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Special Report The COVID-19 induced recession has accelerated several paradigm shifts that were already afoot. Populism, anti-immigrant sentiment, deglobalization, and fiscal profligacy were replete – particularly in the US – even before the pandemic. For the first time since WWII, the US budget deficit significantly expanded for three years running at a time when the unemployment rate was declining, late in the cycle. We fear that the Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus, as our geopolitical strategists have posited in the past. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. The most important long-term consequence of the Buenos Aires Consensus will be higher inflation. And we are not talking just the asset price kind – which investors have enjoyed over the past decade – but of the more traditional flavor: consumer price inflation (Chart 1). Chart 1Inflation Is Coming A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (Chart 2). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium (Chart 3). Chart 2Only A Whiff Of Inflation Is Good For Stocks Importantly, the magnitude of the economic damage, the likelihood that a “second wave” requires renewed lockdowns, and a new steady state of the apparent “square root” type of recovery remain unknown. This means that “deflationistas” may continue to have an upper hand on the “inflationistas”, as witnessed by the subdued inflation expectations (Chart 3). Chart 3In The Near-Term Disinflation Looms The Federal Reserve’s Function As The Lender Of Last Resort What is certain is the Fed’s resolve to keep things gelled together and allow businesses and the economy enough time to heal and overcome the coronavirus shock. Simply put, there are high odds that the Fed will remain accommodative and take inflation risk “sitting down” for quite some time, certainly for the next year, and likely longer (Chart 4). While early on, the Powell-led Fed had been ambivalent, the FOMC’s swift and immense response to the coronavirus calamity with unorthodox monetary policies has been appropriate and unprecedented (Chart 5). Clearly, the sloshing liquidity cannot cure the coronavirus, but providing the credit needed in parts of the financial markets and select business sectors that had completely dried up was the proper policy response. The Fed acted promptly as a lender of last resort. Unlike the difficulty in defeating deflation – look no further than Japan – ending inflation is easy. The great Paul Volcker has taught the Fed and the world how to break the back of inflation. The Fed, therefore, has the credible tools to deal with a possible inflationary impulse. Chart 4Do Not Fight The Mighty Fed Chart 5Joined At The Hip Until economic growth regains its footing and climbs to its post-GFC steady 2-2.5% real GDP growth profile, the probability is high that the Fed will take some inflation risk (Chart 6). Chart 6The Fed Can Afford To Take Inflation Risk This is especially the case given that political risk in the US is tilted to the downside. With income inequality at nose bleeds levels, US policymakers (both fiscal and monetary authorities) will hesitate to act on the inflation mandate with gusto and objectivity (Chart 7). Chart 7The Apex Of Globalization And Income Inequality The Fed will therefore not rush to abruptly tighten monetary policy, a view confirmed by the bond market: fed funds futures are penciling a negative fed funds rate in mid-2021 and ZIRP as far as the eye can see (Chart 8). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside, which would compel the Fed to aggressively raise the fed funds rate. But that is not on the immediate horizon especially given the recent coronavirus-related blow to unit labor costs (please see Appendix below). Even if there were an inflationary backup in longer term Treasury yields, yield curve control is a tool the Fed is considering, something it first tried on the Treasury’s orders during and following WWII for a nine year period. Chart 8ZIRP As Far As The Eye Can See Dollar And The Inflationary Valve Importantly, the US dollar’s direction will be critical in determining whether any lasting inflation acceleration occurs. The top panel of Chart 9 shows that inflation accelerates during U.S. dollar bear markets. A depreciating greenback greases the wheels of the global financial system and also serves as a global growth locomotive given that trade is largely conducted in US dollars (bottom panel, Chart 9). Thus, the Fed’s recent US dollar swap lines to other Central Banks, along with its FIMA facility, were instrumental in unclogging the global financial system. Sloshing US dollar liquidity restored a semblance of normality to asset prices (Chart 10). Chart 9Inversely Correlated Chart 10Ample Liquidity To Debase The Greenback As we highlighted in our December 16 Special Report titled “Top US Sector Investment Ideas For The Next Decade” ,1 there are rising odds that a US dollar bear market takes root this decade. Eventually, the steeper the greenback’s fall, the higher the chance of a longer lasting inflationary spurt as US import price inflation will rear its ugly head (Chart 11). Chart 11US Dollar Bear Markets Are Synonymous With Inflation So What? While, in the near-term, accelerating inflation is a negligible risk owing to excess economic slack, in the intermediate-term, it is a rising probability outcome. BCA’s long-held de-globalization theme,2 the US/Sino trade war that is here to stay irrespective of the next electoral outcome and excessive US government fiscal largesse will likely, in the next two-to-three years, swing the global deflation/inflation pendulum toward sustained inflation (Chart 12). For investors that are worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap, especially if inflationary pressures become more acute sooner than we anticipate. Chart 12Deglobalization Will Result In Inflation Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be the primary beneficiaries. Table 1 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. On the flip side, utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. Table 1S&P 500 Sector Performance During Inflationary Periods With the exception of real estate, our portfolio will benefit from an accelerating inflationary backdrop. However, our early- and late-cyclical preference to defensives is a consequence of the current stage of the cycle: when in recession it pays to have a cyclical portfolio bent (please see Charts 6 and 7 from our mid-April Weekly Report).3 Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to further shift our portfolio in order to benefit from accelerating inflation. What follows is a one page per sector analysis of the impact of inflation on pricing power and performance. Sectors are ranked by their average returns (largest to smallest) in the six inflationary cycles we studied as shown on Table 1.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Health Care Health care stocks have consistently outperformed during the six inflationary periods we examined. Over the long haul, it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is on a secular rise around the globe most recently further catalyzed by the COVID-19 pandemic: in the developed markets driven largely by the aging population and in the emerging markets by the accelerating adoption of health care safety nets and higher standards. Chart 13Health Care Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector’s pricing power prospects that suffered from a constant derating. Now that political uncertainty has lifted as Biden is a more moderate Democratic President candidate than either Sanders or Warren, a rerating looms. Finally, demand for health care goods and services will not only remain robust, but also get a boost from the recent coronavirus pandemic as governments around the globe beef up their health care response systems. Chart 14Health Care Energy The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 above). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge. Chart 15Energy Relative energy pricing power collapsed during the COVID-19 accelerated recession plumbing multi-decade lows. Saudi Arabia’s decision in early-2020 to refrain from balancing the oil market triggered a plunge in WTI crude oil prices to negative $40/bbl. While global demand remains deficient, this breakdown in oil prices has brought some much needed supply discipline in global oil producers including US shale. As the reopening of economies takes hold oil demand will recover and absorb excess oil inventories. While base effects will push crude oil inflation to the stratosphere in Q1/2021, eventually a more balanced global oil market will pave the way to a sustainable rebound in oil prices. Chart 16Energy Real Estate REITs have outperformed the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (Table 1 above). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation. Chart 17Real Estate Following the GFC trough, REITs pricing power has outpaced the overall CPI. CRE selling prices had been on a tear since the GFC, but the ongoing recession has short-circuited this hard asset’s near uninterrupted price appreciation; according to Green Street Advisors, average CRE prices contracted by roughly 10% in April. Worrisomely the persistent multi-family construction boom and the “amazonification” of the economy will act as a restraint to the apartment REIT and shopping center REIT segments, respectively. Tack on the longer-term knock-on effects of the work-from-home wave that has staying power and even office REITs may suffer a demand-related deflationary shock. Chart 18Real Estate Materials Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind. Chart 19Materials Our relative materials pricing power gauge is currently contracting, but encouragingly it is showing some signs of stabilization. The drubbing in Chinese GDP in Q1 has dealt a blow to commodities-related demand and thus prices as infrastructure projects ground to a halt. As the Chinese economy has restarted slightly ahead of developed markets a return to normalcy is a high probability outcome in the back half of the year. Keep in mind that the delayed effect of stimulus spending should also hit in Q3 and Q4 likely further tightening commodity markets. Chart 20Materials Consumer Discretionary While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power. Chart 21Consumer Discretionary Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, and are on a trajectory to hit double digit growth. Deflating energy prices, ultra-loose monetary conditions and the $3tn fiscal stimulus have kept the US consumer afloat. As Washington and the Fed are providing a lifeline to the economy during the recession, the reopening of the economy has the potential to turbo-charge consumer discretionary spending as pent up demand will get unleashed. Chart 22Consumer Discretionary Financials Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Chart 23Financials Financials sector pricing power has jumped by about 450bps since the 2019 trough and have exited deflation. Given the recent steepening of the yield curve that is typical at the depths of the recession, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop even temporary could also provide a fillip to margins and offset the large precautionary provisioning that banks are taking to combat the looming recession-related losses. Chart 24Financials Industrials The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges. Chart 25Industrials Following a three-year period in the deflation zone, industrials relative pricing power is steadily rising, likely as a consequence of decreasing supplies, CEO discipline and the ongoing US/Sino trade war. The previously expansionary mindset has given way to retrenchment, as the scars from the late-2015/early 2016 manufacturing recession remain fresh. However, infrastructure spending is slated to increase at some point in late-2020 as China revs its economic engine and bolster the demand prospects for this deep cyclical sector. Chart 26Industrials Consumer Staples Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector’s track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign. Chart 27Consumer Staples Relative consumer staples pricing power has slingshot higher and is flirting with the upper bound of the past three decade range near the 10% mark. The current recession has augmented the status of consumer staples. While the lockdowns has dealt a blow to select discretionary purchases, demand for staples has actually increased according to recent retail sales and inflation data releases. Tack on falling commodity input costs and the implication is that consumer staples manufacturers will likely continue to enjoy widening profit margins. Chart 28Consumer Staples Tech Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than is typically perceived, generating enormous amounts of free cash flow. Cash flow growth is also steadier than in the past and has served as a catalyst to embark on shareholder friendly activities. Chart 29Tech Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2016, it has recently soared as tech companies preserved their pricing power, but overall wholesale inflation has suffered a sizable setback. Importantly, demand for tech goods and services has remained resilient during the current recession, further adding to the allure of the tech sector. Chart 30Tech Utilities Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis (Table 1 above). In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry’s lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times. Chart 31Utilities Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry’s marginal price setter, have risen 18% since the early-April trough, signaling that recent utility pricing power gains have more upside. Nevertheless, as the economy is gradually reopening, soft data will stage a V-shaped recovery bolstering the odds of a selloff in the bond market. Such a backdrop will dampen the demand for high-yielding defensive equities, including pricey utilities. Chart 32Utilities Telecom Services Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 above. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa. Chart 33Telecom Services Telecom services pricing power has been on a recovery mode since February 2017 when Verizon surprised investors and embarked on a price war by reinstating its unlimited plans in order to defend its market share. Importantly, earlier in the year telecom carriers relative selling prices exited deflation coinciding with the completion of the T-Mobile/Sprint deal. Intra-industry M&A is over as now only three major wireless providers are left raising the threat of monopolistic power. Nevertheless, the ongoing 5G deployment is of the utmost importance for telecom carriers and a foray further into cable/media/content services is inevitable so that the telecom incumbents move beyond being “dumb pipelines”. Chart 34Telecom Services Appendix Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6     Footnotes 1     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com 2     Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization - All Downhill From Here” dated November 12, 2014, available at gps.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.
Special Report Feature The SPX suffered its third 5.3-7.3% pullback since early April last week, which we deem a healthy development as markets cannot go up in a straight line. While there is a chance this latest pullback may morph into a correction, our sense is that equities will remain range bound in the near-term consolidating the vast gains made since the March 23 lows. Now that earnings season is practically over and macro data will remain backward looking, a large void signals that technicals will dominate trading. On that front, this looming lateral move will likely confine the SPX between the critical 50-day and 200-day moving averages – a roughly 10% range between 2,712 and 3,000 – until a catalyst breaks the stalemate (top panel, Chart 1A). With regard to the cyclical outlook, ultra-accommodative fiscal and monetary policies remain the dominant macro themes, and underpin our sanguine equity market view for the next year. Chart 1AConsolidating Gains Dollar The Reflator Importantly, King Dollar is a key macro variable that we are closely monitoring and as we highlighted last week, the Fed is indirectly aiming at jawboning the greenback.1 US dollar based liquidity is one of the most important determinants/drivers of global growth. The longer US dollar liquidity gets replenished, the more upward pressure it will put on SPX momentum and SPX EPS (Chart 1B). Sloshing US dollar based liquidity will serve as a much needed catalyst for a global growth recovery. Chart 1BHeed The Message From US Dollar Liquidity: Chart Of The Year Candidate The Yield Curve, Interests Rates And Profits Meanwhile, the yield curve, in fact a number of different yield curve slopes, troughed prior to the SPX in March, preserving its leading properties both near equity market tops and bottoms (middle & bottom panels, Chart 1A). The Fed orchestrated the steepening of the yield curve – which is typical during recessions – with the two preemptive cuts in March. Crucially, the yield curve is signaling that in the back half of the year SPX profits will also trough. True, a profit shortfall is upon us in Q2, and the steeper the fall, the higher the chance of a V-shaped recovery, owing to base effects (yield curve shown advanced, Chart 2). Chart 2Steep Yield Curve Slope Will Reflate Profits Encouragingly, the Fed reiterated last week that it will remain ultra-accommodative. While it will refrain from delving into NIRP, QE5 can expand anew and sustain the perching of the 2-year and even the 5-year and 7-year Treasury yields near zero. In fact, the shadow fed funds rate is already below zero as we highlighted last week.2 This monetary backdrop coupled with rising fiscal deficits as far as the eye can see – which will put upward pressure on long-term Treasury yields – will ensure a steep yield curve, and thus engineer a profit recovery (Chart 2). With regard to the interplay of interest rates and profit growth, the two are tightly inversely correlated (Chart 3). Empirical evidence suggests that since the mid-1980s profit growth is the mirror image of the year-over-year change in 7-year Treasury yields, albeit with a significant lag. Chart 3Interest Rate Pummeling Is A Boon For EPS What EPS Growth Is Discounted? Currently, if the relationship between profits and yields were to hold, then SPX EPS growth would stage a sizable come back in 2021. Chart 4 depicts the sell side’s quarterly EPS forecasts all the way to end 2021. Indeed, following a steep contraction, a brisk V-shaped profit recovery is looming in 2021 as we first argued three weeks ago that “historical precedents show an explosive year-over-year growth increase in EPS from recessionary troughs”.3 In more detail, Chart 5 breaks down 12-month forward EPS growth per sector. Tech comes out on top and by a wide margin with a near double-digit profit growth rate in absolute terms. This gulf is even more pronounced relative to the contracting SPX EPS growth rate. In fact, tech relative profit growth just reached the highest level since 2004 and explains the broad market’s tech dependence. As a reminder, tech market cap is back to the 2018 peak despite the fact the GOOGL and FB have now moved to the newly formed S&P communication services index. If one were to add the pair and AMZN back to the tech sector’s weight, it would comprise over 36% of the SPX, higher even than the dotcom bubble era (Chart 6)! Chart 4V-Shaped Profit Recovery Chart 5Tech… Chart 6…Reigns Supreme Tech Titans Digression A brief digression is in order as it pertains to the tech titans. We have been inundated with requests recently on the subject of valuations and the concentration of returns in the top five SPX stocks. We first commented on this in January, and reiterate today that the current tech sector’s supposed overvaluation is nowhere near the dotcom excesses .4 Back then, the top five SPX stocks commanded a forward P/E over 60, but today’s valuation pales in comparison with the late-1990s, as the equivalent P/E is roughly half that multiple (please refer to Chart 2 of the January 27, 2020 Weekly Report). Why? Because at the turn of the millennium, tech stocks had very little earnings to show for, but now the tech sector has the largest profit weight among its GICS1 peers. Thus, tech stocks trade at a modest 9% premium to the broad market whereas in 1999 they were changing hands at more than twice the SPX multiple (Chart 7). Chart 8 attempts to shed more light on the subject. The top panel shows the overall SPX market cap and also excluding the top five stocks. Then we subtract the top five stocks’ forward P/E from the broad market and show where the S&P 500 ex-top five stocks P/E trades (second panel, Chart 8). Since the FB IPO, these stocks have indeed increased their influence on the broad market’s valuation (third panel, Chart 8). Chart 7What Relative Overvaluation? Chart 8Top Five Are Pricey, But For Good Reason Sectorial Profit Growth Breakdown Circling back to the breakdown of 12-month forward EPS growth per sector, traditional defensive sectors (utilities, staples and health care) all enjoy positive 12-month forward profit growth in absolute terms, and so do communication services that just kissed off the zero line. All other sectors are contracting at differing degrees (Chart 5). On a longer-term basis, as expected no GICS1 sector is slated to contract, but their five-year growth rates are widely dispersed. Consumer discretionary, real estate, materials and tech occupy the top ranks with double digit growth rates, while utilities, consumer staples, energy, industrials and financials are in mid-single digits and at the bottom of the pit. Communication services and health care hover in the middle, on a par with the broad market (Chart 9). Chart 9Long-Term Growth Has Reset Lower Higher Profits Are Synonymous With Higher Returns Intuitively, the higher the forward profit growth rate, the higher each sector’s trailing return. Chart 10 depicts this positive correlation on the GICS1 sectors and corroborates that the laggard energy sector has the lowest year-to-date return, whereas tech stocks lead the pack. Importantly, SPX sector profit weights are extremely important. Chart 11 ranks the GICS1 sectors 12-month forward profit weights. Tech, health care and financials comprise roughly 60% of total S&P 500 earnings for the coming year. Whereas the drubbing in the energy sector (83% projected EPS contraction) has drifted into oblivion within the SPX context and has a mere 0.5% profit weight (Chart 11). Chart 10Higher Growth = Higher Returns Chart 11Top three Comprise 60% Of Profit Weight Bottom Line: While the top three sectors inherently carry the bulk of the risk on the SPX earnings front courtesy of the high concentration, our sense is that both tech (neutral) and health care (overweight) will deliver according to the messages from our macro EPS growth models (Chart 12). Financials (overweight) profits are a question mark, and therefore pose the greatest risk to our still constructive 9-12 month broad equity market view.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Chart 12EPS Growth Models Emit Positive Signals   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2     Ibid. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.          4    Please see BCA US Equity Strategy Weekly Reports, “Three EPS Scenarios” dated January 13, 2020 and “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com.  
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report on China from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt will discuss whether China’s President Xi Jinping is losing his political mandate. Best regards, Peter Berezin, Chief Global Strategist Highlights The pandemic is likely to have a more severe impact on Main Street than Wall Street, which helps explain why stocks have rallied off their lows even as bond yields have remained depressed. Equity investors are hoping that central banks will keep rates lower for longer, while fiscal easing will revive demand. The end result could be lower bond yields within the context of a full employment economy – a win-win for stocks.  In the near term, these hopes could be dashed, given bleak economic data, falling earnings estimates, and rising worries about a second wave of the pandemic. Longer term, an elevated equity risk premium and the likelihood that the pandemic will not have a significantly negative effect on the supply side of the economy argue for overweighting stocks over bonds. Negative real rates will continue to support gold prices. A weaker dollar later this year will also help. Divergent Signals Chart 1Conflicting Signals Global equities have rallied 24% off their March lows. The S&P 500 is down only 12% year-to-date and is trading close to where it was last August. In contrast, bond yields have barely risen since March. The US 10-year note currently yields 0.63%, down from 1.92% at the start of the year. The yield on the 30-year bond stands at a mere 1.3%. While crude oil and industrial metal prices have generally tracked bond yields, gold prices have rallied alongside equities (Chart 1). It would be easy to throw up one’s hands and exclaim that markets are behaving schizophrenically. Yet, we think it is possible to reconcile these seemingly divergent price patterns in a way that sheds light on where the major asset classes are likely to go in the months ahead. Two important points should be kept in mind: Bonds and industrial commodities tend to reflect the outlook for the real economy (i.e., Main Street) whereas stocks reflect the outlook for corporate earnings (i.e., Wall Street). The two often move together but can occasionally diverge in important ways. Stock prices and bond yields will tend to move in tandem when deflationary pressures are intensifying; however, the two often move in opposite directions when monetary policy is becoming more accommodative. The former prevailed in early March whereas the latter has been the dominant force since central banks have opened up the monetary spigots. The Real Economy Is Suffering The current economic downturn will go down as the deepest since the Great Depression. The IMF expects global GDP to contract by 3% this year, compared with a flat reading in 2009. GDP in advanced economies is projected to fall by 6%, twice as bad as in 2009 (Chart 2). Chart 2Severe Damage To The Global Economy This Year Unemployment rates are also likely to reach the highest levels since the 1930s. The US unemployment rate spiked to 14.7% in April. Even that understates the true increase in joblessness. The labor force has shrunk by 8 million workers since February. If everyone who had left the labor force had been considered unemployed, the unemployment rate would have jumped to nearly 19% (Chart 3). Unemployment among less-skilled workers rose more than among the skilled. Joblessness also increased more among women than men (Chart 4). Chart 3Increase In Joblessness Is Understated Chart 4Unemployment Has Risen More For Less Skilled Workers And Women The one silver lining is that unlike in past recessions, temporary layoffs have accounted for the vast majority of job losses (Chart 5). This suggests that the links between firms and workers have yet to be severed. As businesses reopen, the hope is that most of these workers will be able to return to their jobs, fueling a rebound in spending. Chart 5Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Risks Of A Second Wave Will that hope be realized? As we discussed last week, the virus that causes COVID-19 is highly contagious – probably twice as contagious as the one that caused the Spanish flu.1 While some social distancing measures will persist even if governments relax lockdown orders, the risk is high that we will see a second wave of infections. Even if a second wave ensues, we do not expect stocks to take out their March lows. In many places, the second wave could come on top of a first wave that has barely abated. This is precisely what happened during the Spanish flu pandemic (Chart 6). Stock prices and credit spreads have closely tracked the number of Google queries about the coronavirus (Chart 7). If the number of new infections begins to trend higher, concern about the pandemic will deepen. This makes us somewhat wary about the near-term direction of risk assets. Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Chart 7Joined At The Hip   March Was The Bottom In Equities Nevertheless, even if a second wave ensues, we do not expect stocks to take out their March lows. This is partly because the cone of uncertainty around the virus has narrowed. We now know that the fatality rate from the virus is around 1%-to-1.5%, which makes COVID-19 ten times more deadly than the common flu, but still less lethal than SARS or MERS, let alone some avian flu strains which have mortality rates upwards of 50%. A few treatments for the virus are on the horizon. Gilead’s remdesivir appears to be effective in treating COVID-19. Blood plasma injections also look promising. A vaccine developed by researchers at the University of Oxford has been shown to be safe on humans and effective against COVID-19 on rhesus monkeys. Production of the vaccine has already begun, and if it works well on humans, the Oxford scientists expect it to be widely available by September.2 The Stock Market Is Not The Economy Then there is the issue of Main Street versus Wall Street. US equities account for over half of global stock market capitalization. Tech and health care are the two largest sectors in the S&P 500. The former has benefited from the shift towards digital commerce in the wake of the pandemic, while the latter is a highly defensive sector that has gained from the flurry of interest in new treatments for the disease (Chart 8). Chart 8AUS Equity Sectors: Winners And Losers From The Pandemic (I) Chart 8BUS Equity Sectors: Winners And Losers From The Pandemic (II) Even within individual sectors, the impact on Wall Street has been more muted than on Main Street. For example, spending on consumer discretionary goods and services has plummeted across the real economy over the past few months. Yet, this has not hurt equity investors as much as one might have expected. Amazon accounts for 55% of the retail sector’s market capitalization. Home Depot is in second place by market cap. Home Depot’s stock is trading near an all-time high, buoyed by increased spending on home improvement projects by people stuck at home. McDonald's, which is benefiting from the shift to take-out ordering, is the largest stock in the consumer services sector (followed by Starbucks). Contrary to the claim that the stock market is blissfully ignorant of the mounting economic damage, those sectors that one would expect to suffer from a pandemic-induced downturn have, in fact, suffered. Airline stocks, which account for less than 2% of the industrials sector, have plunged. The same is true for cruise ship stocks. Bank stocks have also been beaten down, reflecting fears of heightened loan losses. Likewise, lower oil prices have undercut the stocks of energy exploration and production companies (Chart 9). At the regional level, non-US stocks, with their heavy weighting in deep cyclicals and financials, have underperformed their US peers. Small caps have also lagged their large cap brethren, while value stocks have trailed growth stocks (Chart 10). Chart 9Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Chart 10Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Tech stocks are overrepresented in growth indices, which helps explain why growth has outperformed value. Tech companies also tend to carry little debt while sporting large cash holdings. Companies with strong balance sheets have greatly outperformed companies with weak ones since the start of the year (Chart 11). Chart 11Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Chart 12Real Rates Have Come Down This Year In addition, growth companies have disproportionately benefited from the dramatic decline in real interest rates (Chart 12). A drop in the discount rate raises the present value of a stream of cash flows more the further out in time those cash flows are expected to be realized.   What Low Bond Yields Are Telling Us Doesn’t the decline in real long-term interest rates signal that future economic growth will be considerably weaker? If so, doesn’t this nullify the benefit to growth companies in particular, and the stock market in general, from a lower discount rate? Not necessarily! While lockdowns have led to a temporary drop in aggregate supply, they have not severely undermined the long-term productive capacity of the economy. Unlike during a war, no factories have been destroyed. And while heightened unemployment could lead to some atrophying of skills, the human capital base has remained largely intact. Chart 13 shows that output-per-worker eventually returned to its long-term trend following the Great Depression. Chart 13No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth What the pandemic has done is made some forms of capital obsolete. We probably will not need as many cruise ships or airplanes as we once thought. But these items are not a huge part of the capital stock. And while some brick and mortar stores will disappear, this was part of a long-term shift toward a digital economy – a shift that has been raising productivity levels, rather than lowering them. Demand Is The Bigger Issue So why have long-term real interest rates fallen so much? The answer has more to do with demand than supply. Investors are betting that the pandemic will force central banks to keep interest rates at ultra-low levels for a very long period of time. All things equal, such an extended period of low rates might be necessary if the pandemic causes households to increase precautionary savings and prompts businesses to cut back on investment spending for an extended period of time. All things are not equal, however. As discussed in greater detail in Box 1, if real interest rates fall by enough, aggregate demand could still return to levels consistent with full employment since lower interest rates would discourage savings while encouraging capital expenditures. What if interest rates cannot fall by enough because of the zero-lower bound? In that case, fiscal policy would have to pick up the slack. Either taxes would need to be cut so that the private sector becomes more eager to spend, or the government would need to undertake more spending directly on goods and services. When interest rates are close to zero, worries about debt sustainability diminish since debt can be rolled over at little cost. In the end, the economy could end up in a new post-pandemic equilibrium where real interest rates are lower and fiscal deficits are larger. Applying Theory To Practice Framed in this light, we can make sense of what has happened over the past few months. The drop in long-term bond yields in February and early March was driven by falling inflationary expectations and rising financial stress. Yields then briefly jumped in mid-March as panicky investors dumped bonds in a mad scramble to raise cash. Not surprisingly, stocks suffered during this period. The Federal Reserve reacted to this turmoil by cutting rates to zero. It also initiated large-scale asset purchases, which injected much needed cash into the markets. In addition, the Fed dusted off the alphabet soup of programs created during the financial crisis, while launching a few new ones in an effort to increase the availability of credit and reduce funding costs. Other central banks also eased aggressively. As Chart 14 illustrates with a set of simple examples, even a modest decline in long-term interest rates has the power to significantly raise the present value of future cash flows. To compliment the easing in monetary policy, governments loosened fiscal policy (Chart 15). The point of the stimulus was not to raise GDP. After all, governments wanted most non-essential workers to remain at home. What fiscal easing did do was allow many struggling households and businesses to meet their financial obligations, while hopefully having enough income left over to generate some pent-up demand for when businesses did reopen their doors. Chart 14What Happens To Earnings During A Recessionary Shock? Chart 15Will It Be Enough? Ultimately, equity investors are hoping for an outcome where fiscal policy is eased by enough to eventually restore full employment while interest rates stay low well beyond that point in order to induce the private sector to keep spending: A win-win combination for stocks. Chart 16Gold Prices Move In The Opposite Direction To Real Rates The discussion above can also explain the divergent moves in commodity prices. Most industrial metals are consumed not long after they are produced. This makes industrial metal prices highly sensitive to the state of the global business cycle. In contrast, almost all of the gold that has ever been unearthed is still around. This makes gold an anticipatory asset whose price reflects expectations about future demand. Since owning gold does not generate any income, the opportunity cost of holding gold is simply the interest rate (Chart 16). When real interest rates rise, as they did briefly in early March when deflationary fears intensified, gold prices tend to fall. When real interest rates decline, as they did after central banks slashed rates and restarted large-scale QE programs, gold prices tend to rise. Investment Conclusions The current environment bears a passing resemblance to the one that prevailed in late 2008. Following the stock market crash in the wake of Lehman’s bankruptcy, the S&P 500 rallied by 24% between November 20, 2008 and January 6, 2009 to reach a level of 935. Had you bought stocks on that day in January, you still would have made good money over a 12-month horizon. However, you would have lost money over a 3-month horizon since the S&P 500 ultimately dropped to as low as 667 on March 6. During that painful first quarter of 2009, the economic surprise index remained firmly below zero, while earnings estimates continued to drift lower, just like today (Chart 17). As noted above, we do not expect stocks to take out their March 2020 lows, but a temporary sell-off would not surprise us, especially against a backdrop where a second wave of the pandemic looks increasingly likely. Chart 17Is Today A Replay Of Late 2008/Early 2009? Chart 18Favor Equities Over Bonds Over A 12-Month Horizon Despite our near-term concerns, we continue to think that stocks will outperform bonds over a 12-month horizon. The equity risk premium remains elevated, particularly outside the US (Chart 18). While non-US stocks do not have as much exposure to tech and health care, they do benefit from very cheap valuations. European banks are trading at washed out levels (Chart 19). The cyclically-adjusted PE ratio for EM stocks is near record lows (Chart 20). Investors should consider increasing exposure to non-US equities if global growth begins to reaccelerate this summer. Chart 19European Banks Are Trading At Washed Out Levels Chart 20EM Stocks Are Very Cheap Given our view that central banks want real rates to stay low and will refrain from tightening monetary policy even if inflation eventually begins to rise, investors should maintain above-average exposure to gold. A weaker US dollar later this year will also help bullion. Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2  Charlie D’Agata, “Oxford scientists say a vaccine may be widely available by September,” cbsnews (April 30, 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores
In the month of April, the performance of markets strongly bore the imprint of central banks' actions. The Fed was the most aggressive central bank in the world, thus assets directly exposed to the Fed’s programs experienced the largest abnormal returns. For…
Highlights Uncertainty over the duration of lockdowns globally will continue to hamper the estimation of the global demand recovery for commodities. This uncertainty will continue to fuel safe-haven demand for USD for the balance of 2Q20. In addition, markets continue to experience a shortage of USD, which can become acute for EM debtors servicing dollar-denominated debt. The combination of safe-haven demand and a continued dollar shortage will keep the USD well bid, which will, at the margin, suppress commodity demand, compounding the effects of COVID-19-induced demand destruction. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions, which also reduces the level of economic activity and commodity demand. Commodity demand will recover in 2H20. Given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the Communist Party of China (CCP) – base metals and grain prices should recover earlier than other commodities.  Oil likely recovers in 3Q20, as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. We remain long gold as a portfolio hedge against continued global policy uncertainty. Feature The short-term path forward for commodity prices will be a function of uncertainty regarding the global economic recovery and its impact on the US dollar, which, at present, remains well bid and is keeping global financial conditions tight. The sharp USD appreciation – mostly vs. EM currencies – is a response to the COVID-19 economic shock, which intensified in March. This significantly tightened global financial conditions (Chart of the Week). EM economies’ capacity to withstand the hit to aggregate demand locally – caused by widespread lockdown measures meant to contain the spread of the virus – has led to capital outflows. EM economies, therefore, are forced to combat a combination of plunging currencies, crumpling domestic and export demand, and increasing financing costs. Low risk appetite globally and diminished liquidity in money and credit markets add to USD demand, and will keep it elevated over the next few months. Chart of the WeekEM Currencies Plunged Vs. The USD Chart 2Commodity-Intensive Industries Are Vulnerable To USD Shocks After that, we expect the dollar will reverse – mostly on the back of massive Fed accommodation to redress these factors – in 2H20. As COVID-19-induced demand destruction abates, this weakening in the USD will propel EM economic growth higher and bolster commodity demand (Chart 2). USD Well Bid On Safe-Haven Demand, Dollar Shortage The dollar could retest its recent highs in the short term. Heightened volatility over the past two months powered a surge in demand for safe havens and highly liquid risk assets globally. We expect this to persist as stringent lockdowns remain in place to combat the COVID-19 pandemic. This will keep economic policy uncertainty elevated. Over the short term, the USD will benefit in this environment. Demand for USD and dollar-denominated assets will remain strong. Indeed, our FX strategists believe the dollar could retest its recent highs (Chart 3).1 Chart 3Global Uncertainty Lifts The US Dollar And Rates Since the Global Financial Crisis (GFC), US dollar movements have been a prime driver of cross-currency basis swaps and can be indicative of risk-taking capacity in capital markets.2 Also, a rising dollar limits the cross-border supply of dollar-denominated loans and increases funding costs. The Fed is monitoring domestic and global liquidity conditions closely, and is fulfilling the role of global USD lender of last resort. Its rapid extension of swap lines to foreign central banks, as well as a temporary repo facility for foreign and international monetary authorities (FIMA), temporarily eased liquidity concerns in some regions (Chart 4). Chart 4Fed Actions Have Eased Global Liquidity Constraints   It is too early to presume the dollar liquidity constraints have been wholly contained. However, it is too early to presume the dollar liquidity constraints have been wholly contained. The Fed cannot force foreign central banks to direct these dollars to the sectors in which they are needed in their domestic economies. Besides, not all EMs have access to these swap lines. This means much-needed swap lines are inaccessible to a significant portion of the global financial system. In addition, close to 60% of outstanding foreign exchange swaps/forwards involve non-bank financial and other institutions.3 It is highly likely, therefore, the Fed will have to provide additional liquidity to struggling foreign entities. We believe the Fed is well aware of these constraints on global growth and is addressing the need for additional global USD liquidity. However, as has been the case throughout the post-GFC period, policy action will continue to be uncertain as to its duration and its effectiveness. Combined with expanding fiscal deficits in the US, we believe this extraordinary accommodation by the Fed will considerably increase USD supply this year. Following a volatile 2Q20, we expect the US dollar will face severe downward pressures – assuming lockdown measures are successful in containing the pandemic and are gradually lifted. With interest rates now close to zero in most DM economies, relative balance-sheet dynamics will become important drivers of exchange rates (Chart 5). Ample liquidity globally will propel pro-cyclical currencies up and the combination of fiscal and monetary easing could lead to a debasing of the dollar next year as inflationary pressures intensify. Momentum will start working against the dollar in 2H20. Chart 5Massive QE In The US Will Pressure The USD Downward USD Strength Hinders Global Growth The dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened. The strong dollar remains a headwind to global growth – particularly in EM economies – as it pushes up funding costs and tightens financial conditions. This negative dollar shock adds to the devastating effects of lockdowns, record portfolio outflows, and collapsing commodity prices on EM economies (Chart 6). Since the GFC, the dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened (Chart 7). EM economies’ rising responsiveness to dollar movements is in part explained by their growing share of foreign USD-denominated debt, a larger foreign ownership of their sovereign debt, and increasing integration into global supply chains, in which transactions typically are invoiced in dollars (Chart 8). Chart 6Record Portfolio Outflows From EM   Chart 7Brent Prices Are Closely Correlated With EM Currencies Post-GFC Chart 8EM Vulnerability To The USD Increased Since The GFC Elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Thus, elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Interestingly, this relationship is non-linear and asymmetric – i.e. the dollar’s impact on commodity prices is higher in dollar bull markets, and positive dollar changes have a greater impact. For instance, its impact on oil prices is 30% stronger in dollar-appreciation cycles. Large increases in the relative value of the USD – on a monthly, weekly, or daily basis – have a disproportionate negative impact on oil prices compared to large decreases (Chart 9). Hence, sudden rushes to safe and liquid assets in periods of rising global economic uncertainty have a magnified negative effect on commodity prices. This means the recovery in commodity prices will be more gradual. Chart 9Asymmetric Impact Of USD Changes On Commodity Prices Base Metals Could Recover In 2Q20 Gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. The USD strength is keeping commodity demand growth in check. Until uncertainty re the speed of economic recovery dissipates – mainly vis-à-vis EM economies – commodity prices will remain under pressure (Chart 10). Base metals and grain prices could recover earlier than other commodities given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the CCP. Specifically, copper prices could decouple from the USD, following China’s economic growth as it contributes close to 50% of both supply and demand of refined copper (Chart 11). Chart 10USD Strength Will Weigh Down Commodity Prices In 2Q20 Chart 11Metals' Prices Will React To China's Economic Recovery Oil will rebound in 3Q20 as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. China consumes a smaller 14% of world oil demand, which is not sufficient to support a sustainable rally in prices on its own. For 2Q20, the correlation with the USD will intensify and weigh down its price (Chart 12). Lastly, gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. Bottom Line: As the global economy recovers from the COVID-19 pandemic and things get back to normal in 2H20, the USD will weaken and commodity prices will rebound. These two factors will halt the deflationary impulse from the COVID-19 demand shock. On the back of this improvement, we expect inflation expectations to recover throughout 2021 (Chart 13). Chart 12Oil Prices' Correlation With The USD Increases In Contango Chart 13Weaker USD, Rising Commodity Prices Will Revive Inflation Expectations   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Oil price volatility as measured by the Crude Oil ETF Volatility Index (OVX) surged to above 300% earlier this week as WTI futures for May 2020 delivery fell to a low of -$40.40/bbl (Chart 14). Unprecedented negative pricing for the North American benchmark crude oil will accelerate supply destruction and bankruptcies among highly levered, unprofitable E+P companies operating in the principal shale basins, particularly the Permian. We will be looking at the supply-side implications of the massive price volatility, coupled with the first-ever negative pricing for the benchmark crude oil in next week’s publication. We currently expect US production to fall 1.5mm b/d this year. Base Metals: Neutral Front month Singapore Iron Ore Futures continue to perform relatively well, with the 62% Fines contracts hovering around $83/MT. This contract is down 5.3% ytd, after having peaked in January at $92/MT. Chinese steel inventories while elevated, have started to turn the corner since Mid-March when they reached a record 26 Mn MT (Chart 15). Resilience in iron ore and steel reflects favorable fundamentals, as Chinese manufactures starting to get back to business are reviving demand in China, and as supply concerns stemming from reduced mine activity among major mining groups around the world persist. Precious Metals: Neutral We are going long palladium at tonight’s close, following its break below $2,000/oz. We expect the global economy to recover in 2H20 on the back of massive fiscal and monetary stimulus. We expect this will be supportive of consumer spending, particularly automobiles. Palladium is essential to pollution-abatement technology in gasoline-powered cars. While work is being undertaken to rehabilitate South Africa’s derelict power grid, this is at least a five-year effort. In the meantime, rolling backouts will continue to threaten the 73% of global palladium supply produced in South Africa. Ags/Softs:  Underweight CBOT corn May futures fell 1.55% on Tuesday, closing at $3.09/bu, the lowest level since 2009. Corn has been under pressure in recent weeks as the COVID-19 pandemic caused large demand destruction for this grain. Initially, this stemmed from a lower ethanol demand. However, concerns over a slowdown in demand for cattle feed has impacted corn demand as meat plants close in North America. Chart 14Crude Oil ETF Volatility Index Surged Over 300% Chart 15Chinese Steel Inventories Have Turned The Corner     Footnotes 1     Please see QE And Currencies, published by BCA Research’s Foreign Exchange Strategy April 17, 2020. It is available at fes.bcareserach.com. 2     Please see Avdjiev, Stefan, Wenxin Du, Cathérine Koch, and Hyun Song Shin. 2019. "The Dollar, Bank Leverage, and Deviations from Covered Interest Parity." American Economic Review: Insights, 1 (2): 193-208. 3     Please see Capitulation?, published by BCA Research’s Foreign Exchange Strategy April 3, 2020. It is available at fes.bcareserach.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades
Highlights Q1/2020 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -40bps during the first quarter of the year – a number that would have been far worse if not for the changes in exposures for duration (increased) and spread product (decreased) made in early March. Winners & Losers: Underperformance was concentrated in sovereign debt, US Treasuries in particular (-94bps), as yields plummeted. This detracted from the outperformance in spread product (+51bps) led by US investment grade corporates (+34bps) and emerging markets (+20bps). Scenario Analysis For The Next Six Months: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Feature Global bond markets were roiled in the first quarter of 2020 by the economic fallout from the COVID-19 pandemic. Government bond yields crashed to all-time lows while volatility reached extremes across both sovereign debt and credit. The quick, coordinated policy response from global monetary and fiscal authorities – which includes unprecedented levels of direct central bank asset purchases, both in terms of size and the breadth across markets and counties - has helped stabilize global credit spreads and risk assets, more generally. The outlook remains highly uncertain, however, with many governments worldwide looking to reopen their collapsed economies, risking the potential resurgence of a virus still lacking effective treatment or a vaccine. We are focusing more on relative value between counties and sectors. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful first quarter of 2020. We also present our updated recommended positioning for the portfolio for the next six months. The main takeaway there is that we are focusing more on relative value between counties and sectors while staying close to benchmark on both overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 1Q1/2020 Performance: Lagging, But It Could Have Been Much Worse As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2020 Model Portfolio Performance Breakdown: A Missed Rally In Sovereigns, Outperformance In Credit The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -0.1%, underperforming the custom benchmark index by -40bps (Chart 1).1 That relative underperformance came from the government bond side of the portfolio, while our spread product allocation outperformed the benchmark. US Treasuries underperformed the most (-91bps) with losses concentrated in the +10 year maturity bucket. (Table 2). After US Treasuries, euro area high-yield corporates were the second worst performer, underperforming the benchmark by -10bps. Outperformance in spread product was driven by US investment grade industrials (+22bps) and EM credit (+20bps). Table 2GFIS Model Bond Portfolio Q1/2020 Overall Return Attribution The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. Our decision to raise overall global duration exposure to neutral at the beginning of March helped shield the portfolio as yields plummeted.2 We followed this by upgrading sovereign debt in the US and Canada, both higher-beta countries, to overweight while moving to an underweight stance on US high-yield debt, euro area investment-grade and high-yield debt, and emerging market (EM) USD-denominated sovereign and corporate debt.3 In an environment of rampant uncertainty, these allocation changes helped prevent catastrophic losses in the model portfolio that had previously been positioned for a pickup in global growth. The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -91bps of underperformance versus our custom benchmark index while the latter outperformed by +51bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q1/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2020 Spread Product Performance Attribution By Sector The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+22bps) Underweight euro area investment grade corporate bonds (+16bps) Underweight EM USD-denominated corporates (+12bps) Overweight US investment grade financials (+10bps) Underweight Japanese government bonds with maturity greater than 10 years (+8bps) Biggest Underperformers Underweight US government bonds with maturity greater than 10 years (-36bps) Underweight US government bonds with maturity of 3-5 years (-17bps) Underweight US government bonds with maturity of 5-7 years (-16bps) Underweight US government bonds with maturity of 1-3 years (-13bps) Underweight US government bonds with maturity of 7-10 years (-12bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2020. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Predictably, government debt performed the best in Q1/2020 as global bond yields fell and monetary authorities raced to support economies and inject liquidity. UK, US, and Canadian government debt delivered the best returns this quarter. While we started the year neutral or underweight those assets, we moved to an overweight allocation in March, which helped salvage some returns. Also worth noting is that Australian government debt, where we have maintained a structural overweight stance, was one of the top performing markets during the first quarter. The deepest losses were sustained in EM USD-denominated sovereign and corporate debt, and euro area high-yield. Although it seems a distant memory at this point, we did start this quarter on an optimistic note and expected spreads on these products to narrow as global growth picked up. However, we were able to shield our portfolio against excessive losses in these products by moving to an underweight stance in March once the severity of the COVID-19 global economic shock become apparent. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the first quarter of the year. The underperformance was concentrated in government bonds, which rallied on the back of the global pandemic. However, the portfolio outperformed the benchmark in spread products, where the combination of massive fiscal/monetary easing and direct central bank asset purchases have brought credit spreads under control. Future Drivers Of Portfolio Returns Typically, in these quarterly performance reviews of our model bond portfolio, we attempt to make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. In the current unprecedented economic and financial market environment, however, we are reluctant to rely on model coefficients and correlations to estimate expected returns. Instead, in this report, we will focus on discussing the logic behind our current model portfolio positioning and how those allocations should expect to contribute to the overall portfolio performance over the next six months. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: Our recommended overweight stance on US spread product that is backstopped by the Fed—US investment grade corporates, Agency CMBS, and Ba-rated high-yield; Our recommended overweight stance on relatively higher-yielding sovereigns like the US and Italy; Our recommended underweight stance on EM USD-denominated corporates and sovereigns, where the specter of defaults and liquidity crunches looms. In terms of specific weightings in the GFIS model bond portfolio, we have moderated our stance on global spread product since our previous review of the portfolio.5 While the monetary liquidity backdrop is highly bullish, with central banks aggressively buying bonds and keeping policy rates at the zero lower bound, it is still unclear if and when economies will be able to successfully reopen and put an end to the COVID-19 recession. We are now recommending only a small relative overweight of two percentage points for spread product versus the benchmark index (Chart 5), leaving room to add more should the news on the virus and global growth take a turn for the better. Chart 5Overall Portfolio Allocation: Slightly Overweight Credit We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has plunged and is signaling bond yields will stay depressed over the next six months (Chart 6). Yet at the same time, yields in most countries have been unable to hit new lows after the panic-driven bond rally in late February and early March, even as global oil prices have collapsed and inflation expectations remain depressed, suggesting that yields already discount a lot of bad news. Chart 6Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low We do not see much value in taking a big directional bet on yields through overall duration exposure at the present time. We also think it is far too early to contemplate reducing duration – even with many global equity and credit markets having rallied sharply off the lows – given the persistent uncertainty over the timing of a recovery in global growth. Thus, we are maintaining a neutral overall portfolio exposure (Chart 7). Chart 7Overall Portfolio Duration: At Benchmark Chart 8Country Allocation: Favor Those With Higher Betas To Global Yields Within the government bond side of the model bond portfolio, we recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and peripheral Europe while maintaining underweights in core Europe and Japan, where yields have relatively little room to fall. That allocation also lines up with the sensitivity of each market to changes in the overall level of global bond yields, i.e. the yield beta (Chart 8). By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields, while still maintaining an overall neutral level of portfolio duration. By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields. Turning to spread product allocations, we recommend focusing more on policymaker responses to the COVID-19 recession rather than the downturn itself. Yes, the earlier widening of global high-yield spreads is forecasting a sharp plunge in global growth and rising unemployment rates (Chart 9, top panel). At the same time, the now double-digit year-over-year growth in global central bank balance sheets - a measure that has led global high-yield bond excess returns by one year in the years after the Global Financial Crisis (bottom panel) – is pointing to a period of improved global corporate bond market performance over the next 6-12 months. Chart 9Global Corporate Performance Should Benefit From Global QE In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. Chart 10Credit Allocation: Buy What The Central Banks Are Buying That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets. That means concentrating spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). We are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed is now allowed to hold in its corporate bond buying program, and euro area investment grade corporate bonds (excluding bank debt) that the ECB is also buying in its increased bond purchase programs. Chart 11Stay Underweight EM Credit One new change we are making this week is upgrading US agency commercial mortgage-backed securities (CMBS) to overweight, funding by a reduction in US agency residential mortgage-backed securities (MBS) to underweight. While the Fed is still buying agency MBS debt in its new QE programs, MBS spreads have already compressed substantially and are now exposed to potential refinancing risk as eligible US homeowners look to take advantage of the recent plunge in US mortgage rates. We prefer to increase the allocation to agency CMBS, which the Fed can now buy within its expanded QE programs and which offer more attractive spreads than agency MBS (middle panel). One part of the spread product universe where we continue to recommend an underweight stance is USD-denominated EM corporate and sovereign debt. The time to buy those markets will be when the US dollar has clearly peaked and global growth has clearly bottomed. Neither of those conditions is in place now, with the price momentum in both the EM currency index and the trade-weighted US dollar still tilted towards a stronger greenback. That backdrop is unlikely to change in the next few months, suggesting a defensive stance on EM credit is still warranted (Chart 11). A defensive stance on EM credit is still warranted. Model bond portfolio yield and tracking error considerations The selective global government bond and credit portfolio we have just outlined does not come without a cost. While we are currently overweight countries with higher-yielding government bonds, our underweight positions on riskier spread product like EM debt and lower-rated US junk bonds bring the yield of our model portfolio down to 1.8%, –15bps below the yield of the model portfolio benchmark index (Chart 12). We feel that is an acceptable level of “negative carry” given the still heightened levels of uncertainty over global growth. This leads us to focus more on relative value between countries and sectors to generate outperformance that we expect to offset the impact of underweighting the highest yielding credit markets. Chart 12Portfolio Yield: Moderately Below Benchmark Chart 13Portfolio Volatility: Currently High, But Expected To Fall Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. However, given our pro-risk positioning in the first two months of 2020, combined with the extreme volatility in markets during the first quarter, the realized portfolio tracking error blew through our self-imposed ceiling of 100bps (Chart 13). We expect this to settle down in the coming months as the recent changes in our positioning start to be reflected in the trailing volatility of our portfolio. Bottom Line: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "What Bond Investors Should Do After The 'Great Correction'", dated March 3 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q1/2020 will have multiple colors in the respective bars in Chart 4. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "2019 GFIS Model Bond Portfolio Performance Review: Praise Credit & Blame Duration", dated January 14, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy Our conservative dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – result in an SPX 3,000 fair value target. Relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. An upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all warrant an overweight stance in the S&P software index. Recent Changes Trim the S&P packaged foods index to neutral today, which pushes the S&P consumer staples sector to a benchmark allocation. Boost the S&P software index to overweight today, which lifts the S&P tech sector to a benchmark allocation. Table 1 Feature The SPX jumped to a five-week high last week, on the back of news that the economy will gradually reopen next month. In other news, GILD’s remdesivir drug showed some positive early signs in fighting off the coronavirus, sparking an impressive late-week rally in the SPX. From a macro perspective, flush monetary liquidity and extremely easy fiscal policy remain the dominant market forces. While we remain confident that equities will be higher on a 9-12 month cyclical time horizon, we believe that the easy money since the March 23 lows has already been made and a consolidation phase now looms. Thus, monetizing some of these gains would make sense at the current juncture. Keep in mind that the SPX, junk spreads and the CBOE’s put/call ratio have returned to their respective means since 2018 (horizontal lines denote the historical averages, Chart 1). Tack on the stiff resistance that the S&P 500 will face near the 50-day and 100-week moving averages, and a lateral move is likely in the coming weeks. Meanwhile, in our seminal report “SPX 3,000?” on July 10, 2017 we introduced our SPX dividend discount model (DDM) when we first came up with the SPX 3,000 target.1 It is now custom to update our DDM every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Chart 1Consolidation Mode Chart 2Dividends Rule As a reminder, we have been and remain very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 2). Our 8.2% discount rate mirrors the corporate junk bond yield historical average. This year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. In the spirit of conservatism, we pick the lowest point hit in early April across the different dividend futures expirations. Tables 2 & 3 summarize the results. In the dividend futures derived approach, SPX fair value is close to 2,110. Granted, such dividend contractions for two years running (33% in 2020 and 14% in 2021, Table 2) are extreme and highly unlikely. Moreover, dividend futures have since rebounded violently. However, we stick with them to derive our worst case SPX value. Table 2SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Our own dividend growth estimates result in an SPX 3,000 fair value target (Table 3). While our assumptions are not as dire as the nadir in dividend futures, they are slightly more conservative than the GFC experience. As a reminder, in the aftermath of the GFC dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively (please click here if you would like to receive our DDM and insert your own assumptions). Table 3SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Building up on this analysis, we want to identify sectors that are at risk of a dividend cut, and thus pose the greatest threat to our SPX dividend projections. Table 4 shows the 2019 sectorial dividends, profits, and the payout ratio along with indebtedness. While during the Great Recession financials cut their handsome dividends, the current recession is not a financial crisis and we doubt the financials sector will cut their dividends, at least not as aggressively as in the GFC (Table 5). Table 4S&P 500 GICS1 Sector Dividend Analysis Table 5The GFC S&P 500 GICS1 Sector Dividend Experience Energy is a clear standout, but neither XOM nor CVX will forego their dividend aristocrat status (minimum 25 consecutive years of rising dividends) and chop their dividends. In other words, these Oil Majors will do everything in their power including raising debt to ever so modestly increase their dividends and maintain their aristocrat status. Thus, $24bn of energy sector related dividends are safe or 55% of the overall energy sector’s dividend. Keep in mind that the energy sector increased their dividends in the GFC (Tables 4 & 5). Industrials (GE is no longer a big dividend payer), materials, real estate and select consumer discretionary are sore spots, but not large enough to undermine the SPX (Table 4). Tech, health care and consumer staples are in excellent shape and judging by JNJ’s and COST’s recent dividend hikes, these sectors that enjoy mostly pristine balance sheets may even increase their payouts as they did during the GFC (Tables 4 & 5). While utilities and telecom services are debt saddled, their defensive stature and stable cash flow streams along with their history of steady dividend payments also do not pose a real threat to the SPX’s dividend (Tables 4 & 5). This leaves financials as the key sector to monitor for a possible large inflicted wound to the SPX dividend. In the most adverse scenario where the Fed instructs banks to eliminate their dividends, as the BoE and the ECB recently did in Europe, then the SPX dividend will contract, but only by 15%, ceteris paribus. This is because last year the tech sector had the highest dividend weight in the SPX and also because the financials sector’s dividend weight has fallen from 30% in 2007 to 15% in 2019 (Tables 4 & 5). Netting it all out, we are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. However, given that the easy SPX gains from the March 23, 2020 lows – when we turned cyclically bullish2 – have been made, opportunistic/nimble investors could monetize at least a part of these massive one-month returns. As aforementioned the SPX may face resistance near the 50-day moving average where it attempts to consolidate its recent gains. This week we are downgrading a defensive group to neutral and boosting a deep cyclical group to an above benchmark allocation. Turning Stale Following up from last week’s report, we heed the message from our research to be wary of staples stocks at the depth of the recession and downgrade the S&P packaged foods index to neutral. This move also pushes the S&P consumer staples sector down to a benchmark allocation from previously overweight. While this defensive index had been severely bruised from the accounting scandal at Kraft/Heinz, it has really flexed its safe haven muscles year-to-date. We use this opportunity to trim exposure down to neutral as we deem that this relative advance has run out of steam, despite the once in a lifetime jump in a number of key demand indicators. Chart 3 shows that food & beverage store retail sales now garner 17% of total retail sales a percentage last hit in the early 1990s. Impressively, not only did industry sales rise in absolute terms, but also overall retail sales suffered a severe setback accentuating last month’s spike. Similarly, food output hit a high mark last month, outpacing overall industrial production that came to a standstill. Food products resource utilization also soared, outpacing overall capacity utilization by 10% (bottom panel, Chart 3). As a result, relative share price momentum came close to accelerating by triple digits on a short-term rate of change basis (Chart 4). While such euphoria is warranted, we reckon that most if not all the good news is already reflected in prices, especially given the early signs of a possible reopening of the US economy some time next month. Importantly, sell side analyst optimism has climbed to a similar height observed in late-2015/early-2016 when industry 12-month forward EPS were slated to outshine the broad market by over 10% (bottom panel, Chart 4). Chart 3Demand Boost… Chart 4…Is Already Baked In Worrisomely, despite the rising demand profile, operating margins have been drifting lower over the past decade and a further profit margin squeeze remains a high probability outcome (Chart 5). Finally, on the food export front, the rising US dollar is warning that volumes will remain in check in coming quarters (greenback shown inverted, middle panel, Chart 6). All of this is reflected in valuations that have returned to the 25-year mean with packaged food manufacturers now trading at a 9% forward P/E premium to the broad market (bottom panel, Chart 6). Chart 5Margin Trouble Chart 6Past Expiry Date In sum, relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. Bottom Line: Trim the S&P packaged foods index to neutral, today for a loss of 20% since inception. This downgrade also pushes the S&P consumer staples sector to neutral for a loss of 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PACK – MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, GIS, HSY, HRL, K, LW. Boost Software To Overweight We recently monetized over 50% relative gains in our overweight in the S&P software index, but today we are compelled to lift this heavyweight tech sub-index back to an overweight stance. One key reason for our renewed bullishness is that for the second time in the past 15 months, software stocks managed to eke out relative gains when the broad market fell peak-to-trough 20% and 35% in late-2018 and in Q1/2020, respectively (Chart 7). This resilience on the way down confirms both the defensive stature of this services tech subgroup and simultaneously our long held belief that when growth is scarce investors will flock to secular growth stocks. Chart 7Recession Proof As a result and following up from our recent data processing upgrade, another defensive services tech group, we are compelled to augment exposure to the S&P software index to overweight. Last week we showed that the tech sector (along with financials and consumer discretionary) best the broad market from the recessionary troughs onward, signaling that the key software sub group will likely lead the recovery.3 Software investment is on a multi decade upward trajectory and is slated to rise further in coming quarters as overall spending takes the back seat, but defensive software capex remains resilient (Chart 8). Not only do corporate executives upgrade software in downturns as these upgrades yield near instantaneous return on investment and are immediately productivity enhancing, but also the push to cloud-based services will only accelerate during the ongoing recession (bottom panel, Chart 8). Tack on that the global coronavirus social distancing measures are also boosting demand for remote working services specifically, and software sales will continue to grind higher (Chart 9). Chart 8Capex Market Share Gains Chart 9Rising Demand Buoys Sales Meanwhile, industry M&A remains robust and both the number of deals are still rising at a brisk rate and the premia paid remain near historically high levels (Chart 10). Contrary to a slew of corporations that have announced dividend cuts and equity buyback suspensions, pristine software balance sheets underscore that shareholder friendly activities will remain in place, if not accelerate, during the current recession (bottom panel, Chart 10). Chart 10What’s Not To Like? Chart 11Model Says Buy Our macro-based software EPS growth model does an excellent job in capturing all these moving forces and it is signaling that industry profits will continue to expand at a healthy pace for the rest of the year, in marked contrast to the broad market’s expected profit contraction (Chart 11). Adding it all up, an upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all bode well for an earnings-led outperformance phase in the S&P software index. Bottom Line: Boost the S&P software index to overweight, today. This upgrade also lifts the S&P tech sector to neutral for a loss of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.     Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights The May-June WTI spread settled earlier in the week at a $7.29/bbl contango, the widest level since February 2009 during the GFC. This reflects an extraordinarily tight storage market in the US Gulf and Midcontinent. WTI for May delivery breached $20/bbl Wednesday, touching a 18-year low (Chart of the Week). Output cuts starting in May agreed by OPEC 2.0 over the weekend will remove 6.1mm b/d on average for May-December vs. 1Q20 levels. Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y. We raised our estimate of COVID-19-induced demand destruction in 2Q20 to 14.6mm b/d from 12.1mm b/d. We expect demand to fall ~ 8mm b/d in 2020 vs. our previous estimate of 4mm b/d, as global fiscal and monetary stimulus revives growth in 2H20. We expect 2021 demand to rise 7.7mm b/d, averaging 100.6mm b/d. In our updated forecast, Brent is expected to average $39/bbl – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Our Brent forecast for 2021 remains ~ $65/bbl. WTI will trade $2-$4/bbl lower. Feature   April is the cruellest month … - T.S. Eliot, The Waste Land1 Global oil logistical capacity will be tested in extremis this month, as cargoes laden with oil arrive in ports that have no need for ready supply and few storage options to hold the crude until its needed. This is filling traditional global storage, inland pipelines and ships, which, as typically occurs in extremis, are used as floating storage (Chart 2). Chart of the WeekCrude Oil In Extremis Chart 2Floating Storage Volumes Soar As Terminals and Pipelines Fill The most extreme testing of global logistics likely will occur in this cruel month, to borrow once again from the laureate, as markets are forced to absorb the production surge from OPEC 2.0 – mostly from KSA and its allies. Repeated excursions to and through $10/bbl in physical markets, as already have been registered in Canada and US shale basins, can be expected this month (Chart 3). Indeed, we expect price pressures to reduce US oil ouput – mostly in the shales – by 1.5mm b/d or more.2 Beginning in May, OPEC 2.0 will begin cutting production, with its putative leaders – KSA and Russia – accounting for 1.3mm b/d and 2.1mm b/d, respectively, of the coalition’s total pledged cuts of 7.6mm b/d vs. 1Q20 production levels. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to 9.7mm b/d for May-June, and 7.7mm b/d for 2H20).3 Chart 3Cash Markets Pressing /bbl While the official OPEC communique notes the coalition also will implement a 6mm b/d cut from January 2021 to April 2022, we doubt this will be necessary. The coalition meets again in June, and KSA’s Energy Minister, Prince Abdulaziz bin Salman, said the Kingdom is prepared to increase its cuts if needed.4 Based on historical experience, we expect KSA to over-deliver on cuts, and for Russia to gradually meet its pledged volumes. We are haircutting other states’ production cuts based on historical observation, and are projecting cuts of ~ 75% for 2020 and 70% for 2021 compliance (Table 1). Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y on average. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Lowering Our Demand Forecast The COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008. Our estimate of COVID-19-induced demand destruction in 2Q20 is now 14.6mm b/d, up from 12.1mm b/d. For all of 2020, we expect demand to fall 7.9mm b/d in our base case vs. our previous estimate of 4mm b/d. These estimates are highly conditional on the trajectory of the containment of the COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global real GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008 (Chart 4). Nonetheless, we believe the massive global fiscal and monetary stimulus now being deployed will restore growth beginning in 2H20 and carrying through to expect 2021 demand to rise 7.7mm b/d, and to average 100.6mm b/d (Chart 5). Chart 4COVID-19 Real GDP Hits Dwarf 2009 GFC Recession Chart 5Massive Stimulus Will Revive Demand We assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. While our demand expectations are slightly weaker, in our modeling we see supply being curtailed sufficiently to produce a physical deficit beginning in 3Q20 (Chart 6). Our supply-demand trajectory projects a peak in OECD storage of 3.7 billion barrels in May, after which inventories fall sharply (Chart 7). Indeed, we assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. Chart 6Oil Supply-Demand Balances Point To Physical Deficit By 4Q20 Chart 7Inventories Spike, Then Draw Sharply Two-Way Price Risk Our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. In our updated forecast, we see Brent averaging $39/bbl this year – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Next year, our expectation remains ~ $65/bbl. WTI will trade $2-$4/bbl lower (Chart 8). As noted above, our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. However, as the pandemic spreads deeper into less-developed EM economies without robust public-health infrastructures, or social security systems providing a basic income in the event of job loss due to recessions the risk of widespread infection rises significantly.5 Chart 8Stronger Price Recovery Expected No amount of fiscal or monetary stimulus will allow an economy to weather such a storm. This is a clear and present danger to the global recovery and to a recovery in commodities generally, oil in particular. Investment Implications Our expectation for prices is reflected in Chart 8, premised, again, on COVID-19 being contained and fiscal and monetary stimulus reviving global growth. We are retaining our long exposure to the market, expecting the supply and demand policies set in motion will be effective. However, there is no way of accurately assessing the likelihood of an uncontained pandemic hitting EM markets, and, from there, re-entering other markets that presumably have dealt with the coronavirus.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight Global oil inventories will be filled rapidly in 2Q20 as major economies remain in lockdowns. High-cost Canadian oil sand producers will be severely hit as their output is landlocked, distant from key demand centers, and facing storage and pipeline infrastructure constraints. More than 500k b/d of production will be shut-in in April and May as crude-by-rail collapses, local and US refinery runs are reduced, and Alberta’s limited inventory moves closer to its maximum capacity – estimated at ~ 90mm bbls (Chart 9). Separately, a €20/MT stop to our EUA futures recommendation was triggered on April 14, 2020, leaving us with a 14.2% gain. Base Metals: Neutral China’s iron ore imports fell to 85.9mm MT in March, a decline 0.6% y/y, after growing 1.5% in January and February. This came as steel mills arranged maintenance or slowed production to deal with record-high inventories after the COVID-19 pandemic curtailed construction and industrial activities. However, in the long run the outlook for iron ore and steel appears to be improving. Mysteel data for China indicates utilization rates at blast furnaces have been rising for four weeks and are now at ~ 79%. Chinese Steel exports also picked up in March, up 2.4% from a year earlier, but are now facing new anti-dumping duties on stainless steel in the EU. Precious Metals: Neutral Gold continues to trade above $1700/oz – reaching its highest level since October 2012 – supported by easing fiscal and monetary policy in the US and fear of a prolonged economic slowdown. A lower US dollar – the DXY index fell back below 100 last week – and depressed real rates supported gold’s move higher (Chart 10). Dollar debasement risks and negative real rates increase gold’s attractiveness as a safe asset. Ags/Softs:  Underweight China’s March soybean imports came in at 4.28mm MT y/y, the lowest level since February 2015. Rains in Brazil delayed that country’s exports to China. The fall also reflects a 6% contraction in soymeal (i.e., the “crush”) consumed by livestock – as the African Swine Fever slashed China’s pig herd by more than 40% and shortages forced operations to grind to a halt. Similarly, meat suppliers in the US and Canada are closing plants temporarily due to COVID-19 cases among employees. As a result, Chicago soybean futures traded 0.8% lower on Tuesday. Chart 9Limited Storage Capacity In Alberta Chart 10Lower US Rates And Dollar Support Gold   Footnotes 1     The Waste Land, by T.S. Eliot, originally was published in 1922 in The Criterion, which was founded and edited by Eliot. 2     The Texas Railroad Commission held day-long hearings April 14 to consider returning to its historic roll as an oil-production regulator on Tuesday.  As we went to press no ruling on the petition to revive pro-rationing was delivered.  The Oklahoma Corporation Commission will hold similar hearings next month.  Please see Texas and Oklahoma weigh production quotas for oil published by washingtonpost.com April 13, 2020. 3    Please see The 10th (Extraordinary) OPEC and non-OPEC Ministerial Meeting concludes, posted by OPEC April 12, 2020. 4    Please see Saudi energy minister leaves door open for more cuts in June, published by worldoil.com April 13, 2020. 5    Please see National governments have gone big. The IMF and World Bank need to do the same. This op-ed by Gordon Brown and Larry Summers, published by washingtonpost.com April 14, 2020, lays out some of the issues that elevate downside risk to a COVID-19 recovery.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 Commodity Prices and Plays Reference Table   Trades Closed in 2020 Summary of Closed Trades
Special Report Highlights As government bond yields have fallen to zero or below, many of our clients have asked us how to obtain income from other asset classes. In this report we analyze three income opportunities in the equity market: high-dividend yield stocks, dividend growth stocks, and preferred shares. High-dividend yield stocks have a large style bias to the value factor. Thus, investors who wish to invest in high-dividend yield stocks might be better served by investing in dividend plays in the non-value universe. Dividend growth stocks – such as the ones in the S&P 500 Dividend Aristocrats index – are historically less likely to cut their dividends, thanks to their defensive nature and corporate incentives. The Aristocrats should continue increasing dividends during this crisis. Our screening points to the following as the most attractive: ExxonMobil, Franklin Resources, 3M, Procter & Gamble, AT&T, and Genuine Parts. We would not buy US preferred shares, given that they are heavily weighted to Financials, a sector that will do poorly in an environment of low interest rates. Feature As the crisis caused by COVID-19 has battered risk assets, many of our clients have asked us how to obtain income in this current environment. In the past, investors could rely on a consistent coupon provided by government bonds. However, this is no longer the case. The crisis has dragged DM government bond yields around the world to below or near zero, which means that investors looking for income opportunities must search outside of government bonds, in riskier asset classes. One such asset class is equities. Over the last 50 years, income return has accounted for roughly a third of the total return of global equities (Chart 1, top panel). Moreover, in contrast to other sources of equity return such as earnings growth or multiple expansion, income return is always positive, making it much more consistent through time as well as resilient to recessions (Chart 1, middle and bottom panels). However, there are a couple of drawbacks to equities as income-generating assets: The income yield of equities is not particularly high, especially when one compares them with asset classes such as corporate debt which have similar or lower volatility (Chart 2, top panel). As opposed to fixed-income assets, where a set income return is guaranteed provided there is no default and the security is held to maturity, companies can actually cut their equity dividends when they come under stress. As a consequence, while trailing dividend yield is often an accurate indicator of future income return, it can overestimate it during bear markets (Chart 2, bottom panel). Chart 1Dividends Make Up A Substantial Portion Of Equity Returns Chart 2The Income Return Of Equities Is Low And Can Be Deceiving During Bear Markets In this report we examine two different dividend strategies that try to address the issues above: high-dividend yield stocks and dividend growth stocks. In addition to these strategies within the common equity space, we also explore whether preferred shares can be an attractive income opportunity. For each of these three income strategies we try to answer the following questions: How are these dividend indices constructed? How has each strategy performed historically? How has it performed during bear markets? What is the sector composition of each strategy? How are valuations now? To answer these questions, we examine the MSCI High-Dividend Yield indices, the S&P Dividend Aristocrat indices and the iShares Preferred Shares indices. Moreover, based on our analysis, we also make some recommendations as to which is the best income strategy in equity markets for the current environment. Please see our Investment Implications section for more details. High-Dividend Yield Stocks As their name suggests, high-dividend yield indices select for stocks with the highest dividend yields. In practice however, many more screening criteria are imposed. In order to ensure some stability in dividend payout, MSCI excludes REITs, payout outliers, negative dividend growth stocks, low-quality stocks, and low-performance stocks. Once all of these screening criteria are applied, MSCI selects for stocks which have a dividend yield that is at least 30% higher than its benchmark. Table 1 shows details on these screening criteria. Table 1Criteria For MSCI High-Dividend Yield Indices How has the MSCI High-Dividend index performed historically? Since 1996, high-dividend yield stocks have outperformed the benchmark at the global level by 50% (Chart 3, top panel). This outperformance has been mostly a result of the income advantage this index provides, given that price return has outperformed only by a paltry 3%. It is also worth noting that price performance has been particularly poor since the Financial Crisis, and has actually caused high-dividend yield stocks to underperform on a total return basis over the past decade. Relative performance has been flat to down, even in those markets where high-dividend yield had been very successful previously such as Canada, Japan, and Emerging Markets (Chart 3, bottom panel). What has caused this underperformance? One reason is the low allocation that the high-yield index has to Technology (Chart 4, panel 1). Another reason is style tilt. Factor analysis reveals that the high-dividend yield index has a very strong value bias1 (Chart 4, panel 2). This strong style tilt is likely responsible for the poor relative price performance of high-dividend yield stocks, as value has been notorious for underperforming over the past decade (Chart 4, panel 3). Chart 3High-Dividend Yield Stocks Have Not Outperformed In The Past Decade Chart 4The High-Dividend Yield Index Has A Strong Value Bias   But while high-dividend yield stocks are an implicit bet on value, there is evidence that investing in high-dividend yield stocks within the non-value universe is a profitable strategy. In the paper “What Difference Do Dividends Make?”, Coronover et al. found that high-dividend yield companies actually outperform their low-dividend yield counterparts in the high and median price-to-book universes2 (Table 2). Additionally, they found that high-dividend yield stocks also performed better vis-à-vis low-dividend yield stocks in the mid-cap and large-cap universes. Table 2High-Dividend And Low-Dividend Yield Stocks Sorted By Price-To-Book And Market Cap Dividend Growth Stocks Dividend growth stocks are securities that have increased their dividend for a certain number of consecutive years.  In the US, companies with a track record of at least 25 years of dividend increases are usually called “dividend aristocrats”, while companies with a 10-year track record are known as “dividend achievers”.3 However, the requirements to be classified as a dividend aristocrat or a dividend achiever are not uniform across index providers, and even within providers they are not uniform across different countries, which means that investors need to pay attention to selection criteria when investing in a dividend growth index (Table 3). In this report we will focus on the best-known dividend growth index: the S&P 500 Dividend Aristocrats index. Table 3Different Criteria To Become A Dividend Aristocrat In Different Countries How has this index performed historically? The S&P 500 Dividend Aristocrats index has outperformed the S&P 500 by nearly 60% since 1995 in total-return terms and by more than 30% in price terms. Additionally, it has enjoyed less volatility and has outperformed significantly during recessions (Chart 5, panel 1). Chart 5Dividend Aristocrats Outperform During Bear Markets The main difference between the benchmark and the Aristocrats index comes down to sector tilt and leverage.  The second panel of Chart 5 shows that the Aristocrats index has a large overweight in Consumer Staples and a large underweight in Technology relative to the S&P 500. Meanwhile, while valuations are not that different, and equity profitability is actually lower, the companies in the Aristocrats index are significantly less levered than those of the S&P 500, a testament to their defensive nature (Table 4). Table 4Dividend Aristocrats Have Low Leverage But are dividend aristocrats really a more reliable source of income than the rest of the market? Empirically, they have been. In the US, the likelihood of a dividend increase in any given year has historically been a function of how many consecutive dividend increases a company has done before (Chart 6). Beyond the strong balance sheets and stable business models that dividend aristocrat companies have, this is most likely a result of the incentives created by the asymmetry of the index: A multi-decade policy of dividend increases is a significant investment of time and resources to signal stability to the market. However, the status obtained by this policy – and all the resources devoted to it– is immediately lost the moment dividends are cut, with no possibility of reclaiming it in at least a quarter century.4 Importantly, the longer a company raises dividends the bigger the investment becomes, creating a very high incentive to not cut dividends. That being said, sometimes this incentive is not enough to overcome extreme business conditions, such as those that occurred in 2008. Chart 7 shows that the members of the S&P Dividend Aristocrats index declined by roughly a third during the Financial Crisis, mostly as a result of previously reliable banks that had to cut their dividends in 2008 and 2009.5 Chart 6The Likelihood Of A Dividend Increase Is Higher For Dividend Aristocrats Chart 7Extreme Business Conditions Can Force Some Aristocrats Off The Index   Preferred Shares Preferred shares are securities which have traits of both debt and common equity: Like debt, they have a par value, no voting rights, and they provide a prespecified cash flow. Nevertheless, they do not have a maturity date and they represent an ownership stake in the company, just like common equity. Analyzing the historical performance of preferred shares is difficult since most indices begin only around the Financial Crisis. However, from the limited data we have, we can make some observations: Preferred shares in the US have underperformed common equity, investment- grade debt and high-yield debt since 2004 (Chart 8). They also experienced very deep selloffs during recessions, often similar to the selloffs that common equities have experienced (Table 5). However, preferred shares do seem to have similar return drivers to corporate credit. In particular, much like corporate credit, they tend to fall whenever yields on corporate debt rise (Chart 9). Chart 8Preferred Equity Has Underperformed Credit And Common Equity Table 5Preferred Equity Has Similar Drawdowns To Common Equity During Recessions Chart 9US Preferred Shares React Negatively To Rising Credit Yields Chart 10US Preferred Shares Are Heavily Tilted To Financials In theory, the co-movement of preferred equity and corporate debt is not that surprising. Much like credit, preferred shares are fixed-income securities which are subject to credit risk. Whenever yields on risky credit rise, these fixed-income securities become relatively less attractive, making their price fall. Chart 11Canadian Preferred Shares Are An Oil Play However, what is surprising is that preferred shares have underperformed both investment-grade and high-yield credit. How could an asset that technically has more risk – and thus should offer a better rate of return – underperform for such a long time? One plausible explanation is sector skew. Preferred shares are heavily skewed to Financials, a sector that has underperformed significantly over the past decade (Chart 10). While Financials tend to dominate most preferred indices, other factor may also affect returns. In Canada, the preferred share index is most sensitive to changes in the price of oil – a consequence of both the relatively high weight of Energy in the index, and the importance of the commodity for the Canadian economy (Chart 11). There are many types of preferred shares which include rate-resets, perpetuals, and variable rate. We do not analyze them in this report since indices tracking most of these securities have a very short history. We do advise our clients to be wary of compositional differences between indices, since sector composition could be a larger driver of returns than the type of preferred equity itself. Finally, while it is outside the scope of this report, it is worth remembering that preferred shares might still be worth looking at for taxable investors, given that dividends and interest income are often not taxed at the same rates. Investment Implications Dividend Growth Stocks Investors should consider including dividend growth stocks in their portfolios. Their defensive nature means that they should be able to weather the recession brought about by the coronavirus lockdowns better than the overall market, while their long-term dividend policy implies that these companies will be more reluctant to cut dividends. One drawback of the S&P 500 Dividend Aristocrat index is that it is yielding less than 3%. Thus, investors would be better served by selecting individual securities within the index. In order to help with this exercise, we have ranked the companies in the S&P 500 Dividend Aristocrat index according to our own GAA Income Score. The score is based on the following three traits: Raw Income: the company’s current dividend yield. Yield Stability: the number of consecutive years the company has raised its dividend. Attractiveness: The company’s current score from the BCA Equity Trading Strategy service. Please find the ranking of the S&P 500 Dividend Aristocrats in Appendix A. According to our GAA Income Score the best S&P 500 Dividend Aristocrats are ExxonMobil, Franklin Resources, 3M, Procter & Gamble, AT&T, and Genuine Parts. High-Dividend Yield Stocks What about high-dividend yield stocks? The MSCI All-Country World High-Dividend Yield index is currently yielding a formidable 5%, making it an attractive income opportunity. However, investors should remember that high-dividend yield stocks have a significant exposure to the value factor. GAA is currently neutral on value versus growth, but we are concerned that value continued to underperform when equities were falling and has not been able to outperform in recent weeks as equities rebounded. For those who do not want to take on value exposure, overweighting high-dividend yield within non-value stocks and mid and large caps might be a better option. Preferred Equity Currently preferred shares have a dividend yield of roughly 5%. Do they make an attractive income opportunity? We don’t believe so. Low interest rates and tepid loan growth even after the quarantines are over will likely weigh on Financials – the sector which preferred shares are most exposed to. Moreover, its strong similarity to corporate debt makes this asset somewhat redundant for investors who already own credit. Appendix Juan Correa Ossa  Associate Editor juanc@bcaresearch.com Footnotes 1 This is in part by construction. The MSCI Value index uses dividend yield as one of its variables to asses value. 2 Mitchell Coronover, Gerald R. Jensen, and Marc W. Simpson, “What Difference Do Dividends Make?”, Financial Analyst Journal, Volume 72, Number 6 (2016). 3 Companies which have increased their dividend for at least 50 years are sometimes called “dividend kings”. 4 Eberner Asem and Ahamsul Alam, “The Market’s Reaction To Consecutive Dividend Increases,” (December 2017). 5 Not all companies exit the index due to dividend cuts. Some companies exit because of corporate restructurings or because they no longer meet the minimum market capitalization to qualify.
Special Report Highlights The potential range of book value outcomes for large banks is enormous, … : Total credit losses will be a function of the virus’ persistence, the intensity and duration of the social distancing actions taken to combat it, and the efficacy of monetary and fiscal policy measures meant to mitigate the economic pain. … making it almost impossible to assess their equity valuations: With the uncertainty around each of the three independent variables, estimating default rates and recovery rates is a guessing game. This is the most sudden recession on record, … : Nearly 10 million people have filed initial jobless claims in the last two weeks, more than the average over the first 26 weeks of the last seven recessions. … but the biggest banks have entered it on more stable footing than they typically would, and they have a few things going for them: The biggest banks are nowhere near as extended as they typically are after expansions, with unusually conservative asset portfolios and a large stockpile of equity capital. Feature “It depends” is always the answer to quite a few questions in economics, but right now, it’s the answer to just about all of them. Global economic activity is hostage to the COVID-19 outbreak, and the social distancing measures that have been implemented in an attempt to impede its progress. No one can say for sure how long those measures will have to remain in place, though their impact has been starkly apparent on the broad swath of businesses that they have rendered unviable. Non-essential retailers, pro sports leagues, movie theaters, concert venues, gyms, barbers, nail salons, bars and restaurants have had their revenue streams cut off entirely. Nearly all of them have some fixed costs: rent if they don’t own their space; maintenance, mortgage payments and property taxes if they do. Table 1A Half-Year Of Jobless Claims In Two Weeks Monthly rent and mortgage obligations pose a thorny issue for the banking system, because they could lead to a surge of defaults among retailers and their landlords. The unprecedentedly rapid rise in unemployment (Table 1) could trigger a tsunami of home mortgage, credit card and auto loan delinquencies. Congress, the Fed, and various executive-branch departments and agencies are doing their best to protect the individuals and businesses sucked into the vortex, but the ultimate success of their efforts is uncertain. That uncertainty makes it impossible to project the SIFI banks’ credit losses within a reasonably useful confidence interval. To take an extreme example, what if the collateral securing auto loans were reduced to its scrap value because consumers developed an aversion to previously-owned vehicles? Getting less far-fetched, what if all used cars had to be marked down by 20 or 30% to entice drivers to swallow their discomfort, and the value of soon-to-be-vacant homes and apartments faced similar haircuts? Neither is our base-case scenario, but the fact that the markdown scenario is at least plausible illustrates the difficulty of estimating credit losses, and the challenge of coming up with decent estimates of SIFI banks’ earnings and capital adequacy. For the time being, we cannot say if the SIFI banks are better bought or sold at their current prices because we don’t know how 1Q loan-loss provisions will affect their March 31st book value, or what June 30th book might be. Our thinking has evolved in the week since we published Part 1 of this Special Report on the biggest US banks’ vulnerability. Initially, 50 years of Wells Fargo’s financials led us to believe that the SIFI bank de-rating over the last month and a half was excessive, and we concluded that buying SIFI banks at or below their December 31st tangible book value provided investors with a significant margin of safety. The chance to buy at or below tangible book would be a gift even in a bad recession, but the current episode threatens to go well beyond bad. Though we still lean to buying the SIFIs rather than selling them, we now recommend that investors watch and wait before committing, as they should with risk assets more generally. We hold to that bias because our review of system-wide data revealed ample instances of how the largest banks have entered this recession in better shape than normal. We also take heart from the idea that the Fed and elected officials will vigorously pursue policies that directly and indirectly benefit the banks. The banking system is considerably more solid than it was ahead of the 2007-8 crisis. It’s not immune to the shocks that are roiling the economy, but it will not be a driver of them. A Lack Of Banking Excesses Back in 2007, the last time that a recession/financial crisis was taking aim at the US, a bank-examiner-turned-analyst told us that, “Banks create value on the liability side of the balance sheet [via deposits], and destroy it on the asset side.” At the time, the destruction was centered on subprime mortgages and the securities they spawned, but the story plays itself out in every cycle. Bad loans are made in good times, as bankers let their guard down after an extended period of low defaults and market share takes precedence over lending standards. Banks exercised more restraint over the last 10-plus years than they have in any prior postwar expansion. 11 years of zero- and negative-interest-rate policy have promoted plenty of credit excesses, as many investors have gone far afield in search of yield. Bond covenants have been shredded, and corporate leverage has duly risen. Yet banks have largely stayed out of the fray. Bank lending grew at a markedly slower rate between July 2009 and February 2020 than it has in any other postwar expansion1 (Chart 1, top panel). Chart 1An Especially Restrained Expansion Total loan growth slid all the way to 3.8% annualized versus 9.7% in prior postwar expansions. While real estate lending slowed the most, following the frenzy that precipitated the 2007-8 crisis (Chart 1, bottom panel), C&I (Chart 1, second panel) and consumer lending (Chart 1, third panel) also fell well short of their postwar expansion pace, and only consumer lending failed to set a new postwar expansion low (Table 2). From the examiner-analyst’s perspective, banks behaved less self-destructively in the last ten-plus years than they have in any other postwar expansion. Regulatory efforts to curb banking excesses really did get some traction. Table 2Core Bank Lending Growth During Expansions Setting An Uncharacteristically Good Example Historically, the largest banks are at the center of the excesses that make the banking system vulnerable and help set the stage for crises. It wasn’t a community banker, after all, who smugly declared that countries don’t go bust after having plunged headfirst into lending to shaky Latin American governments. It has been the biggest players who have hatched dubious financial innovations and scaled them to the extremes that trigger systemic rumbles. Since the 2007-8 crisis, however, the biggest banks have demonstrated uncommon restraint. As we noted in Part 1, loan-to-deposit ratios around 100% and above are a sign of instability because they have to be funded with capital flows that are here today but gone tomorrow. Lower loan-to-deposit ratios hold down profits, but they buffer banks’ exposure to the business cycle, provided that deposit funding isn’t diverted to uses that are riskier than straightforward loans. The FDIC and the Fed maintain data series that offer insight into different-sized banks’ use of their lending capacity. The FDIC’s Quarterly Banking Profile, published since the mid-‘90s, breaks out total system loan-to-deposit ratios into categories based on the size of individual banks’ assets. Using its data, we were able to compare the largest banks’ activity with all other FDIC-insured banks’ activity since 1997. The comparison showed that the largest banks performed an about-face after the subprime crisis, going from operating with uniformly higher loan-to-deposit ratios than all other banks to operating with uniformly – and significantly – lower loan-to-deposit ratios (Chart 2). Chart 2The Biggest Banks Are Using Less Of Their Lending Capacity ... The Fed’s commercial bank balance sheet data covering large and small banks extend back another decade. The data do not align perfectly with the FDIC’s, as the Fed’s large-bank subset (the top 25 banks by assets) has been broader than the FDIC’s since 2016 (top 9 or 10 banks) and was narrower in prior years (the FDIC’s top subset included 66 to 119 banks). The Fed’s data do not show large banks making fuller use of their deposit capacity in the ‘90s and most of last decade, but they echo the post-2007-8 drop-off in the FDIC data (Chart 3). The biggest banks have operated with less risk under the Basel 3/Dodd-Frank/Volcker Rule regime, allocating less of their capacity to loans, and considerably more to Treasuries, agencies and cash (Chart 4). Chart 3... No Matter How They're Defined ... Chart 4... And They're Directing It To Safer, More Liquid Assets Banks Are Better Capitalized Than They Used To Be The overall banking system is operating with considerably less leverage than it did in the ‘80s or ‘90s, as equity capital now accounts for 12% of total assets (Chart 5). Wells Fargo’s leverage history as shown in Part 1 suggests that banks were even more thinly capitalized in the ‘70s. An increased proportion of equity capital makes a bank more resilient to loan losses and other operational stumbles. Critically for the stability of the system, the SIFI banks are forced to maintain additional capital buffers. The combination of increased equity capital and increased holdings of liquid assets with little to no credit risk like Treasury and agency securities has made all of the largest banks safer. Chart 5Increased Equity Financing Has Made Banks More Resilient Some Fears Seem Overblown We reiterate from Part 1 that larger banks do not borrow short to lend long, and have not for a long time. According to the latest Quarterly Banking Profile, barely a sixth of the 4,400 banks with assets of less than $1 billion report having any derivatives exposure. A considerable majority of community banks must therefore take their asset and liability maturity profiles as given, leaving them exposed to the vagaries of shifts in the yield curve. No management team at a decently-sized publicly traded bank would dare to run anything more than a very narrow mismatch in asset and liability duration, however, as evidenced by the gargantuan interest-rate swaps market. Bank stocks may trade with 10-year Treasury yields, but the slope of the curve has very little bearing on bank earnings.2 During recessions, banks usually encounter more customers trying to park money than businesses trying to borrow it.  Unused loan commitments have provoked much agita among investors in recent weeks. A floundering company, desperately trying to stay afloat, may well draw down all of its available credit lines. Line drawdowns could force banks to make good on loan commitments made in better times that now have little prospect of repayment. While they do not appear to have been a significant issue in the ’90-’91 or 2001 recessions, lines were drawn down sharply in 2007-8 (Chart 6). Chart 6Much Ado About Nothing? The positive news for banks is that their exposure to untapped commitments is considerably smaller than it was heading into the last recession. They may also be less likely to be drawn, thanks to multiple Fed initiatives aimed at ensuring the availability of credit, like its ambitious plan to backstop investment-grade corporate borrowers, and the CARES Act’s expansion of Small Business Administration funding and provision of loans and loan guarantees for ailing companies in industries related to national security. There are going to be considerably more strapped borrowers, but they will have more non-bank avenues to obtain funding than they have had in prior recessions. Banks know that line demand may spike soon after the business cycle peaks; they reserve for unused commitments and will not be caught entirely unawares. Finally, not all of the unused commitments are to suffering C&I borrowers that investors most fear; Wells Fargo’s commitment history suggests that the largest share of the outstanding commitments are to individual credit card borrowers. Despite rising distress, lending has increased at a fairly modest rate during recessions, as households and businesses broadly shrink from risk, while deposits have grown at a faster rate, as the safety of FDIC-insured accounts gains appeal (Table 3). We do not expect that increased consumption of credit line capacity will materially alter the banking system’s credit exposures. Table 3Core Bank Lending And Deposit Growth During Recessions Investment Implications The banking system, anchored by the SIFI banks, is in considerably better shape now than it was in 2007, and does not pose an active threat to the financial system this time around. The banking system is not only better capitalized than it has been in the past, but large banks have invested far more conservatively. We cannot assess how expensive SIFI stocks are without having a better handle on potential loan losses, however, and we need to get a sense at how successful the Fed’s and Congress’ interventions to stem the building economic distress will be. We hope for the best, but the last-mile issues are complicated, and we expect that the mitigation efforts will have to work out some kinks before they begin to get traction. Don't worry about the banks, but give it some time before buying them. Congress and the Fed are trying to perform challenging new routines, and it's unlikely they'll stick the landing on their first try. Table 4Comfortably In The Money Our no-rush-to-buy take on the broad market applies to the SIFI banks, as well. We have high conviction that Congress and the administration will do whatever it takes to shore up the most vulnerable parts of the economy as they reveal themselves, and the Fed has already moved to a war footing. Stocks can go lower as they climb the learning curve, and may have to do so to signal the need for further intervention. We would not be concerned in the slightest if the SIFI banks were to cut or suspend their dividends. Husbanding cash is a good idea in times of uncertainty, and a couple of quarters without dividends is far preferable to shareholders than a dilutive secondary equity offering or rights issue. To the extent that it may leave elected officials more favorably disposed to the banking sector, it would be a plus. One may as well stay on the good side of legislators doling out goodies. Finally, our newly increased sense of caution does not extend to the put-writing idea we detailed two weeks ago. If implied volatility in the SIFI banks’ stocks returns to the triple-digit level, investors selling put options would be generously compensated for assuming the inherent risks. Even though the SIFIs have stumbled over the last six sessions, time decay and the steep decline in the VIX have the contracts we highlighted well in the money (Table 4).   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Until the NBER makes the official designation, our working assumption is that the recession began in March. 2 Please see the February 28, 2011 US Investment Strategy Special Report, "Banks And The Yield Curve," available at usis.bcaresearch.com.