Developed Countries

The SPX remains near all-time highs and the invincible tech sector continues to lead the pack. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, comprising our “ATLAS” index. If history at least rhymes, the mania in these stocks will likely end in tears (see chart). Bottom Line: The SPX remains 6% overvalued according to our EPS scenario analysis published two weeks ago. Caution is still warranted, especially if profit growth fails to materialize in the coming months. ​​​​​​​

Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Chart 2Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX Chart 3Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… Chart 7…To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index.  Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2     Ibid. 3     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. 4     Ibid.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights Commercial rents have fallen in real terms, revealing that the commercial property price rally has been fueled exclusively by low rates. Limited upside for rents and an upward direction for future rates are two significant headwinds. However, commercial real estate is especially pro-cyclical and inflationary pressures need to work their way into the economy before the risk of a downturn becomes imminent. The good news is that the economy is less vulnerable to slipping commercial property prices. Large banks have shrunk their commercial property loan books and their composition has shifted towards safer categories of commercial loans. While the macroeconomic outlook remains somewhat neutral, CMBS’ risk/reward profile appears reasonably attractive relative to other US bond sectors. Feature Real estate was a bane for markets and the banking system in the last recession, and commercial properties have lately become an increasingly popular source of concern among investors. Average prices have grown by 90% over the past decade, rising well above their pre-Great Financial Crisis peaks. We have made the case that we are heading into the expansion’s last stretch. The study of economic cycles and our relentless quest to identify inflection points ahead of time become more timely as the bull market ages. To this end, current commercial property valuations deserve close scrutiny and we explore whether any underlying excesses could potentially disrupt financial stability or precipitate a recession in the US. We conclude that although commercial property prices have little hope of appreciating significantly from current levels, a reversal is not imminent until inflationary pressure forces rates higher. When prices eventually slip, the impact on the overall economy should be more attenuated than it was in the last recession, as the banking system has become less vulnerable to a downturn in commercial real estate. While the fundamental macro outlook remains neutral, suggesting no imminent pressure on spreads, US bond investors can find relative value in non-agency Aaa-rated CMBS (vs. corporate bonds rated A or higher) and in agency CMBS (vs. agency residential mortgaged-backed securities). A Rate-Driven Rally Chart 1Commercial Rents Have Decoupled From Property Prices Like all financial assets, commercial property prices are derived from discounting future cash flows to their present value. Since the crisis, a low rate environment, supported by a sluggish inflation backdrop and continuously accommodative monetary policy, has depressed the valuation equation’s denominator. Meanwhile, strong economic fundamentals and demographic trends - such as urbanization and the millennials’ tendency to marry and purchase a home at a later age - have helped boost the numerator for commercial and multi-family residential properties in the past decade. However, with the exception of multi-family residential real estate - for which price appreciation has also been the strongest - real rents have fallen (Chart 1), revealing that low rates have propelled commercial properties’ price appreciation over the past decade. The combination of falling real rents and surging property prices has depressed commercial real estate cap rates1 to cyclical low levels, raising the question of a potential unwind. Mathematically, an increase in cap rates could result, on the one hand, from rent growth outpacing inflation growth, translating into an increase in real rents on the numerator. Alternatively, cap rates could rise from falling property prices, reducing the denominator. On a cyclical horizon, the latter outcome seems more likely than the former. Little Upside Left For Rents First, the fact that rents in real terms have decreased in spite of sluggish inflation is a bad omen for the outlook for future real rents. We have made the case that there is more inflationary pressure than meets the eye beneath the surface of the US economy. The combination of an already very tight labor market and a pickup in manufacturing activity point towards further wage growth. Inflation is a lagging indicator that has more scope to rise than roll-over at this stage of the cycle. All else equal, upward inflationary pressure will depress real rents further. Second, nominal rents themselves are also facing significant headwinds. Office buildings’ and retail shopping centers’ vacancies have barely recovered from the hit they took in the last recession, while new inventory is struggling to get absorbed by new demand (Chart 2). A strong labor market generally supports the demand for office spaces but a tight labor market limits its future upside. The latter, though, increases potential wage gains and consumers’ purchasing power, whose fundamentals are already strong. We have shown that US consumers’ increased savings rates and lower debt levels put them in a good position to spend their incremental income. Chart 2Post-Crisis Office And Shopping Center Vacancies Remain Elevated... Chart 3...As These Sectors Face Structural Disruptions However, both sectors are facing structural disruptions. Co-working has introduced a new player in the office segment – a sub-lessor who signs long-term leases on space it rents out in short-term chunks. If a sizable sub-lessor like WeWork were forced to shrink its footprint, a lot of office supply would come back on to the market, while demand is shrinking as businesses attempt to reduce the area each employee occupies. Brick-and-mortar retailers continue to be buffeted as e-commerce captures an increasing share of consumer spending, keeping downward pressure on retail rents (Chart 3). The picture looks slightly brighter in the industrial properties space, where vacancies have recovered to healthier levels, though low vacancies have failed to lift rents as demand for properties is being met by new inventory (Chart 4). The revival in global manufacturing activity that we are expecting to occur this year should support industrial property rents in the near term, but the advanced age of the cycle limits future upside. Chart 4A Brighter Picture For Industrial And Apartment Buildings... Chart 5...Thanks To Rising Renters Income Chart 6Over-Construction Of High-Tier Properties Multi-family residential housing is the only sector that has experienced steady real rent growth, fueled by a combination of rising rentership rates and rising household income amongst renters (Chart 5). Homebuilders’ focus on building higher-end units has led to an oversupply of more expensive properties, and their prices have already started to contract on a year-on-year basis (Chart 6). Multi-family residential properties rents should lose momentum as the alternative cost of owning homes falls, especially as homebuilders attempt to right-size their mix of properties to offer more lower-end supply. Exhausted Demand A commercial real estate rally fueled by perpetually falling rates is unsustainable. Although the market sees the potential for an additional rate cut, we think the Fed is done cutting. Labor market strength and a revival in global manufacturing activity argue that no further accommodation or insurance rate cuts are necessary. From current levels, the path of least resistance for rates is upwards (Chart 7). Strong demand from institutional investors has also contributed to fueling prices. Pension funds and insurance companies’ holdings of mortgages and agency-backed securities have nearly doubled since 2010 (Chart 8, first panel) and their allocation as a percentage of total assets is nearing pre-recession highs (Chart 8, second panel). These levels allow them little flexibility to sustain their demand impulse, as there is only so much they can allocate to real estate and other alternative investments. Chart 7Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 8Saturated Demand From Institutional Investors... Demand from yield-hungry investors may also get exhausted if CMBS yields deflate to the point where they lose competitiveness relative to other income-producing investments. CMBS yields have broadly moved with other bond yields since the crisis, though US high-yield corporates have widened somewhat over the last few years, making them a slightly more appealing alternative to CMBS, all else equal (Chart 9). The steady downward pressure on multi-family cap rates since 2010 (Chart 10) reveals that the collateral underlying multi-family loans has become increasingly ambitiously priced, suggesting that losses given default on multi-family backed CMBS without agency backing may be rising, eroding prospective default-adjusted returns. Chart 9...And From Yield-Hungry Investors? Chart 10Cap Rates Have Reached Cyclical Lows New regulations also have the potential to retract a significant share of demand for commercial mortgages. The severe housing market deterioration during the Great Financial Crisis and the government intervention required to ensure Freddie Mac’s and Fannie Mae’s solvency led the Federal Housing Finance Agency (FHFA) to place these two government sponsored enterprises (GSEs) under conservatorship in 2014 and to cap their holdings of multi-family mortgages to US$ 100 billion for each GSE. A commercial real estate rally fueled by perpetually falling rates is unsustainable. Current holdings of multi-family residential loans far exceed the stated limits (Table 1). GSEs hold nearly half of all multi-family residential loans outstanding. The post-crisis growth in GSE-guaranteed loans is largely attributable to the exclusion from the cap of certain categories of loans such as green energy loans (Chart 11). The FHFA eliminated these exemptions last year, making the US$ 200 billion cap more binding and applicable to all multi-family loans without exception.2 The impact on mortgage originators and investors is yet to be seen but it would naturally follow that demand for multi-family mortgages to bundle into CMBS would decline if the GSEs are forced to take a step back from the space. Table 1Commercial Real Estate Loans By Holder ($US Mn) Chart 11Multi-Family Mortgage Debt Outstanding By Mortgage Holder Late-Cycle Dynamics Commercial mortgages are typically non-recourse (in case of default, the borrower can only recover the value of the collateralized property) making the loss given default a function of property prices. When times are good and property prices rise, borrowers can easily refinance their loans. The opposite holds in bad times. Therefore, commercial real estate prices are especially pro-cyclical. In spite of the headwinds outlined above, a commercial property downturn does not seem imminent. In spite of the headwinds outlined above, a commercial property downturn does not seem imminent. First, the US economy still has momentum, is supported by highly accommodative monetary policy and should get a boost from a global growth revival. Absent any major exogenous shock to the global economy, we expect that a recession is at least eighteen months away. For as long as the economy keeps expanding, commercial real estate prices can remain elevated. Second, sources of financing remain abundant as the emergence of alternative lenders (Chart 12) has offset the banks’ tighter lending standards for commercial properties (Chart 13). The proliferation of non-bank lenders is typically a late-cycle indicator. Chart 12The Proliferation Of Alternative Lenders… However, when the economy starts contracting, a commercial real estate downturn could have an outsized impact on banks with significant exposure. In the late 1980s, the commercial property downturn induced a recession and the subprime mortgage bust gave rise to the Great Financial Crisis. Healthier Balance Sheets The good news for the economy today is that banks are less vulnerable to a downturn in commercial real estate than they were back then. The good news for the economy today is that banks are less vulnerable to a downturn in commercial real estate. Banks have decreased their overall exposure to commercial property loans to levels below their 2008 and 1989 peaks (Chart 14). It is worth noting, though, that smaller banks have taken an increasingly important role in the commercial property market as they now finance 65% of all commercial property loans. However, a stronger concentration in smaller banks represents a localized rather than systemic risk, as smaller banks tend to have a more concentrated geographic exposure. Conversely, large banks have significantly shrunk their commercial real estate loan books.3 Chart 14Large Banks Have Shrunk Their CRE Books... Chart 15...And Shifted Away From Speculative-Grade Loans Most importantly, the composition of the commercial property loan book has changed drastically since the Great Financial Crisis. Banks have significantly reduced their exposure to more speculative construction and development loans (Chart 15). Risk appetite typically increases in the latter stages of an expansion, yet construction loans remain at relatively depressed levels. The growth in commercial property loans since 2013 has entirely been explained by the rise in relatively less risky multi-family and non-residential non-farm loans. Investment Implications A commercial real estate downturn is probably not a 2020 event. Inflationary pressures need to make their presence felt across a wide swath of the economy before Fed hikes will give rates the scope to move sustainably higher. In the meantime, bond investors with a mandate to remain exposed to CMBS can reap the benefits of attractive risk/reward profiles relative to other segments of the US bond market. US Bond Strategy’s Excess Return Bond Map measures the number of standard deviations of spread widening a sector would need to experience, before losing 100 basis points relative to a duration-matched position in Treasuries4 (Chart 16). Sectors plotting near the top-right of the Map carry both high expected return and low risk. Sectors plotting near the bottom-left carry low expected return and high risk. Chart 16BCA US Bond Strategy’s Excess Return Bond Map Chart 17Tighter Standards And Decelerating Prices This valuation framework currently suggests that CMBS look reasonably attractive. Non-agency Aaa-rated CMBS’ expected return is more promising than Aaa-and Aa-rated corporate bonds and somewhat similar to the expected return on an A-rated corporate bond. Meanwhile, CMBS exhibit a lower risk of losing 100 bps. Similarly, Agency CMBS offer greater expected return than Conventional 30-year Agency-backed residential MBS, along with a similar risk of losses. Although relative valuations appear attractive, the fundamental outlook remains neutral for CMBS spreads, for now. Periods of tightening commercial real estate lending standards and weakening commercial loan demand have historically coincided with decelerating commercial real estate prices and widening CMBS spreads. The Fed’s Q3 2019 Senior Loan Officer Survey revealed only a small net tightening of lending standards and unchanged demand (Chart 17). Overall, the lack of inflationary pressure suggests that neither a commercial real estate downturn nor a meaningful widening of CMBS spreads is an imminent threat.   Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 A capitalization rate is the ratio of net operating income (rent) to price and measures the expected rate of return on a real estate investment. As such, a property’s price can also be derived by dividing its rent by its cap rate. 2 More information about GSE’s conservatorship can be found on the FHFA’s website (https://www.fhfa.gov/Conservatorship/Pages/History-of-Fannie-Mae--Freddie-Conservatorships.aspx and https://www.fhfa.gov/Media/PublicAffairs/Pages/New-Multifamily-Caps-9132019.aspx). 3 An analysis of the largest banks’ earnings call we carried out last October also revealed that large banks were unanimously shrinking their commercial real estate books. For more details, please refer to US Investment Strategy Weekly Report from October 28, 2019, "What The Biggest Banks See", available at usis.bcaresearch.com. 4 For more details on the methodology behind our Excess Return Bond Map please see US Bond Strategy October 15, 2019 Weekly Report "A Perspective On Risk And Reward", available at usbs.bcaresearch.com.