asset allocation recommendations.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com