Developed Countries

Special Report

Highlights The odds of universal health care legislation being enacted in the U.S. by 2022 are about 10%-15%. Former Vice President Joe Biden is the most likely Democratic candidate in 2020, but the alternative is most likely a progressive candidate seeking universal health care. Trump is slightly favored to win in 2020, but a Trump loss is likely to translate into full Democratic control of the U.S. government, making ambitious legislation more likely to pass Congress. An overweight portfolio allocation in the S&P health care index is a sensible and defensive move. Fear selling in health care stocks could easily return but would create an exploitable trading opportunity at this late stage of the cycle. We are executing the upgrade of the S&P health care index via an upgrade of the S&P health care equipment index, which has seen a material valuation de-rating at the same time as profits are expanding, to overweight. Feature Will The Democrats Win? Can They Pass Universal Health Care? “Medicare for All,” or government-led universal health care in the United States, is less likely to become the law of the land by 2022 than the market expects. We put the probability at around 10%-15%. Here’s why. The industry faces only two certainties: Americans are getting older and the federal government is increasing its involvement. The former is a secular driver for health care demand. The latter is an inference drawn from the fact that the Republican Party failed to repeal the Affordable Care Act, or Obamacare, even when it had full control of government. It is very unlikely that the Republicans will get another chance at repeal. It is also very unlikely that the public will tolerate the current status quo forever. The result is that the U.S. will eventually end up with a restored Obamacare or an altogether new system with a greater government role. The Republican failure to repeal was not idiosyncratic – it was not based on the fact that the late Senator John McCain, who cast the decisive vote on July 27, 2017, had been diagnosed with brain cancer earlier that year. Rather, it was structural – the repeal failed because (1) it is always extremely difficult to remove an entitlement once it has been given to voters and (2) a slim majority of Americans approved of Obamacare – and still do (Chart 1). Republicans went on to dismantle aspects of Obamacare, including the problematic “individual mandate.” But they did so without replacing it. The result was a severe electoral defeat in the 2018 midterm elections, despite a huge drop in the unemployment rate (Chart 2) – which matters directly in a country where 49% get their health insurance through their employer. Health care was the single most important issue driving people to vote against the ruling party in November 2018, judging by both pre-election polls and exit polls (Charts 3 & 4). Chart 2Low Unemployment Has Not Solved Health Care Woes The need for reform is manifest. It is widely known that the U.S. spends more than other countries on health care (Chart 5) and yet achieves worse results: preventable mortality is higher than in other countries that spend less (Chart 6). Democrats have tried to overhaul the system since 1993. Even President Trump is seeking to cap prescription drug prices and maintain the Obamacare requirement that health care insurers accept customers with “pre-existing conditions.” Uncertainty has risen since the Republicans’ midterm defeat, which increases, or is seen as increasing, the odds of a Democratic victory in 2020. Such a victory would mark the third time in 12 years that American policy would witness a 180-degree reversal – and it would have a major impact on the health sector (Chart 7). Chart 7The Sector's Response To Major Political Events In truth Trump is still favored to win in 2020, on the back of the incumbent advantage – as long as the economy holds up. But with a chronically weak approval rating, and narrow 2016 margins of victory and the aforementioned midterm losses in key swing states, his odds of reelection are probably not much better than 55%. Meanwhile the Democrats are swinging to the left and may not settle simply for restoring Obamacare. Left-wing or “progressive” candidates for the Democratic nomination are polling in line with traditional center-left candidates (Chart 8), which is highly unusual (even compared with the 2007-08 race). Candidates are crowding onto the democratic socialist bandwagon in the wake of Bernie Sanders’s formidable challenge to Hillary Clinton and her subsequent loss to Trump. Could a progressive candidate win the nomination? Certainly. Former Vice President Joe Biden leads the pack at this early stage in the nomination process. He would seek to restore and build upon Obamacare. The second-ranked candidate is Sanders, whose initial proposal to create Medicare for All has transformed the national debate. Following Sanders are Senators Kamala Harris, who co-sponsored the latest version of the bill with Sanders, and Elizabeth Warren, an outspoken progressive who is also in favor of universal health care (Chart 9). Sanders does have a path to winning the nomination, as the leading progressive candidate at a time when the party is becoming more progressive. He performs better than Biden in head-to-head polls against Trump in the key battleground states (Chart 10). Strategic voters will have trouble convincing fellow Democrats that they should not vote for him because he is unelectable: he has a clear electoral path to the White House via Michigan, Pennsylvania, and Wisconsin, where he performed well in 2016 and polls well today. If Sanders has a chance, then Medicare for All has a chance. Because it is extremely difficult to unseat an incumbent president, a victory over Trump in 2020 is only likely to occur if there is a surge in voter turnout and Democratic Party support among (1) blue-collar workers who abandoned the Democrats for Trump in 2016, or (2) young voters, women, or minorities. Any such surge would also enable the Democrats to defend their senate seats while picking up Arizona, Colorado, and Maine, which are statewide elections that will be affected by the headline presidential race. And if the Democrats win 50 seats, they would get a majority in the senate, as the vice president would break any tie. With a majority, Senate Democrats could use the “nuclear option” to bypass the filibuster and drive through their priority legislation.1 This would set a new precedent with far-reaching consequences. But recent majority leaders have already begun eroding the filibuster and there is no hard constraint preventing a ruling party from removing it entirely. It is perfectly possible, and all the more likely if the nation sweeps a progressive candidate to power in a wave of enthusiasm for dramatic changes like universal health care. In other words, any victory against Trump is likely to entail full Democratic control of government. In this scenario, Democrats would have a very good chance of passing a major piece of legislation. Hence, if a progressive wins the nomination, and makes Medicare for All the policy priority, there is at least a 50/50 chance it will pass, probably more like 60%. The catch is that a progressive may not win the nomination. There is not decisive evidence that Americans really want Medicare for All. First, Americans tend to view their own health costs as “reasonable” (Chart 11). They are not, as a whole, clamoring for a single-payer system. Second, while Americans say they support Medicare for All, that support evaporates when they learn about the various policies that it would necessitate, such as eliminating private health insurance and raising taxes (Chart 12). Third, most Democrats are closer to Biden’s position than Sanders’s – they want to fix Obamacare rather than revolutionize the system (Chart 13). Fourth, Colorado tried to pass its own version of Medicare for All on the state level in 2016. The bill’s advocates were handed a 79% defeat by voters. Colorado is a swing state so it is not an irrelevant experiment. Fifth, independents are not shifting to the left in a way that would validate the sharp leftward shift within the Democratic Party (Chart 14). Nominating Sanders or another progressive is more likely to lead to a loss in the general election than it is to ensure that universal health care gets passed.   Chart 14Independents Not Swinging Dramatically To The Left A simple back-of-the-envelope exercise suggests that odds of universal health care by 2022 are about 10%-15%. Nevertheless, we attempt a conservative, back-of-the-envelope method for estimating the probability of passage. It runs like this: There is a 50% chance a progressive wins the Democratic nomination. We assume that if Biden wins it is because Democratic voters prefer a restitution of Obamacare. There is a 45% chance that Trump loses the presidential election. We assume that for the Democrats to unseat an incumbent is difficult enough that they will also win the Senate. Under these circumstances, there is a 50%-60% chance that universal health care legislation passes – even though it will be very difficult to get it over the line. (Note that the ACA passed very narrowly at a time when the Democrats had a huge tailwind due to voters’ disenchantment after the global financial crisis). With these assumptions, the conditional probability of passage is around 13.5% (0.5 x 0.45 x 0.6 = 0.135) These odds can be moderated by boosting Trump to a 69% chance of reelection (the historical average for sitting presidents), which brings down the odds of ultimate passage to 9%. Note, however, that the bond market is pricing a 27% probability of a recession 12 months from now (Chart 15). If there is a recession, then President Trump is virtually assured to lose reelection and the Democratic victor will have a strong tailwind of public support. This will increase the chance that universal health care passes to 80%. (We still assume in this case that Biden would stick with Obamacare as he would not be committed to Medicare for All and it is not an economic stimulus package). The conditional probability would become 0.5 x 0.27 x 0.8 = 11%. Chart 15Probability Of Recession Is Rising NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low In other words, whether we upgrade Trump’s chances of winning or we upgrade the chances of a recession that kicks him out of office, the odds are roughly the same at 9%-11%. And they could be a bit higher at 14%. Medicare for All has a chance of becoming law, although it is not all that great. Bottom Line: With fairly conservative assumptions the odds range from 10%-15%. that the U.S. could legislate a sweeping overhaul of the health care system and new social entitlement by 2022. This is a serious risk to the industry. Health care equities have recovered the losses suffered since Sanders’s latest push for Medicare for All, which means that it is not pricing in a high probability of passage at present. Additional policy-related selloffs are likely between now and the spring of 2020, if and when the odds increase of Sanders (or another progressive) winning the Democratic nomination. Buy Into Health Care Weakness Regardless of the likelihood of passage, the faintest hint of the winds of change has brought about significant price changes in the relevant equities. In the lead up to the 2016 U.S. presidential election, Hillary Clinton, a health care reformer (though importantly NOT a Medicare for All advocate) was polling well ahead of Donald Trump. Health care stocks underperformed the broad market in anticipation of potential reforms resulting from a Clinton win (Chart 16). Two years after Donald Trump’s election, both S&P health care equipment and S&P managed health care have significantly outperformed with the effect most dramatic in the former. Chart 17 shows the reverse picture: a “blue wave” in the 2018 midterm elections was swiftly followed by the zenith for health care stocks as the market digested the implications of a Democratic House and the resulting higher probability of a similar sweep in 2020 in the Senate and executive branch. Chart 16Election Fear Creates Buying Opportunities... Chart 17...And History Appears To Be Repeating Itself Furthermore, our prior research shows that S&P health care has been the top performer in the last equity market surge to take place between the peak of the ISM manufacturing composite index and the beginning of the subsequent recession.2 This research was confirmed in a report last month analyzing sector returns after a Fed loosening cycle begins. The S&P health care index has historically outperformed from six months before a rate cut all the way to two years after easing policy.3#fn_3 As a reminder, the market has now priced in two rate cuts over the next year. We recommend an overweight position for the broad S&P 500 health care index as well as for health care equipment. BCA’s U.S. Equity Strategy has already moved to an overweight recommendation on the S&P managed health care index, a move that has netted our portfolio 12.4% of alpha. Today U.S. Equity Strategy is raising our recommendations on both the S&P health care equipment and, more importantly, the broad S&P health care index from neutral to overweight. Further, considering U.S. Equity Strategy’s recent portfolio changes, namely moving the S&P materials index to neutral, this upgrade of S&P health care to overweight moves our cyclicals vs. defensives style preference from overweight cyclicals to neutral. This move to the sidelines on the cyclical/defensive portfolio bent has netted modest gains of 2% since its October 2, 2017 inception. Equipping The World’s Hospitals Our upgrade of S&P health care equipment to overweight is not contingent upon earnings outperformance. Rather, it is a combination of overwrought investors having created a buying opportunity, combined with health care’s historic outperformance at the end of the business cycle. Nevertheless, an examination of the sector’s macro environment is revealing. The health care equipment index has recently completed an inventory clear-out cycle, as evidenced both by a slingshot rebound in the shipments-to-inventories ratio (second panel, Chart 18) and a recovery in industry pricing power (bottom panel, Chart 18). This is remarkable in the context of the deceleration in equipment fixed-investment growth that the industry has faced since reaching decade-highs in 2017 (third panel, Chart 18). The upshot is that steady pricing and resilient volume growth should deliver positive top-line growth. The margin picture has also dramatically improved: industrial production has been surging for the past year while hours worked have remained tepid (second and third panels, Chart 19). The combination has driven our productivity proxy to a multi-year high where it has recently diverged from the relative stock price (bottom panel, Chart 19). Chart 18Inventories Have Cleared Chart 19Productivity Is Soaring This underpins our thesis that health care stocks in general and health care equipment stocks in particular have recently suffered based on fear, not fundamentals, amidst a stable domestic demand environment and rosy profit picture. The export channel is at least as important to the S&P health care equipment index as the domestic demand environment. In fact, roughly 60% of sector revenues are generated outside the United States. The news on this front is encouraging. Europe, the other key market for domestically-manufactured health care equipment, has lately seen a pickup in new orders and coupled with the loss of momentum in the trade-weighted U.S. dollar signal that future export growth will remain upbeat (trade-weighted U.S. dollar shown inverted and advanced, bottom panel, Chart 20). The global PMI has historically led exports. While this series has turned down, it has been diverging from export growth for the past year. We believe this is a function of the early stages of a secular trend in health care equipment: the expansion of the EM safety net with health care at its core. The same demographic trend that has been driving the explosion of health care spending in the DM for the last 20 years is rapidly impacting the EM, namely an aging population. The UN projects that the share of the population aged 65 and older in the EMs will rise from roughly 7% this year to 16% in 2060, while population growth slows to below the replacement rate, a tectonic shift in the demographic landscape (Chart 21). Meanwhile, according to IMF data, EM health care spending is approximately 5% of GDP. By contrast, the DMs stand in excess of 14%. Chart 20The Export Valve Is Wide Open A catch-up phase looms, driven by both demographics and an overall global harmonization of standard of care, resulting in a secular outperformance of internationally geared health care equipment manufacturers’ earnings. This bodes well for U.S. health care equipment providers who are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Notwithstanding the bright outlook, fear selling in the S&P health care equipment index has driven a reversal in the two-year valuation rerating that the index has undergone (bottom panel, Chart 22). With the valuation retreating back to its historical range, our main concern that the index is too expensive has eroded. Further, the valuation decline is coming at a time when forward earnings growth has come out of hiding and is now slated to materially outgrow the broad market (middle panel, Chart 22). Chart 22Valuations Have Returned To Earth Bottom Line: Something has to give in this equation and macro tailwinds suggest that a valuation re-rating phase looms. Accordingly, we are moving to an overweight recommendation on the S&P health care equipment index. This move pushes our S&P health care index to an above benchmark allocation and also moves our cyclical vs. defensive preference back to neutral. The ticker symbols for the stocks in the S&P health care equipment index are: BLBG: S5HCEP – ABT, MDT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMD, TFX, HOLX, ABMD, VAR. BCA’s Geopolitical Strategy echoes the tenor of these recommendations and is going long the S&P 500 health care index and the health care equipment index versus the broad market. A Word On Pharma Between 1980 and 2000, pharma earnings expanded at a record clip, taking sector share prices into the stratosphere (top panel, Chart 23). Since the zenith in the early 2000’s, margins have been continually under pressure as R&D costs have outpaced volume gains (second panel, Chart 23). However, earnings growth has continued mostly uninterrupted as the industry has raised drug prices. Since 2015, however, price increases have flat lined and now they move at the same pace as overall inflation, though the current convoluted system keeps pricing mostly opaque (bottom panel, Chart 23). We think this is the new normal. The thesis of this report revolves upon a blue vs. red probability outcome. However, as noted, both parties seem united in the fight against high drug costs and Republicans under President Trump are not averse to government intervention to drive down prices. As such, we expect the pharma pricing headwinds to remain a secular trend, driven by outrage from both sides of the aisle and even universal coverage is not enough to bear the pressure. Accordingly, we reiterate our underweight recommendation. Chart 23Pharma Remains Underweight Conclusion Universal health care will be negative for the U.S. budget deficit but positive for economic growth. As for the macroeconomic impact of universal health care, it is complex to assess because much would depend on the extent of any reduction in private health-related sectors. Almost certainly, the U.S. would adopt a parallel system where private health care remains available, but there inevitably would be some job losses in the insurance sector. And drug companies would face downward pressure on pricing. On the other hand, the marked increase in government spending would be stimulative. And we do not see future American administrations exercising a heretofore unknown fiscal discipline once such a new entitlement is established. Many families would enjoy a reduction in health care costs. Overall, it should be positive for economic growth.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy ChrisB@bcaresearch.com Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      The filibuster is a means of prolonging debate and obstructing a vote. It can be defeated if 60/100 senators vote to move to end debate (“cloture”). It effectively ensures that the three-fifths majority is the standard majority needed to pass legislation in the senate. However, it is possible for the senate majority leader, backed with a simple majority, to alter the senate rules and remove the filibuster, so legislation can be passed with a simple majority. But it would be an aggressive move and a historic precedent. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Portfolio Positioning For A Late Cycle Surge” dated May 22, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap” dated May 6, 2019, available at uses.bcaresearch.com.   Current Recommendations

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Chart 1Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 17Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation  

Feature The GAA DM Equity Country Allocation model is updated as of May 31, 2019.  The quant model has not made significant changes in the major country allocations, but has further increased Australia’s overweight after the upgrade in the previous month, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1,  2 and  3, the overall model outperformed the MSCI World benchmark by 17 bps in May, largely from a 17 bps of outperformance from the Level 1 model, as the Level 2 model only eked out 1 bp of outperformance.  Directionally, five out of the 12 choices generated positive alpha. The largest contributions to the outperformance in May came from the overweight in Switzerland and Australia, as well as the underweight in the U.S.  Since going live, the overall model has outperformed by 170 bps, with a 350 bps of outperformance by Level 2 model, and an 11bps of outperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of May 31, 2019. Chart 4Overall Model Performance Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations       The model’s relative tilts between cyclicals and defensives have changed compared to last month. On the backdrop of weaker global growth, the model has become positive on Consumer Staples and upgraded the sector. This was driven by both the momentum and growth components. This in turn decreases the overweight allocations to Industrials and Utilities, the model’s two overweights, and increases the underweight allocation to the eight remaining sectors. The valuation component remains muted across all sectors. Our expectations are that global growth bottoms in the back end of the year. However, the hard data has not fully materialized yet. While escalated trade war tensions between the U.S. and China continue to put downward pressure on growth indicators, Chinese credit and fiscal stimulus, similar to that of 2009 and 2015, will more than likely put a floor under further downside. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com

Highlights We talk about “Mr. Market,” the bond market and the equity market, but prices in free economies and markets are set by innumerable interactions between individuals: Hence the failure of central planning; without bottom-up price signals, one can do no more than guess at how best to allocate resources. We are macro practitioners at BCA, but our work could benefit from a little thinking about micro-level motivations and constraints: Mundane structural constraints like wide bid-ask spreads, high borrow costs and prospectus terms can be hard to see from 30,000 feet. Getting into the heads of a handful of representative investor types might give us some fresh insights: This is a different approach for BCA, to be sure, but there has to be more to life than reading Fed tea leaves and parsing official statements and media leaks from American and Chinese trade negotiators. Feature Creative narratives – written, filmed, staged or sung – can open a window onto the motivations underlying broad social or cultural movements. We only care about movements that affect financial markets, of course, but we’re always looking for new ways to tap into the market Zeitgeist, which isn’t always laid bare on spreadsheets. In this report, we begin a summer long exploration of several market types with introductions to two veteran mutual fund managers, a university endowment CIO, and the founder of a new RIA firm. The point of these fictional composites is to think about institutional investor decision-making at the ground level, and so enhance the real-world relevance of our big-picture observations. There are no one-size-fits-all investment solutions. Itinerant BCA managing editors, going from client meeting to client meeting, quickly learn that institutional investment objectives come in all shapes and sizes. An idea received with resounding approval by one client (You know, that would make a lot of sense for us. Yes, yes, that’s perfect!) may go over like a lead balloon with three others (Oh, we can’t do that. We’re not set up to trade those/that would never fly with our board/the prospectus forbids anything like that.). The institutional investment landscape is an aggregate of several disparate constituencies. Faster money constituencies most often take the lead in setting prices, but different constituencies come to the fore at different times in particular market niches. Leadership rotation reflects the symbiosis among the constituencies’ varying aims, which regularly balance each other out, helping to ensure the maintenance of orderly two-way markets. As our European Investment Strategy service has noted in its fractal trading framework, excesses ensue when all the constituencies line up together, and our imaginative exercise just might provide a way to anticipate when consensus views are coalescing into stretched positioning. Survivors’ Biases Chart 1For Nimble Managers Only There are fewer mutual funds in New York than there were when Nick Andruzzi and Sanjay Patel entered the industry as analysts out of Wharton 20 years ago, but the two friends are still standing. “You hear about Oppenheimer?” Andruzzi asks as they grab a Thursday night drink in Grand Central. “Just about everyone laid off once Invesco closes the deal?” Patel shakes his head. “It keeps you on your toes, doesn’t it? Any more chatter about you guys?” “It’s died down over the last few weeks, but we’re too small to go it alone.” “Your fund still five stars?” “Over five years, four over three and one, and sitting right on the four/five line so far this year.” “Then you’re protected, no?” “I wouldn’t be the first to go, but I’d need to be five to be totally safe.” “What would that take for this year?” “Perfect knowledge of the yield curve. Can you help me with that one, bond guru?” Andruzzi laughs. “I’m my own Financials analyst again – every team had to cut at least one analyst before year-end – and we got ahead by using all our cash to fund a 500-bps overweight the banks in the last week of December and the first week of January (Chart 1). Once Bank of America got back into the 30s, we cut back to minus 200 bps. You tell me what the 10-year’s going to do and we’ll ride the banks to five stars.” Patel finishes his drink. “You got time for one more?” “One more. It’ll give you a chance to tell me about the ten-year.” “The economy looks fine to us, and we can’t possibly see why the Fed would cut once, much less twice, in the next twelve months when unemployment’s at a 50-year low. We think yields should be rising, but we thought that 30 basis points ago, too. We’ve been cutting back on our duration underweight for a while and we’re barely below benchmark now. We’ve even started trimming our credit overweights; I don’t buy into the worst-case trade scenarios, but we have to be prudent about risk management.” “Spoken like a true CIO.” A falling 10-year Treasury yield didn’t interrupt banks’ snapback rally at the beginning of the year, but it’s lately begun to exert a gravitational pull on the group that a tactical manager might exploit. “There’s just no upside to putting our funds on an island relative to the rest of the industry. I’m not playing the hero at this stage of my career, and it doesn’t make sense for the firm, either. We’ve got one of the biggest and best sales teams; the assets aren’t going anywhere as long as we deliver benchmark returns.” “And you keep your annuity going another three or four years.” “Amen, brother.” “So what’s a lower level on the 10-year that’d scare you, and a higher level that’d give you some confidence that the threat of yields breaking down is gone?” “2%, if 2.14% doesn’t hold, and 2.4% on the upside (Chart 2).” Chart 2Looking To The Long Bond ... “All right. We stay underweight BAC until the 10-year gets above 2.4%, then we get back up to overweight until we sell it again when the stock sticks its head above 30 (Chart 3). Lather, rinse, repeat.” Chart 3... To Inform Niche Equity Positioning Alumni Q&A Just around the corner at the Yale Club, Blair Howell, CIO of her alma mater’s Top 20 endowment, is participating in a panel discussion before a group of alumni. During the audience Q&A, an alumnus asks a question that’s been nagging at her for some time. “All of the panelists see stocks and bonds delivering pretty thin gruel over the next five to ten years. Everyone recognizes that this expansion has been going on for an awfully long time, and the consensus expects a recession in the next year or two. Against that backdrop, does it make sense to raise cash in anticipation of the inevitable downturn, when you’ll be able to put it to work more profitably?” Chart 4Defaults Pick Up Ahead Of Recessions “That’s a great question,” she says. “We’ve talked a lot internally about the feasibility of trying to align our asset allocation decisions with market cycles. The trouble is that no one can call market bottoms or tops with any certainty. That said, recessions and equity bear markets tend to coincide, and loan defaults start to take off in the run-up to a recession (Chart 4), so we do seek to reduce our risk profile in the more liquid parts of the portfolio when the storm clouds appear.” “There are two practical problems, though. One is that equities regularly take off in the latter stages of bull markets, so there’s a real cost to heading to the sidelines too early. And since there’s no better time to be invested in equities than at the start of a bull market (Chart 5), there’s also a significant cost to staying underinvested for too long. We’re working on developing models that will help us better time cyclical inflections in the public sleeves of the portfolio, but it’s easier said than done.” “The bigger issue is that we have to distribute 5% of the principal to the university every year. If we want to grow the endowment, we need an annual return of 7.5 to 8%. Zero interest-rate policy has essentially precluded us from making any material allocation to cash since I’ve come back here. If we let a significant portion of the portfolio lie fallow, the principal base would shrink and we’d need even bigger returns on the other side to catch up.” The five-to-ten-year outlook for stocks and bonds is not encouraging. “We share the view that public-market returns are going to be tepid relative to the post-’82 history. The best predictor of real bond returns five years out is the real yield at time of purchase (Charts 6 and 7). The cyclically-adjusted P/E ratio is an outstanding predictor of equity returns over ten years (Chart 8). The data point to public market returns that may fall short of funding a 5% annual distribution, much less meeting our 7.5-8% bogey. Our strategy for combating it is not to hide in cash and wait for a bear market, but to try to do better by investing outside of the crowded public markets.” Chart 8Equities Face An Uphill Climb “We are not Harvard, or Stanford, or Yale, but we do have enough heft to gain entrée to the private equity funds that have earned the bulk of the industry’s returns. We have sufficient heft to access hedge funds with solid track records in both bull and bear markets. The central premise isn’t historical returns per se – we can all recite the past-performance disclaimer in our sleep – it’s the notion of a liquidity premium. We are truly long-term investors, so we can seek out the greater prospective returns accruing to illiquid investments. That’s the structural edge we’re trying to exploit with alternatives.” She beams a smile at the alum and the room at large. He nods emphatically when she asks if that answered his question. That’s great, she thinks, but it doesn’t answer mine. She has been feeling increasingly hemmed in by the consultant-driven ecosystem that affords very little scope for endowment managers to turn the asset-allocation or manager-selection dials. She has made some modest incremental changes to the investment office, but she is beginning to view managing a large endowment as an exercise in painting by numbers. Start-Up Investing is the easiest part of Kate Palmer’s job, which is good, because everything else involved in trying to achieve critical mass at her fledgling Austin, Texas RIA firm is time consuming. She brought $125 million of client assets with her from the high net worth arms of the bulge-bracket investment banks where she worked for her first decade after law school, and she’s raised a fresh $25 million so far. The resulting $1.5 million in fees is enough to pay the rent on a tastefully appointed space in a newish office park, hire two full-time analysts, a part-time rising third-year law student, and two full-time wealth managers, with whom she’s split point-of-contact responsibility for their 21 existing clients. We’re trying to walk a mile in the shoes of several types of investors to learn what makes them tick. Prospecting for new clients, servicing existing ones, offering estate- and tax-planning guidance, and vetting outside managers eats up 50 to 55 hours a week, so she has streamlined the portfolio management process according to the principles embedded in her new-client pitch. The portfolios get diversified market exposure via a basket of low-cost index ETFs, and active management from a pool of mutual-fund and alternative-asset managers she worked with at the investment banks. The firm uses research from two independent macro research providers and its account custodian to develop cyclical views that inform client positioning. She intends to bulk up in-house portfolio management to allow for more customization of client portfolios once AUM gets into the $250-to-500 million range, but she needs the assets first. What Comes Next These four investors comprise half of our cast of characters, and we will introduce the rest before the Fourth of July. We are seeking a bottom-up perspective on how investors interpret and react to the macro data that BCA researchers live and breathe, but which shows up on their radar only intermittently. The goal is to get a better read on how markets process the data series we model and track to gain insight into the future direction of the cycles that most influence investment outcomes. Maybe we’ll even figure out why markets’ expectations for the Fed differ so sharply from ours.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com

Underweight High-Conviction The latest GDP release as it pertains to housing made for grim reading: residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel). Residential investment is also on the verge of contracting in absolute terms (second panel) and will likely weigh on home improvement retailers (HIR). The direct link to HIR comes via existing home sales: when a home changes ownership usually some renovation activity takes place. Finally, lumber prices continue to crumble and given that HIR make a set margin on lumber sales, HIR profits will likely underwhelm (bottom panel). Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Home Improvement Retailers: Timber Alert