Developed Countries

Underweight In yesterday’s Weekly Report1 we recommended downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. The drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders and is no longer a positive catalyst. For instance, the mortgage application purchase index (MAPI) initially benefited from the plunge in interest rates, but the recent 30bps rise in the 10-year Treasury signals that the MAPI has tentatively crested (second panel). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel). Bottom Line: Downgrade the S&P homebuilding index to underweight. For additional details on the rationale behind this move please refer to the most recent Weekly Report.1 The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR.   1  Please See U.S. Equity Strategy, "Is This It?," dated October 21, 2019.

The latest Standard & Poor’s update of Q2 buybacks revealed that one of the largest equity buyers since the Great Recession went on a buyer’s strike. The chart shows that SPX buybacks are actually contracting. Not only has the fiscal impulse died down from the 2018 zenith, but also the economic soft patch is re-concentrating CEO minds. In other words, there is evidence that not only are CEOs pruning capex (as a reminder investment spending contracted in Q2), but also they are cutting back on equity retirement. Such prudent cash management typically happens when confidence in the longevity of the business cycle is low. Historically, the ISM manufacturing and the Conference Board CEO surveys are excellent leading indicators of SPX buybacks and the current message is to expect further contraction in the latter. Bottom Line: This “slaying of animal spirits” as we highlighted in recent research1 represents a red flag and warrants caution on the prospects of the broad equity market in the coming months.​​​​​​​ 1 Please See U.S. Equity Strategy, "Slaying Animal Spirits," dated October 10, 2019.

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Soft housing demand, the trough in interest rates, new home price deflation and weak industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index.      Firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Recent Changes Downgrade the S&P homebuilding index to underweight, today. Table 1 Feature Equities made a run for fresh all-time highs last week, continuing to cheer the trade war “phase one” deal and breathing a big sigh of relief on better-than-expected bank earnings. We doubt a real deal will materialize which would include Intellectual Property and the tech sector. Instead all we got was a trade truce, at best. Larry Kudlow’s recent football analogy is worth repeating: “It's like being on the seven-yard line at a football game…And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone…When you get down to the last 10 percent, seven-yard line, it's tough". As a reminder, steep tariffs remain in place and there are high odds that the damage already done to global trade is severe enough that it will be months before the emergence of any green shoots. Meanwhile, following up on our “chart of the year candidate” we published two weeks ago, we drilled deeper and discovered two additional economically sensitive indexes that have consistently peaked prior to the SPX in the past three cycles (Chart 1). They now comprise the U.S. Equity Strategy’s Equity Leading Indicator – an equally weighted composite of the S&P Banks index, the Russell 2000 index and the Value Line Geometric index – which signals that the easy money has already been made this cycle in the SPX (Chart 2). Chart 1Three Bulletproof Signals... Chart 2...Combined Into One Leading Equity Indicator Importantly, absent profit growth, it remains extremely difficult for equities to embark on a sustainable fresh leg up by solely relying on multiple expansion. Chart 3 shows our updated Corporate Pricing Power Indicator (CPPI) and it continues to deflate. In fact the steep fall in our CPPI more than offsets the fall in wage growth warning that the margin contraction in the S&P 500 has staying power1 (bottom panel, Chart 3). Drilling beneath the surface, our CPPI is waving a red flag. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Only 42% of the industries we cover are lifting selling prices by more than 1%, and 33% are outright deflating. Worrisomely, only 26% of sectors are raising prices at a faster clip than overall inflation. With regard to pricing power trends, two thirds of the industries we cover are either flat or in a downtrend (Table 2). Chart 3Nil Corporate Pricing Power Table 2Industry Group Pricing Power Gold has jumped to the top of our table galloping at a 26%/annum rate (keep in mind it was deflating in our early July update), and only three additional commodity-related industries made it to the top twenty (Table 2). The disappearance of the commodity complex from the top ranks is consistent with global PPI ills and U.S. dollar strength. This week we update two groups, one early and one deep cyclical. Interestingly, defensive sectors have a healthy showing in the top ten spots with five entries. On the flip side, commodities in general and energy-related industries in particular occupy the bottom of the ranks as WTI crude oil is steeply deflating from the October 2018 peak. Adding it up, corporate sector selling price inflation is sinking in line with depressed inflation expectations. As we posited in our recent profit margin Special Report, profit margins have already peaked for the cycle. We reiterate our cautious overall equity market view on a cyclical 9-to-12 month time horizon. This week we update two groups, one early and one deep cyclical. Cracking Homebuilding Foundations We recommend downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Since the Great Recession, homebuilders have been in clearly defined mini up-and-down cycles, and there are high odds we will soon enter a down oscillation (bottom panel, Chart 4). Interest rates bottomed in early September and there is little additional push they can exert to relative share prices (10-year Treasury yield shown inverted, top panel, Chart 4). Chart 4Relative Gains Are Exhausted Worrisomely, consumers’ expectations to purchase a new home nosedived last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 5). Chart 5Cracks Forming Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled recently. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 6). While the mortgage application purchase index (MAPI) has been rising on the back of the plunge in interest rates, the 30bps rise in the 10-year Treasury yield since September 1 signals that the MAPI has tentatively crested (second panel, Chart 7). Chart 6Contracting Sales Chart 7Margin Trouble Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels, Chart 7). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel, Chart 7). Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. On the operating front, the labor market is also emitting a distress signal. Job openings in the construction industry are sinking like a stone and residential construction employment growth is flirting with the contraction zone. Historically, the ebbs and flows in construction jobs have moved in lockstep with relative share price performance and the current message is to expect a drawdown in the latter (Chart 8). Most of the indicators we track underscore a challenging homebuilding backdrop in the coming months. However, there is a key risk to our view: interest rates. Were the 30-year fixed mortgage rate to fall further from current levels, it would entice first time home buyers and cushion the blow to homebuilding demand (mortgage rates shown inverted, top panel, Chart 9). Similarly, bankers are willing extenders of mortgage credit and are reporting rising demand for residential real estate loans as a lagged consequence of falling rates. But, our sense is that the easy gains are exhausted and a reversal is in the offing in most of these measures (Chart 9). Chart 8Heed The Labor Market's Message Chart 9Potentially Lower Rates Are A Key Risk Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Bottom Line: Downgrade the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Stick With Refiners While our bullish take on refiners got to a slippery start, it has recovered all the losses and this position is now in the black. Factors are falling into place for additional gains in the coming months and we recommend investors stick with this overweight recommendation in pure-play downstream stocks. Encouragingly, refining stocks have been trouncing the overall energy index of late and have resumed their multi-year relative uptrend (top panel, Chart 10). With regard to the export relief valve, U.S. net exports of refined products are on a secular uptrend and surprisingly unaffected by the greenback’s moves (bottom panel, Chart 10). Tack on the soon to be adopted International Maritime Organization (IMO) Sulfur 2020 regulations in maritime transportation fuel, and U.S. refiners that produce lower-sulfur fuel oil are well positioned to outearn the SPX. Chart 10Resumed Uptrend Domestic refined product consumption remains upbeat and should serve as a catalyst to unlock excellent value in this niche energy subgroup (middle panel, Chart 11). In fact, gasoline consumption is expanding anew on the back of rising vehicle miles travelled (bottom panel, Chart 11). Chart 11Solid Demand... Refining product supply dynamics are also moving in the right direction. Gasoline inventories are getting whittled down and should boost beaten down refining relative profit expectations (inventories shown inverted, bottom panel, Chart 12). Importantly, this firming demand/supply backdrop has been a boon to refining margins and should continue to underpin relative share price momentum (middle panel, Chart 12). In terms of what is baked in the cake for this industry, the expected profit growth bar is extremely low and falling and relative value has been fully restored. First in terms of relative valuations, the relative trailing price-to-sales ratio has corrected 35% from the mid-2018 peak (middle panel, Chart 11). On a forward PE ratio basis refiners are extremely appealing compared with the SPX following a near halving in the relative forward PE in the past fifteen months (second panel, Chart 13). Chart 12...Supply Backdrop Is Boosting Crack Spreads  Chart 13Profit Hurdle Is Uncharacteristically Low Second, relative EPS growth has sunk below the zero line both twelve months and five years forward. Such pessimism is overdone and we would lean against sell-side bearishness (bottom panel, Chart 13). Even the refining industry’s net earnings revisions ratio has collapsed, which is contrarily positive (third panel, Chart 13). Adding it all up, firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Bottom Line: Stay overweight the S&P oil & gas refining & marking index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Special Report, “Peak Margins” dated October 7, 2019, available at uses.bcaresearch.com. 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%)