Real Estate

Overweight We have been bearish this niche S&P sector and delivered alpha to our portfolio both via the cyclical and high-conviction underweights this year. Nevertheless, we do not want to overstay our welcome and the time is ripe for a bullish commercial real estate (CRE) stance. The bearish story is well known, but some bullish undertones are widely neglected. The rebound in relative share prices is substantially trailing the 2009 episode, when REITs outshined the SPX by 65% one year following the March 2009 trough. Currently, on a similar SPX advance from the March 2020 lows, REITs are lagging the S&P 500 by 22% (top panel). As large parts of CRE have been at the epicenter of the pandemic, any return to even semi-normalcy in 2021 should see these beaten down stocks sling shot passed the SPX. CRE prices will likely recover in the New Year as vulture funds and opportunistic investors are already bargain hunting. Tack on the likely refinancing lifeline bankers will extend to CRE debt originators (middle & bottom panels) and such a backdrop will loosen the noose around distressed property landlords. Bottom Line: Boost the S&P real estate sector to an above benchmark allocation and add it to the high-conviction overweight call list.

Dear client, Next Monday December 14, 2020 we will be hosting our last webcasts for the year “From Alpha To Omega With Anastasios”, one at 10am EST for our US, European and Middle Eastern clients and one at 8pm EST for our Asia Pacific, Australia and New Zealand clients; our final weekly publication for 2020 will be on Monday December 21, 2020 where we will highlight our top charts of the past year. Kind Regards, Anastasios Highlights Portfolio Strategy Our high-conviction overweight calls comprise four “Back-To Work” beneficiaries, and a hedge. In marked contrast, all of our high-conviction underweights are focused on “COVID-19 Winners” that should lose some of their luster next year. Recent Changes Upgrade the S&P real estate sector to overweight, today. Feature Favorable Macro Backdrop Easy monetary and loose fiscal policies will remain intact and sustain flush liquidity conditions next year. As a result, the global economy will continue to gain traction. Importantly, early-August marked a critical economic inflection point. Gold prices peaked and 10-year real and nominal yields troughed (yields shown inverted, top & middle panels, Chart 1). The bullion and bond markets corroborated the economic recovery that equities and the ISM manufacturing surveys sniffed out in late-spring. This is important for cementing the bull market in equities which is predicated on a durable economic recovery. In other words, the rise in real yields serves as a green light for further stock gains as it signals that the economy is on the recovery path. The bottom panel of Chart 1 also highlights that non-US equity markets started sporting accelerating profit growth expectations in August. Eurozone and other ex-US bourses zoomed past the US EPS growth trajectory as the latter reached a plateau. Chart 1Inflection Point This gives us confidence that 2021 will be a bumper year for SPX profits and help carry the market higher near our 4,000 target. As a reminder, on November 9 in a Special Report, we lifted our EPS estimate to $168 for calendar 2021 and introduced an end-2021 SPX target of 4,000 (Chart 2). Chart 2Earnings Will Do The Heavy Lifting In 2021 Two Risks To Monitor Nevertheless, the bond market represents a risk to our sanguine equity market view. Simply put, if the 10-year US Treasury yield stalls, then it will also stop the rotation trade in its tracks. The budding improvement in the Chinese and EM economic cycles will likely be sustainable next year, consistent with the Chinese four-year cycles of the past twenty years (Chart 3). Each up-cycle has typically been driven by credit expansion and capital spending, on the back of fiscal and monetary easing. These conditions are in place once again. Chart 3Follow The Chinese Four-year Cycle We recently showed that China’s fiscal easing will likely continue to grease the wheels of global trade into mid-2021 and thus debase the greenback (Chart 4), but will likely run out of steam in the back half of next year. Thus, China’s reflation going on hiatus is another key risk we will monitor in 2021 that could serve as a growth scare catalyst and reset stocks. Chart 4Laggard Deep Cyclicals Have The Upper Hand Year In Review 2020 is a year to forget as far as the coronavirus human toll is concerned; the economic and EPS recessions, while short lived, were deep. The COVID-19-inflicted wounds, especially to services industries the world over, were deep and there will be severe scarring. Early in the year, equities felt the COVID-19 tremor and collapsed 35% from the February 19 highs, but extremely aggressive monetary and fiscal policy responses filled the void and were the dominant themes in the ensuing recovery that saw the SPX vault to all-time highs. Our portfolio was resilient and was able to absorb the COVID-19 shock as we were bulletproofing it in the back half of 2019 and early-2020 for a recession owing largely to the yield curve inversion. Importantly, we were not dogmatic and on March 16 we turned cyclically bullish. This eventually culminated into the March 23 Strategy Report where we penned 20 reasons to start buying stocks and coincided with the trough in the SPX. This cyclical shift in our view from bearish-to-bullish aided our portfolio performance as we started adding cyclical exposure and trimming defensive exposure in order to benefit from the immense monetary and fiscal policy responses. Early on, we deemed these macro forces were forceful enough to really turn things around and we remained bullish on a cyclical time horizon. All in all, our trades produced alpha to the tune of 425bps. While our pair trades were sub-par (as is custom we are closing the remaining today), our high-conviction trades and cyclical portfolio moves recorded solid gains (please see the final tally below). Ray Of Light Encouragingly, there is light at the end of the tunnel, as a number of vaccines will become available late this year and/or early in 2021. This is great news for the economy and for stocks. We have positioned the portfolio to benefit from the reopening of the economy and the vaccine will act as an accelerant as our flagship publication posited last week while documenting BCA’s upbeat Outlook for 2021. Our portfolio enjoys a cyclical-over-defensive bent, has a small cap bias and we remain committed to the “Back-To-Work” basket versus the “COVID-19 Winners” basket (Chart 5). In the short-term, equities have discounted a lot of good news, which is likely to steal from next year’s returns. However, as populations get inoculated and large parts of the global economy reopen, a virtuous cycle of increasing consumer and business confidence would boost investment and GDP and prove a boon for corporate profits. Already the rally is broadening out with the value line arithmetic and geometric indexes outshining the SPX (Chart 6). An active ETF (RVRS:US) that has a reverse weighting to US large caps is also besting the S&P 500 and signals that more gains are in store in the New Year, especially for the still beaten down deep cyclical laggards. Chart 5Stick With The Reopening Trade Chart 6Rally Is Broadening Out, And That’s Healthy More Overweights Than Underweights As is custom every year, this Strategy Report introduces our high-conviction calls for 2021. This year we have four overweights, a bonus volatility trade on the long side, three underweights, and a bonus structural trade that we add to our trades of the decade first introduced in mid-December 2019. Our overweights comprise three “Back-To-Work” beneficiaries, a great rotation trade and a hedge. All of our underweights are focused on “COVID-19 Winners” that should lose some of their luster next year. Finally, this year we take a page out of Byron Wien’s annual “10 surprises” list and offer our clients three “also rans”, which got close but ultimately failed to make our high-conviction list.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Overweight Hotels (Back-To-Work Theme) The recent positive vaccine news is a key reason we are warming up to this consumer discretionary sub group. While neither lodging nor cruise line vacationing will return to their previous peaks any time soon, both industries will survive and thus should no longer be priced for bankruptcy. One key industry demand determinant is confidence. Consumer sentiment has staged a W-shaped recovery. It is still flimsy, but the vaccine efficacy news should catapult confidence higher in the coming quarters. The implication is that the wide gulf between consumer confidence and relative share prices will narrow via a catch up phase in the latter (top panel, Chart 7). Moreover, the ISM non-manufacturing survey is on a sling shot recovery following the bombed out spring readings. This rebound also suggests that the path of least resistance is higher for lodging stocks (second panel, Chart 7). Our hotel demand indicator does an excellent job in encapsulating all these different forces and forecasts an enticing lodging services demand backdrop into 2021 (third panel, Chart 7). Already, consumer outlays on hotels are staging a comeback, albeit from an extremely depressed level. The upshot is that an earnings-led bounce is in the cards (fourth panel, Chart 7). Finally, washed out technicals and extremely alluring valuations provide an attractive reward/risk tradeoff at the current juncture (bottom panel, Chart 7). Bottom Line: The S&P hotels, resorts & cruise lines index is a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH. Chart 7Buy Hotels Overweight Real Estate (Back-To-Work Theme) Boost the S&P real estate sector all the way to overweight today, in order to benefit from the looming full reopening of the economy on the back of the vaccine’s arrival. We have been bearish this niche S&P sector and delivered alpha to our portfolio both via the cyclical and high-conviction underweights this year. Nevertheless, we do not want to overstay our welcome and the time is ripe for a bullish commercial real estate (CRE) stance. The bearish story is well known, but some bullish undertones are widely neglected. The rebound in relative share prices is substantially trailing the 2009 episode, when REITs outshined the SPX by 65% one year following the March 2009 trough. Currently, on a similar SPX advance from the March 2020 lows, REITs are lagging the S&P 500 by 22% (top panel, Chart 8). As large parts of CRE have been at the epicenter of the pandemic, any return to even semi-normalcy in 2021 should see these beaten down stocks sling shot passed the SPX. When the fiscal package finally passes, it will likely serve as a fresh reflationary bridge to support the economy. The proverbial “kicking the can down the road” will thus lift some uncertainty hanging over CRE landlords receiving rents and also via banks not foreclosing distressed properties which would have further depressed CRE prices. CRE prices will likely recover in the New Year as vulture funds and opportunistic investors are already bargain hunting. Tack on the likely refinancing lifeline bankers will extend to CRE debt originators (middle & bottom panels, Chart 8) and such a backdrop will loosen the noose around distressed property landlords. Bottom Line: Boost the S&P real estate sector to an above benchmark allocation and add it to the high-conviction overweight call list.   Chart 8Upgrade Real Estate To Overweight Overweight Industrials (Back-To-Work Theme) Add the S&P industrials sector to the high-conviction overweight list. Emerging markets (EM) and China represent the key source for the sector’s buoyancy. The EM manufacturing PMI clocking in at 53.9 hit an all-time high (top panel, Chart 9). China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 277 points from -239 to +38 over the past nine months (second panel, Chart 9). The upshot is that US industrials stocks should outperform when China and the EM are vibrant. Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve. A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (middle panel, Chart 9). Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (fourth panel, Chart 9). Sell-side analysts have never been more pessimistic with regard to the sector’s long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 9)! This bearishness is contrarily positive as a little bit of good news can go a long way. Bottom Line: The S&P industrials sector is a high-conviction overweight.  Chart 9Overweight Industrials Overweight Small Caps At The Expense Of Large Caps (Rotation Trade) Recent vaccine efficacy announcements have paved the way for a sustainable great rotation trade into small caps and out of large caps. One of the key small size bias drivers is the delta in sector composition between the small and large cap indexes. The relative gap in deep cyclicals alone is 13% as we highlighted in recent research. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirtations with seven-year highs. Thus, the small caps catch up phase has a long ways to go (top & fourth panels, Chart 10). The financials sector gulf is also significant, with small caps’ exposure relative to their large cap brethren clocking in at over 700bps. Already, the yield curve is steepening and there are high odds of a selloff in the bond market as the economy continues to reopen (third panel, Chart 10). In addition, easy fiscal policy is a tonic to the small/large share price ratio. As a flood of money enters the economy with a slight lag, small caps will continue to make up ground lost during the early stages of the pandemic (fiscal balance shown inverted, second panel, Chart 10). Not only is fiscal stimulus providing a lifeline to debt-burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, bottom panel, Chart 10). Bottom Line: A small size bias is a high-conviction call for 2021. Chart 10Prefer Small Caps To Large Caps Long VIX June 2021 Expiry Futures (Hedge Trade) We want to hedge our overweight exposures with a long VIX futures position for the June 16, 2021 expiry. We are spending $25.3 to go long and are comfortable paying up for insurance when the SPX is at all-time highs and there is a risk of some growth disappointment in the next six months. Chart 11 draws a parallel with the March 2009 SPX lows and plots the VIX in 2009 and 2010. While the path of least resistance is lower for volatility, sporadic surges are typical in the year following recessions. The S&P 500 also troughed in March 2020 and if history is an accurate guide, the path to SPX 4,000 will be rocky next year. As a reminder, the S&P 500 suffered a 16% correction in May 2010 and the VIX spiked higher. Positioning remains lopsided with both VIX put/call ratios (volume and open interest) at historically high levels, underscoring investor complacency. Net speculative futures positions as a percent of open interest are also probing multi-year lows, corroborating the complacent options data. Finally, the equity volatility curve has flipped from a 10% backwardation to a steep contango in the past month with the 3rd month now trading at a 25% premium to spot VIX; such a complacent level typically warns of a looming spike in the VIX. Bottom Line: Go long the VIX June 2021 futures as a small hedge to overweight equity positions. Chart 11Go Long VIX Futures As A Hedge Underweight Homebuilders (COVID-19 Winner Theme) We deem that most, if not all, of the good news (low mortgage rates, low inventories, high demand, work-from-home reality, all-time highs on the overall NAHB housing sentiment survey) is already priced in galloping homebuilders stock prices and exuberant expectations. While being contrarian is fraught with danger, because more often than not the herd is right, there is a key macro driver that gives us confidence to be bearish homebuilders: interest rates. If our economic reopening thesis proves accurate next year, then the COVID-19 winners – homebuilders included – will take the back seat. Historically, interest rates and relative share prices have been inversely correlated and a steep selloff in the bond market is bad news for homebuilding stocks (top panel, Chart 12). On the operating housing front, some cracks are forming. New home sales, while brisk in absolute terms, are losing out to existing housing sales and homebuilders have resorted to price concessions in order to drive volumes (second & third panels, Chart 12). Profit margins are at the highest level since the subprime crisis and are vulnerable to a squeeze, not only from lower selling prices, but also from rising input costs. Framing lumber comprises roughly 15% of a new home’s commodity related costs and lumber prices have been expanding all year long (bottom panel, Chart 12). Bottom Line: Put the S&P homebuilding index to the high-conviction underweight call list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. Chart 12Avoid Homebuilders Underweight Pharma (COVID-19 Winner Theme) The S&P pharmaceutical index is a high-conviction underweight for 2021. On the macro front, the Fed’s ZIRP bodes ill for defensive pharma equities. The Fed was uncharacteristically quick this recession to drop rates to the lower zero bound to reflate the economy. As a result, safe haven equities, Big Pharma included, typically trail the broad market as the economy gets out of the ER and into the recovery room (second panel, Chart 13). Importantly, relative pharmaceutical profits are highly counter cyclical: they rise at the onset of recession and collapse as the economy heals. Currently, as the world economy has transitioned to a V-shaped recovery, the reopening of the economy into the New Year will continue to knock the wind out of relative pharma profitability. Similarly, an appreciating greenback has historically been synonymous with pharma outperformance and vice versa (third panel, Chart 13). Keep in mind, Big Pharma make the lion’s share of their profits domestically, further cementing the positive correlation with the US dollar. This local profit sourcing represents one of the main reasons why politicians on both sides of the aisle are after domestic pharma profits. Pharma prices are on the cusp of contracting. Importantly, President Trump’s late-July executive order “to allow importation of certain prescription drugs from Canada” among other provisions is a direct blow to the profit prospects of Big Pharma (bottom panel, Chart 13). Bottom Line: We are cognizant that the COVID-19 vaccine will lift Big Pharma, but only temporarily, as cyclical forces will more than offset the positive vaccine news. The S&P pharmaceuticals index is a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG – S5PHARX: JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO. Chart 13Sell Pharma Underweight Consumer Staples (COVID-19 Winner Theme) Countercyclical consumer staples stocks served their purpose and supported our portfolio in the front half of 2020. Now that vaccines are coming, we are adding the S&P consumer staples sector to the high-conviction underweight call list. The current macro backdrop underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also, consumer confidence is forming a trough (ISM manufacturing shown inverted, second panel, Chart 14). One of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis, staples stocks benefit much less than the rest of the market from a falling currency (third panel, Chart 14). Our relative macro earnings model does an excellent job in encapsulating all these moving parts and paints a dark profit picture for this GICS1 sector in the New Year (fourth panel, Chart 14). Bottom Line: The S&P consumer staples sector is a high-conviction underweight.   Chart 14Underweight Consumer Staples Short NASDAQ 100 / Long S&P 500 (Secular 10-year Call) We first wrote about the extreme market cap concentration in January when we were cautioning investors of an SPX drawdown and drew parallels with the dotcom era. Back in late-1999/early-2000 the top 5 stocks comprised 18% of the S&P 500. In July we delved deeper and split the S&P 500 in the S&P 5 versus the S&P 495 to highlight the extraordinary narrow returns since 2015. Such extreme concentration in a handful of tech titan stocks is clearly unsustainable. The bullish case for tech is well documented and understood; the COVID-19 pandemic acted as an accelerant to the technological adoption of the new remote working realities. However, $2tn valuations (AAPL, MSFT & AMZN) make little sense to us, especially if there is little earnings follow through and most of the returns are explained by multiple expansion. In all likelihood, the easy money has been made. Going back to the early 1970s is instructive in order to put the tech juggernaut into proper perspective. Every decade or so there have been clearly defined booms and busts in US tech stocks (Chart 15). Schumpeter’s “creative destruction” forces are undoubtedly at play. What is interesting is that not only have tech stocks likely stalled near the dotcom era peak, but also they have been outperforming since the end of the GFC (i.e. roughly a decade); they are due for at least a breather. If history rhymes, we have entered a new bust cycle and the tech sector’s underperformance will play out over the coming decade. Bottom Line: We are compelled to add to our structural trades and recommend investors underweight the tech sector on a ten-year time horizon via the short QQQ / long SPY exchange traded funds which offer the most liquidity. Chart 15Short QQQ / Long SPX For The Next Decade Also Rans Within consumer discretionary, automobiles & auto parts & components piqued our interest from the long side. These stocks would greatly benefit from a reopening economy as a semblance of normality returns sometime next year. Nevertheless, two key factors kept us at bay. First, similar to homebuilders, this index has gone vertical since the March lows, besting the SPX by a factor of 2:1 (top panel, Chart 16). We maintain exposure via our “Back-To-Work” basket with GM, but even this auto manufacturer is up 50% since the September 8, 2020 inception. Finally, TSLA is about to enter the SPX at a stratospheric valuation that would dominate the automobile sub group. This is eerily reminiscent of YHOO’s SPX inclusion in late-1999 that led the dotcom bubble peak by four months. The parallel is making us nervous, therefore we are staying patiently on the sidelines. On the underweight side we wanted to include the niche S&P semi equipment index, but opted not to as the Bitcoin mania has really pushed these stocks to the stratosphere (middle panel, Chart 16). In addition, this chip sub-group has one of the highest export exposures in the SPX with a large slice of foreign revenue originating in China. Hence, news of a Biden presidency also served as a catalyst to propel them higher (i.e. at the margin, a less hawkish president on the Sino/American trade war). We really struggled with global gold miners (GDX:US). Our initial thinking was to downgrade them to underweight (from currently neutral), which is consistent with global growth reaccelerating and interest rates rising. However, we missed the boat when it set sail in early August (bottom panel, Chart 16). Now, the gold bearish trade is gaining momentum and has become a consensus trade as big macro investors (Tudor and Druckenmiller among others) are shifting toward Bitcoin and have been vociferous about their positioning. Thus, we preferred to remain on the sidelines with a benchmark allocation. Chart 16Three “Also Rans” Footnotes   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth  

Special Report

Your feedback is important to us. Please take our client survey today. Feature Feature ChartHouse Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) Real estate is the world’s most important asset class. It accounts for 60 percent of the $500 trillion of mainstream global assets. To put this into context, the $300 trillion worth of global real estate makes the $7 trillion worth of all the gold ever mined look like chicken feed. It even dwarfs the $90 trillion global economy by more than three to one. In recent years, the valuation of global real estate has decoupled from underlying rents, and has become critically dependent on ultra-low bond yields. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of the world’s income, would make the pandemic’s economic shock feel like a waltz in the park. Hence, to anybody calling for significantly higher bond yields, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate? House Prices Have Decoupled From Rents The $300 trillion valuation of global real estate in 2020 is an 80 percent increase compared with 2010. Coincidentally, the value of the global stock market has also increased by 80 percent over the past decade. But the stock market’s $75 trillion capitalisation is small fry compared to the $300 trillion real estate market.1  Within the real estate market, residential real estate constitutes the lion’s share, accounting for around 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. The valuation of global real estate has become critically dependent on ultra-low bond yields. It follows that the most important component of the real estate market is the homes that people live in. The overwhelming majority of these homes are owner-occupied. Making house prices the indicator that drives, as well as reflects, the fortunes of ordinary people. The 2010s was remarkable as the first decade in which there was a synchronised boom in housing markets around the world. In the previous decade’s global financial crisis, house prices had crashed in several major economies: most notably, the UK and the US. Yet the UK and US housing markets did not suffer long hangovers. In the 2010s, the party restarted, and got even wilder (Chart I-2). Chart I-2The UK And US Housing Markets Resumed Their Parties In The 2010s Meanwhile, in Sweden, Canada, Australia, and China the global financial crisis barely interrupted their housing market parties, which continued seamlessly into the 2010s (Chart I-3). But perhaps most important of all, in the 2010s, the previous decade’s housing market wallflowers such as Germany and Japan started partying too (Chart I-4). What was behind this synchronised and broad boom in real estate values during the 2010s? The common denominator is the universal decline in bond yields. Chart I-3In Sweden, Canada, Australia, And China, The Parties Never Stopped Chart I-4Germany And Japan Started Their Parties In The 2010s As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields. Now that yields have little room to shift further downward, the scope for capital growth becomes more limited and dependent on rental growth happening first” Empirically, there is a tight long-term connection between house prices and underlying rents (Feature Chart). For example, through the past forty years, US house prices have closely tracked rents, with only two significant deviations. The first deviation happened during the housing bubble of the early 2000s. When that bubble burst in 2007, house prices promptly crashed back to their established relationship with rents. The second deviation is happening now. Since 2012, US house prices have outperformed rents by 25 percent (Chart I-5). In Europe, German house prices have outperformed rents by 20 percent (Chart I-6). The concern is that this house price outperformance versus rents is justified only if bond yields remain ultra-low and rental growth remains robust. Chart I-5House Prices Have Outperformed Rents By 25 Percent In The US... Chart I-6...And By 20 Percent In ##br##Germany   The Pandemic Is Depressing Housing Rents Unfortunately, the pandemic is putting pressure on housing rents. Rent inflation is driven by the security and growth of wages, which itself is inversely tied to the structural unemployment rate. When the number of permanently unemployed workers rises, rent inflation collapses. Indeed, in the aftermath of the global financial crisis, US rent inflation turned negative. Therefore, for the housing rent outlook, the key question is: what is the outlook for structural unemployment? (Chart I-7) Chart I-7Higher Structural Unemployment Depresses Rents The biggest driver of the structural unemployment rate will be the pandemic. Unlike China, large liberal democracies like the UK cannot control the pandemic with a universal track and trace system, because not enough of the UK population will allow the government to track their every move. Hence, until an effective vaccine has protected most of the population, liberal democracies like the UK must go down the route of physical distancing and the use of face masks.  When the number of permanently unemployed workers rises, rent inflation collapses. But as we explained in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs, physical distancing and facemasks restrict any economy activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three labour-intensive sectors – hospitality, retail, and transport – which employ 25 percent of all workers. Hence, if physical distancing and facemasks force these labour-intensive sectors to operate at one third below full capacity, the economy will lose 8.3 percent of jobs. On less optimistic assumptions the economy could lose 10 percent of jobs. Will a vaccine be a gamechanger? Not immediately. While it will mark progress, it will certainly not ‘take us back to normal’. This is because the proportion of the population that is immunised is unlikely to be high enough, fast enough. First, note that: Immunisation rate = Vaccination efficacy rate * Vaccination rate Second, note that no vaccine is 100 percent effective; and that a significant minority of diehards will refuse to get vaccinated. Perhaps understandably so if the vaccine has been rushed out. Even if we optimistically assume that the first vaccine is 70 percent effective, and that 70 percent of the population gets vaccinated, then the resulting 49 percent immunisation rate will still leave most people as sitting ducks for the virus. Under less optimistic – and arguably more realistic – assumptions, the number of unprotected people will be even larger. This means that social and physical distancing will continue for much longer than many people realise. Moreover, some of the reduction in ‘social consumption’ and its associated jobs will become permanent. The result is that the structural unemployment rate will continue to head higher, until the economy fully adapts to the post-pandemic way of living, working, and interacting. For the foreseeable future, this will put further pressure on housing rents, and keep the housing market crucially dependent on ultra-low bond yields. Concluding Remarks The main purpose of this Special Report is to highlight that the $90 trillion global economy is dwarfed by the $300 trillion global real estate market, whose valuation is critically dependent on ultra-low bond yields. If we add in equities, corporate bonds, and emerging market debt, the valuation of so-called ‘risk-assets’ rises to over $450 trillion. Yet many people still put the cart before the horse. They say the economy will drive the asset markets. This year has proved them wrong. A deflationary impulse from the economy unleashed an inflationary impulse in the much larger asset markets, which then helped to stabilise the economy. Unfortunately, the reverse would also be true. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets, which would then destabilise the economy. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets. Of course, any government with its own fiat currency can generate inflation if it really desires. Just look at Argentina or Turkey. But why would an advanced economy like the US, the UK, or the euro area make such a reckless journey, when it is already in the best place, the place it took a lot of blood and sweat to reach – namely, the place known as price stability? Still, if the advanced economies do take the road to inflation, they should realise that the road isn’t straight. The deflationary impulse that would come from the collapse in $450 trillion of risk-assets means that the road to inflation goes via deflation. For investors, this means that the road to much higher bond yields, if ever taken, reverses on itself. The road to much higher bond yields goes via the lower bound. Fractal Trading System* This week’s recommended trade is a soft commodities pair-trade. Go long coffee versus corn. The specific contracts are Brazilian coffee New York traded and Corn number 2 yellow central Illinois. The profit target and symmetrical stop-loss is set at 12 percent. Chart I-8Coffee Vs. Corn The rolling 1-year win ratio stands at 54 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 $300 trillion is our conservative uplift to the $281 trillion assessment that Savills made in 2018. The 2020 valuation constitutes a 40 percent increase versus its 2015 valuation. Before 2015, Savills did not provide an aggregated valuation for global real estate. However, as a good proxy, the firm tells us that the capital values in the top 12 world cities rose by 30 percent in the first half of the 2010s. Please see Savills: 8 things to know about global real estate value, July 2018; What price the world? 28 January 2016; and 12 Cities, H1 2015. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Underweight We remain bearish on the prospects of the S&P real estate sector as the pandemic will continue to severely bruise REITs. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25%. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel). A fresh stimulus bill could come to the rescue, but recent news of President Trump halting negotiations jeopardizes chances for near-term relief. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels). Bottom Line: We remain underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO. For more details, please refer to this Monday’s Weekly Report.

Special Report

Highlights Several malls are likely to fail in 2020 and 2021, but the overall economy will emerge unscathed … : Although lenders will recover a good bit less than par and equity holders will be wiped out, the losses will not create an observable macroeconomic drag. … because no critical element of the financial system has concentrated exposure to them: The amounts involved are not that large and the banking system’s stake is negligible. Malls disrupted the existing retailing footprint during their rise, and now it’s their turn to be disrupted: Creative destruction is natural and healthy. It will be a net positive for the economy if obsolete malls make way for more productive uses of their space. Feature As detailed in the first part of our Mallpocalypse Special Report, enclosed shopping malls are under pressure from a variety of forces. Department stores, which have typically anchored malls, are in the throes of a protracted structural decline; the apparel retailers that fill most of the leasable area between the anchors are in disarray; and e-commerce continues to take share from brick-and-mortar retailers. The pandemic, which forced many malls to close for an extended period and will likely undermine foot traffic until an effective vaccine is available, intensified the pressure. It pushed several national store chains into bankruptcy, emboldened many of their peers to stop paying rent and stymied malls’ pivot to gyms, movie theaters, restaurants and entertainment centers to fill their vacant spaces. Property analysts and investors estimate that the weakest 25% of malls face the possibility of extinction. Their owners’ equity stakes are likely to be wiped out and their lenders will recover considerably less than par. This installment examines the macroeconomic consequences of mall investors’ losses and the obsolescence of a formerly important aspect of the capital stock. Our view is that the malls’ demise does not constitute a macro threat; the mallpocalypse is not the commercial real estate analogue of the subprime crisis. Mall Exposures Are Diffused The sparks generated by the subprime mortgage collapse helped fuel the conflagration of the global financial crisis because they eroded commercial banks’ capital base; hobbled two major investment banks such that counterparties refused to deal with them; brought about declines in the prices of homes, which constitute a meaningful share of the collateral of the US banking system; and crippled the massive multi-line insurer that had been the biggest seller of the credit default swaps that the major banks and broker-dealers were using to hedge some of their residential mortgage exposures. With so many of the biggest players circling the wagons, liquidity dried up, credit spreads blew out and a major financial crisis ensued. No bank or major bank counterparty is sitting on a pile of mall mortgages. Mall failures will not have anything close to the same impact. Retail properties do not undergird the banking system like single-family homes and exposure to them is diffused across owners and creditors that can sustain losses without setting off broad ripple effects. More than half of US malls1 are owned by publicly traded REITs with the remaining ownership scattered among several privately held specialist investors. Developing and owning real estate is a leveraged pursuit and mall owners aren’t shy about borrowing, especially Simon Property Group (SPG), the largest player in the space (Table 1). Like some of its mall REIT peers, and nearly all its shopping center/strip mall counterparts, however, it does the bulk of its borrowing via bond issues. The effect is to reduce the concentration of creditor exposures; instead of borrowing from a bank or a syndicate of banks, SPG and many other publicly traded REITs sell bonds to a range of institutional investors. The mortgages it does take out predominantly wind up being securitized and dispersed across the institutional investor community. Table 1Large US Mall Owners Creditor exposures to mall owners are thereby atomized, making losses a micro issue rather than a macro one. Distributing credit losses across a wide swath of investors neutralizes the systemic risk posed by any given borrower or common group of borrowers. Alan Greenspan was compelled to recant his spectacularly ill-timed praise for securitization’s risk-mitigating properties, but it was conceptually sound. Residential mortgage securitization wasn’t the problem per se, it was that the private-label mortgage market had become a largely closed system in which the banks swapped positions with one another, amplifying counterparty exposures within the banking system without anyone seeming to care, if indeed they were aware. Table 2Top 15 Holders Of SPG Debt The primary owners of SPG’s bonds are the dominant index ETF sponsors, insurers and active mutual fund managers (Table 2). They are unlevered investors whose involvement diversifies exposure to credit losses away from the banks, thereby dissipating systemic risk. Although their losses cause financial conditions to tighten at the margin as spreads widen in response, they don’t disrupt financial intermediation in the way that sizable bank losses do. The worst outcome is a barely observable decline in funds available for consumption or investment and marginal employment declines as defaulting borrowers and their chastened creditors tighten their belts. Institutional investors are agents for the wealthier households that own a disproportionate share of financial instruments. They have a low marginal propensity to consume, which is to say that their consumption patterns are relatively insensitive to one-off income reversals and their investment losses don’t therefore perturb the broad economy. Equity holders in ailing mall REITs may have their stakes wiped out (Chart 1, bottom panel), adding insult to the injuries retail REIT investors have already sustained so far this year (Chart 1, top panel), but no critical intermediaries are shareholders and the overall market cap of retail REITs is not meaningful. Chart 1Trees Falling In Abandoned Mall Courtyards Do Not Make A Sound The Big Short 2.0 Investors who foresaw a future in which e-commerce wipes out department stores and other national chains with sizable mall footprints have sought out ways to bet against malls. Many of them have gravitated to selling the CMBX 6 Index (Box 1). The trade has been talked about so much in credit circles over the last few years that the financial media have labeled it The New Big Short, after the book and movie about investors who anticipated the wreckage of the subprime crisis. The New York Times devoted an article to it last week, and Bloomberg, The Wall Street Journal and countless credit market blogs have been following it for a while. Box 1: The CMBS Insurance Marketplace Credit default swaps (CDS), developed in the mid-nineties as a tool for hedging lending exposures, have become a wildly popular way for investors to bet on the fate of a given bond issue or security. Bonds can be quite illiquid relative to equities, and CDS vastly ease the process of obtaining exposure to them. They are effectively an insurance contract in which the protection buyer pays the protection seller a flat annual fee to indemnify the buyer against missed or partial interest or principal payments. The CMBX indices provide a reference point for buying and selling protection on a large basket of commercial mortgage backed securities (CMBS). They are composed of 25 equally weighted CMBS of common vintage, each of which contains at least 40 loans, and they are divided into quality tranches from AAA to BB, based on the level of credit enhancement provided to each tranche. The BB tranche absorbs losses first, then the BBB- tranche, and so on, up to the AAA tranche. The protection seller is said to go long the index while the buyer shorts it. CMBX trades between counterparties are zero-sum. They produce no aggregate increase or decrease in wealth because the longs’ and the shorts’ return profiles are perfect inverses. The weakest mall REITs aren't long for this world, but their ultimate demise will not trigger any broader repercussions. The CMBX 6, consisting of whole loans issued in 2012, became the darling of the retail bears because a comparatively large 44% of the face value of its mortgages backed retail properties (27% non-mall retail, 17% malls). As of late 2019, the index contained loans on 37 malls (Table 3). Publicly traded REITs have a stake in 26 of the 37 malls in the index and account for 70% of the outstanding principal balance. Table 3Mall Mortgages In The CMBX 6 Index Live By Disruption, Die By Disruption Obsolete malls are not likely to hurt the macroeconomy. Their disappearance will reslice the pie, creating micro winners and losers, but it shouldn’t cause it to shrink. Unwanted malls are a drag on the capital stock, because they’re not worth the cost of maintaining them, and converting the sites to better uses should act to boost productivity. Creative destruction is a positive feature of capitalism and a sign of economic health. The macro-economy didn't suffer when malls disrupted traditional downtown shopping districts and there's no reason to think it will now that the malls themselves are being disrupted. To those inclined to think we’re being cavalier about economic shifts and the near-term disruptions they provoke, we would point to the decades when the malls themselves were the disruptors. Mall construction – and branch department stores – thrived amidst the city-to-suburb migration that unfolded across the ‘50s, ‘60s and ‘70s. Population and wealth flooded out of the cities and into the suburbs, leaving some nasty micro-level scars as once-thriving retail quarters in the urban core became derelict. That outmigration did not produce a wave of bank failures, however. Citing Detroit’s experience in the ‘50s through the ‘70s in its Special Report examining the potential commercial real estate impact of a sizable uptake in work-from-home arrangements, our Global Investment Strategy service found no evidence that urban flight imposed undue stress on the financial system.2 Outmigration was also pervasive along the mid-Atlantic I-95 corridor in those decades. Suburbs of New York, Philadelphia and Washington, DC all experienced phenomenal growth while their core metropolitan areas shrank (Chart 2, top three panels). Even a growing city like Atlanta (Chart 2, bottom panel) saw its surrounding suburban counties welcome six times as many net new residents over the period. Chart 2City And Suburb Net Population Change By Decade Despite inevitable home price declines in several city neighborhoods and reduced demand for retail and office space, aggregate residential (Chart 3) and commercial mortgage performance (Chart 4) held up quite well and there was no uptick in bank failures (Chart 5). Inflation helped to hold down defaults then in a way it won’t now, but the bottom line is that the shift in consumer preferences toward shopping malls did not feed broader disruptions, even though credit exposures were nearly entirely concentrated within the banking system. With exposure to mall operators’ equity, mortgages and unsecured loans widely dispersed away from the banking system, and retail accounting for only a modest share of commercial property value (Chart 6), the shift away from shopping malls will not have broader macro consequences. Chart 3Urban Flight Didn't Undermine Residential ... Chart 4... Or Commercial Mortgage Performance Chart 5Urban Flight Didn't Promote Bank Stress Of Diamonds And Malls The forces behind the rise and fall of malls closely resemble the forces that drove the postwar waves of stadium construction: population shifts, increased reliance on automobiles and fashion’s impermanence. For the first half of the twentieth century, professional baseball’s sixteen franchises were spread across just ten cities. Its geographic footprint stretched from Boston to Washington on the Atlantic seaboard and along the Ohio River, the Great Lakes and the Mississippi to Chicago and St. Louis. The spread of franchises beyond the northeast and industrial midwest has tracked and foreshadowed the southern and westward movement of the population. Franchise moves, expansion and the mothballing of old city-center stadiums without parking led to a multi-decade boom in stadium construction that roughly coincided with the boom in mall construction. On undeveloped parcels on their outskirts, one city after another erected bland, utilitarian stadiums that were as uniform as the malls that had begun to dot suburban highway interchanges. They were hulking concrete structures with synthetic Astro-turf surfaces that could host baseball in the spring and summer and football in the winter, with capacity for between 50,000 and 70,000 fans and their cars. The early ‘90s witnessed a new stadium construction boom, motivated by franchises’ desire to reconfigure their seating to maximize revenues from businesses who used the games as a vehicle for entertaining clients. Stadiums without luxury boxes and enclosed suites were swiftly seen as obsolete. The popularity of Baltimore’s new park (1992), showcasing a retro design that hearkened back to the days of center city stadiums with brick facades and asymmetric quirks, made the stadiums of the sixties and seventies look hopelessly passé. The stock of dual-sport, artificial turf stadiums with concrete facades was eradicated over the next decade-plus, including Houston’s iconic Astrodome. The first fully enclosed stadium, billed as “the eighth wonder of the world” upon its 1965 opening, was the subject of rapturous national media coverage akin to the attention lavished on Southdale, the first mall, a decade before. The conversion of the stadiums did not bring ruin for any franchise, its municipal host,3 or the syndicate of banks and muni bond buyers that financed it. In cities where the new stadiums have been built closer to the center of town, the new ballparks have been a catalyst for a range of commercial and residential development. The broadly positive impact of scrapping faded stadiums for newer, better designed replacement stock looks like what we might expect from the scrapping of obsolete malls to make way for properties able to make better use of the space. Investment Implications Investors should not fear negative economic or market consequences from the retirement of underperforming malls. Their exit will not produce investment losses on a scale that slows the economy or interrupts banks’ intermediation function. Specialist real estate investors may find several opportunities in an industry in which the three most important factors are location, location and location. Credit and equity analysts and PMs may well find ways to profit from micro distinctions, but the lack of macro impacts means the demise of a meaningful share of the country’s malls does not have asset allocation implications. Investors in US assets will continue to be best served by taking their asset allocation cues from the fiscal and monetary policy backdrop. Mallpocalypse may be a clever phrase, but culling the nation’s underperforming malls from the capital stock won’t have adverse impacts on financial markets or the broad economy. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 There are around 1,300 malls in the US, including outlet malls and lifestyle centers. 2 Please see the August 28, 2020 Global Investment Strategy Special Report, "Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?" available at gis.bcaresearch.com. 3 The merits of using public funds to subsidize stadium construction for private concerns are hotly contested. Taking the existing level of public subsidies as a given, however, successful facilities upgrades confer an overall economic benefit, even if it involves a transfer of wealth from taxpayers to private entities.

Special Report

Dear Client, I am on vacation this week. Instead of our regular report, we are sending you a Special Report from my colleague Jonathan LaBerge. Jonathan explores the risks posed to commercial real estate and the banking system from work from home policies and the potential for urban flight towards less populated and more affordable areas. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Despite pronouncements that the “office is dead,” there are several arguments against the idea that working from home policies or urban flight will become broad-based and spell disaster for commercial real estate loans and the economy. However, the reality is that no one truly knows what the office environment will look like as a result of COVID-19. It is quite likely to be negative on balance for owners of office properties, but it is not yet clear whether it will be a marginal or catastrophic effect. Within the US, small banks clearly have more commercial real estate loan exposure than large banks. Applying the recent Dodd-Frank Act Stress Test (DFAST) to small US banks highlights that roughly 2/3rds of small banks might need to raise capital in the scenario modeled by the Fed, underscoring that forbearance and fiscal relief are essential to avoid a very widespread erosion in small bank capital. Still, of the nearly 5,100 banks included in our analysis, only 5 would see their equity capital wiped out by the simulated losses. Incorporating outsized, Work From Home (WFH)-driven CRE loan losses into our test of small banks highlights that WFH policies may act as a moderate “kicker” to severe pandemic-related bank loan losses were they to occur. But it is clear that the latter is by far the core risk facing both the US economy and its financial system. To the extent that the “white flight” phenomenon of the 1950s to 1970s is a reasonable historical analogue for large-scale urban flight today, the experience of Michigan in the 1960s suggests that it would not likely cause widespread problems in the housing market and/or systemic stress in the banking system. But even if large-scale urban flight does not initially occur due to time-saving WFH policies or health & safety concerns, there are some concerning parallels to the severe decay and decline of the city of Detroit that could play out over the coming few years in America’s cities if not prevented by policymakers. This could spur large-scale urban flight for reasons unrelated to WFH policies. The possibility of inadequate fiscal support is the chief risk to our positive cyclical stance towards risk assets and must be continually monitored by investors over the next several months. We expect large bank outperformance at some point over the coming year, reinforcing our positive stance towards value over growth. Feature Chart 1Rising CRE Prices And Deteriorating Fundamentals, Even Before The Pandemic Concern had already been growing among investors over the past few years about the potentially systemic implications of a possible crash in sky-high US commercial real estate (CRE) prices. Chart 1 highlights that overall CRE prices have doubled over the past decade, which has occurred alongside falling real rents (and thus deteriorating fundamentals) in most CRE subcategories. But the COVID-19 pandemic has introduced new risks for US CRE that many investors view as potentially acute. CMBS delinquency rates surged in May and June (but fell in July), led by accommodation and retail properties. And while multifamily and office delinquencies have so far remained low, many investors have questioned whether this can continue if recently enacted work from home policies become permanent and “urban flight” towards less populated and more affordable areas durably takes hold in major US cities. In this report we focus on the issue of WFH policies, the potential for urban flight, and the risk that these factors may pose to the CRE loans of small domestically-chartered US banks (sometimes informally referred to as “community banks”). There are arguments for and against the idea that work from home policies and/or migration out of city centers will have an extremely negative impact on office properties, but the truth is that it is currently a risk of largely unknown magnitude. It is not likely to be positive for owners of office properties, but it is yet unclear how negative it will be. As a result, we address the question as a “what if?” scenario, by stress testing small bank balance sheets. We conclude that the impact of potential WFH-driven CRE loan losses on the banking system is minor compared with the core risks facing the economy and its capital markets: The deeply negative impact of the COVID-19 pandemic on production and spending, and the risk that fiscal relief will fall short of what is required. Did COVID-19 Really Kill The Office? Chart 2Employers Found That Teleworking Worked Well In mid-to-late March, COVID-19 was spreading rapidly in industrialized economies. Following recommended or mandatory stay at home orders from governments, most office-based businesses rapidly shifted to WFH arrangements as an emergency response. However, in the month or two following the beginning of stay at home orders, several national US surveys found many office workers preferred the flexibility afforded by WFH arrangements. Many employers, correspondingly, found that the productivity of their employees did not suffer while working from home, or that it even improved (Chart 2). These findings led many in the business community to conclude that WFH policies are not, in fact, emergency measures that will ultimately be reversed and instead reflect the “new normal” for work. The arrangement ostensibly appears to be a win-win scenario for workers and firms: Employees save time and money not commuting to the office and gain more control over their work schedules, and businesses save money on the rental or purchase of office space. The conclusion for many in the marketplace has thus been that “the office is dead,” with the focus shifting to the potential investment implications. When thinking about the potential consequences that permanent and widespread WFH options may have, there are two distinct issues that must be considered. The first is the degree to which these policies will push up office property vacancy rates, and the second is whether the availability of WFH policies will cause significant urban flight towards less populated and more affordable areas. On the margin, we agree that both events will occur at least to some degree, and thus are likely to be highly unwelcome developments for owners of prime central business district real estate. This is in line with the conclusions of a recent Special Report by my colleague Garry Evans.1 But there are at least a few arguments against the idea that these trends will occur en masse, or that they will spell economic disaster on their own: While surveys show that many employees expect to continue to work remotely after the pandemic ends, these results likely reflect the desire to retain some flexibility afforded by WFH policies. In terms of office property utilization, there is a large difference between an employee never working from an office again and permanently working from home one day per week, and many surveys that have been conducted on the topic are not structured to distinguish between the two. Surveys that specifically ask how long employees expect it will take for them to return to the office and that include “never” as a possible answer imply a considerably lower impact on office space utilization than other surveys would suggest (Chart 3). If the percentage of never-returning workers shown in Chart 3 (5%-7%) is accurate and maps closely to the expected rise in the office vacancy rate, Chart 4 highlights that the corresponding increase in vacancy would not be unprecedented: It rose from roughly 8% in 2000 to 17% in 2003, without causing a disastrous collapse in office property prices (they fell, but not enormously). Today the vacancy rate would be rising from a much higher level than in 2000, but the point is that very significant changes have occurred in the vacancy rate before without substantially destabilizing the office property market. Chart 3Employers Found That Teleworking Worked Well For offices that reopen before the end of the pandemic, the need for physical distancing will act to at least somewhat restrain a rise in the vacancy rate over the coming several months, as it implies the need for more physical space per employee rather than less. Chart 4Large, Non-Impactful Rises In The Office Vacancy Rate Have Occurred Before Some surveys suggest that Americans are already starting to change their minds about their desire to move out of the city. In April and early-May, upwards of 35%-40% of people responding to a Harris poll said that the pandemic made them want to live either in a rural area more than 21 miles outside of a major city or a suburb within 10 miles of a major city. As of late-July / early-August, that number had fallen to 26% (Chart 5), with only 9% reporting that it is “very likely.” This suggests that the end or reduction of lockdown measures may have returned a sense of normality for many Americans, and that the ultimate degree of urban flight may end up being considerably smaller than some investors expect. Chart 5Few People Say It Is Very Likely They Will Move Due To COVID-19 Finally, the example set by Facebook in May suggests that employees who wish to work from home permanently and relocate to more affordable areas will experience salary reductions, as part of a plan to “localize employees' compensation.”2 If adopted on a widespread basis among firms offering their employees the option to permanently work from home, localized compensation will very likely erode some of the cost advantages of moving to a cheaper area, and thus is likely to result in even fewer employees choosing permanent WFH arrangements. However, even after considering these arguments, the bottom line for investors is that no one truly knows what the office environment will look like as a result of COVID-19, because it hinges both on the evolution/resolution of the pandemic as well as potentially ephemeral human sentiment and behavior – both of which are extraordinarily difficult to predict with high accuracy. It is quite likely to be negative on balance for owners of office properties, but it is not yet clear whether it will be a marginal or catastrophic effect. As such, we agree that the chance of a major and lasting shock to the holders of US commercial real estate loans warrants a thorough investigation, focused on its potential to affect the stability of the US financial system. We first present an overview of CRE exposure for all US banks, and then examine in detail the risk facing small domestically-chartered US banks. Reviewing US Bank CRE Exposure Table 1 presents an overview of CRE loan exposure for domestically-chartered US banks from the Fed’s H.8 data release (Assets and Liabilities of Commercial Banks in the United States), as well as a breakdown in exposure for large and small banks. Investors should note that different definitions of “large banks” exist in the US, and in the H.8 release they are defined as the top 25 domestically-chartered banks ranked by domestic assets. Table 1Most US Commercial Real Estate Loans Are Held By Small Banks Table 1 highlights two points. First, while CRE loans account for approximately 13% of total US domestically-chartered bank assets, exposure is clearly more concentrated for smaller banks than for the largest banks. CRE loans account for a full 1/4th of total assets for small banks, compared to just 6% for the top 25 domestic banks. Given this, the focus of our report will be on small rather than large bank exposure to CRE loans. Second, the table makes it clear that loans backed by nonfarm nonresidential structures account for just 2/3rds of total CRE exposure; the remaining exposure is to apartment buildings, construction and land development loans, and farmland. While not shown in Table 1, bank call reports also highlight that 1-4 family residential construction loans are included in the overall construction and land development category, accounting for up to 20% of those loans for small domestically-chartered banks. Chart 6Office Properties Make Up About 40% Of The Value Of Commercial Structures Unfortunately, it is difficult to break down small bank nonfarm nonresidential structure exposure by property type from a top-down perspective. Chart 6 highlights that office properties (including all financial buildings) make up approximately 37% of the current-cost net stock of US nonresidential commercial and health care structures, whereas office loans make up approximately 30%-40% of those included in US commercial mortgage-backed securities. For the purposes of our analysis, we assume that 40% of small domestically-chartered US banks’ nonfarm nonresidential property loans are secured by office properties. Stress Testing Small US Banks The first step in stress testing small US bank CRE exposure is to simply apply the recent Dodd-Frank Act Stress Test (DFAST) that was focused on large banks to the approximately 5,100 small banks in the US. We use Q1 bank call reports (which we use as a pre-COVID benchmark) sourced from the Federal Financial Institutions Examination Council (FFIEC) to test the breadth of the impact on small banks, and include essentially all US banks in our list except the top 25 banks by assets (those designated as “large” in the Fed’s H.8 release). The Federal Reserve recently released the 2020 DFAST results, which examined the impact on capital ratios of 33 large US banks in a “severely adverse” economic scenario. The scenario modeled by the Fed resulted in $553 billion in projected losses on loans and other positions for the banks included in the test over a 2-year period, of which $433 billion were from accrual loan portfolios (Table 2). These projected loan losses corresponded to a 6.3% loan portfolio loss rate; for comparison, Chart 7 highlights that this would represent even higher losses than what occurred during the worst two-year period following the global financial crisis (Q1 2009 – Q4 2010) by roughly one percentage point. Table 2The Fed’s Recent Stress Test Modeled A 6.3% Loan Loss Rate Over 2 Years Chart 7The Fed's Main Loss Scenario Is Meaningfully Worse Than What Occurred After 2008 In combination with additional provisioning, these assumed losses caused a 1.8% projected decline in the aggregate tier 1 capital ratio for the 33 firms participating in the stress test – from 13.6% to 11.8% – and a 1.7% projected decline in the common equity tier 1 capital ratio – from 12% to 10.3% (Table 3). While these declines are not trivial, they are far from a disastrous outcome for the US financial system. The capital ratios shown in Table 3 are relative to risk-weighted assets, and it is important to note that the projected change in capital ratios shown do not match the projected loan losses (plus provisioning) as a percent of risk-weighted assets. This is because projected losses are netted out against the banks’ projected pre-provision net revenue (“PPNR”) in the Fed’s exercise. In short, while the banks’ capital ratios declined roughly 2% in the DFAST scenario, simulated loan losses amounted to roughly 4% of risk-weighted assets and about 1/3rd of tier 1 common equity capital. Table 3Large Bank Capital Ratios Fell In The Stress Test, But Not Dramatically SoTo avoid the need to project PPNR for thousands of small US banks, we use these loan loss metrics (4% of risk-weighted assets and 33% of tier 1 common equity capital) from the 2020 DFAST to represent whether any individual small bank would likely have to raise capital. We also use the overall portfolio loan loss rate of 6.3% to stress small bank balance sheets, rather than a set of loan loss rates by loan type. Chart 8In The Fed’s Main Stress Test Scenario, Many Small Banks Would Likely Have To Raise Capital Chart 8 illustrates the number of small US banks that would “fail” the stated tier 1 common equity and risk-weighted asset thresholds given the DFAST assumptions. Roughly 64% of small banks would fail the equity test and 94% would fail the risk-weighted assets test. Weighting these results by bank assets rather than the number of banks does not generate a materially different result; instead, 63% and 97% of small bank assets would be held by banks failing the equity and risk-weighted assets tests, respectively. This exercise clearly highlights how much better capitalized large US banks are relative to smaller banks, and underscores that the existing forbearance programs and fiscal relief are essential to avoid a very widespread erosion in small bank capital. Still, of the nearly 5,100 banks included in our analysis, only 5 would see their equity capital wiped out by the simulated losses – meaning that while widespread capital raising and the accompanying tightening in lending standards would undoubtedly have a major impact on the economy and capital markets, the solvency of the US banking system is not in question in the scenario modeled by the Fed. Stress Testing Outsized CRE Losses As noted above, we employed the same average loan portfolio loss rate across all loan categories when testing the impact of the DFAST scenario on small banks, including commercial real estate loans. In order to gauge the specific risks facing commercial properties if recent WFH trends persist, we perform two additional exercises. First, we raise CRE loan losses beyond what was assumed in the DFAST scenario (see Box 1) while employing the same 6.3% loan loss rate on all other loan types to measure the incremental WFH effect on small bank balance sheets in a very negative economic scenario. Second, we examine a high CRE loan loss scenario alone, in order to isolate the potential impact of sustained WFH policies. Box 1Simulating Outsized CRE Loan Loss Rates The assumptions detailed in Box 1 result in an overall CRE loan loss estimate of 11.1%, versus the 6.3% assumed in the DFAST. Chart 9 replicates the DFAST scenario shown in Chart 8 but with our outsized CRE loss rate, whereas Chart 10 highlights the isolated impact (i.e., without any losses assumed for other loan categories). Chart 9Adding Outsized CRE Loans To The Stress Test Scenario Only Moderately Increases “Failure” Chart 10Big CRE Losses Alone, With No Other Loan Losses, Would Be A Relatively Minor Problem Two important observations emerge from Charts 9 and 10. First, despite the fact that small US banks carry disproportionately higher exposure to commercial real estate loans than large banks, it seems clear that the isolated effect of WFH policies on CRE loans, even in the extreme, do not amount to a major risk for the banking system. 80% of small US banks would pass our equity capital test, and 70% would pass the risk-weighted assets test, with absolutely devastating and unprecedented office and retail property losses but no losses outside of their commercial real estate portfolio. Second, while our outsized CRE losses would raise the number of banks that fail our equity capital test relative to the base DFAST scenario (from 64% to 74%), it is clear that this pales in comparison to the effect of the other loan losses assumed in the Fed’s stress test. The bottom line for investors is that while WFH policies may act as a “kicker” to severe pandemic-related bank loan losses were they to occur, it is clear that the latter is by far the core risk facing both the US economy and its financial system. Outsized Residential Real Estate Losses: The Elephant In The Room As noted above, the results shown in Charts 8 - 10 only include outsized losses on nonresidential CRE loans (excluding multifamily) in order to test the risk to bank balance sheets of widespread and continued use of highly permissive WFH policies and significantly reduced demand for office properties. On top of that, banks also face the risk of additional potential disruptions to residential real estate loans if the WFH phenomenon morphs into full-blown urban flight. In this scenario, migration out of densely-populated urban areas towards considerably cheaper suburbs and exurbs could possibly lead to significant house price declines in richly-valued metro-areas, leading in turn to defaults on underwater mortgages. Table 2 highlighted that the Fed’s base 2020 DFAST scenario assumed a 1.5% loan loss rate on first-lien mortgages, and a 3.1% loss rate on junior liens and HELOCs over a two-year period. Unfortunately for investors, it is exceedingly difficult to pinpoint the magnitude of urban migration that would be necessary to cause loss rates in line with the DFAST scenario or higher, forcing us to rely on an inferential approach based on historical example. Chart 11“White Flight” In The US: An Analogue For Urban Flight Today? The only meaningful historical analogue that we can identify for the idea of WFH-driven urban flight is the “white flight” phenomenon that occurred in the US from the 1950s to 1970s. During this period, many white middle-class Americans moved from increasingly racially mixed city centers to racially homogenous suburban or exurban areas. The city of Detroit is often cited as an example of the "white flight" phenomenon. Chart 11 shows Detroit’s white population over time, and highlights the sharp decline in the number of white residents that occurred during the 1950s and 1960s. The white share of Detroit’s population fell earlier, beginning after WWII, but this mostly reflected larger increases of the non-white population. Actual “white flight” occurred during the 50s and 60s, when several episodes of racial violence occurred in the United States. In Detroit, this was most clearly epitomized by the 12th Street Riot in 1967, which involved Federal troop deployment and resulted in over 40 deaths and the damage or destruction of over 2,500 businesses. Did “white flight” cause widespread problems for urban housing markets and/or systemic stress in the banking system? Table 4 and Chart 12 suggest that the answer is no. Table 4 highlights that the median real house price in Michigan rose in the 1960s, grew faster than nationwide house prices, and was modestly higher than the national average in 1970. While it is very likely that this reflects outsized suburban house price gains and that urban center prices fell, Chart 12 highlights that there was no noticeable uptick in US banking failures as a share of total depository institutions in the 1960s. Chart 13 also highlights that the late-1960s did not exhibit any particularly unusual behavior for bank stock prices, after considering interest rates and the state of the business cycle. Table 4Real Michigan Home Prices “Outperformed” The US In The 60s Chart 12No Uptick In Bank Failures In The 1960s Chart 13No Unusual Bank Underperformance In The 1960s     The US economy is very different today than it was in the 1960s, and it is possible that “white flight” serves as an insufficient analogue for potential urban flight today. It is also true that real house prices today are considerably higher than in the 1960s and thus have room to fall further. Nevertheless, based on the Detroit experience, our best inference (for now) is that urban flight does not pose a risk of outsized mortgage loan losses for banks. This is reinforced by the fact that mortgage interest rates have fallen to a record low and have the potential to fall even further based on their spread to 30-year Treasury yields (Chart 14), which may act to boost house prices outright or cushion any potential declines. Chart 14Low And Potentially Lower Mortgage Rates Will Help Cushion Any House Prices Declines Is The Real Risk To Cities Urban Flight, Or Urban Blight? In our view, the city of Detroit is a useful case study for two reasons. First, as noted above, it provides us with some sense of whether urban flight has the potential to pose a systemic threat to the financial system. But, second, it also serves as an example of another potential risk of the COVID-19 pandemic: urban “blight,” or decay. Chart 15Progressive Post-War Deindustrialization Hammered Cities Like Detroit The economic and sociological decay of the city of Detroit has taken place over several decades and has been caused by multiple factors whose relative importance is still debated today. But broadly-speaking, Detroit’s decline can be boiled down to three interacting and self-reinforcing sets of factors: Sociological factors: the general post-WWII trend towards suburbanization, rising levels of violent crime, the “white flight” phenomenon, and the outright decline in Detroit’s population that began in the 1950s; Economic factors: the progressive deindustrialization of the US economy that began in the early 1950s, as well as the debilitating effects of high inflation and energy prices in the 1970s and the double-dip recession of the early-1980s on manufacturing employment (Chart 15); Policy factors: the negative impact on city finances, tax competitiveness, and service quality from the previous two factors, as well as poor governance and outright corruption. Even if large-scale urban flight does not initially occur due to time-saving WFH policies or pandemic-related health & safety concerns, there are some worrying parallels to Detroit’s experience that could play out over the coming few years in America’s cities that could cause similarly self-reinforcing effects if not prevented by policymakers. On the economic front, very acute income and wealth inequality arrayed against stout house price gains over the past decade have made home ownership unaffordable for some, increasing the allure of urban flight even if localized compensation programs apply. In addition, the pandemic has most severely affected small retail businesses, raising the specter of a “hollowed out” or abandoned urban retail landscape which could push consumers to avoid shopping and travelling downtown. On the policy front, there is a clear risk that inadequate state & local government funding could contribute to a potential downward spiral of higher taxes, reduced city services, and economic decay – similar to what occurred in Detroit. Chart 16 highlights that the financial situation of state & local governments following the global financial crisis caused persistent fiscal drag for several years into the expansion that followed. This significant fiscal drag contributed importantly to the subpar nature of the expansion, and the odds that this will occur again without federal funding are high. Chart 16 shows that the contribution to real GDP growth from state & local government spending has again turned negative, and the US Center on Budget and Policy Priorities is currently forecasting state budget shortfalls of approximately $555 billion over state fiscal years 2020-2022 – in line with the $510 billion cumulative shortfall that occurred from 2009-2011.4 Finally, in this scenario, the sociological factor somewhat mimicking Detroit’s experience could be a significant rise in urban crime (especially if violent). This could cause urban flight for reasons totally unrelated to WFH policies, but if it occurred it would likely reinforce both the failure of urban center businesses and the deterioration in state & local government finances (risking a downward spiral). Chart 17 highlights that murders have already significantly increased this year in major American cities (by mid-year) relative to 2019, although other types of violent crimes have fallen.5 A trend of rising urban crime could also be sparked or accelerated if recent calls to cut police department funding in favor of other social services succeed, and if those newly funded initiatives fail to effectively prevent criminal activity. Chart 16Persistent State & Local Fiscal Drag Must Be Prevented This Time Chart 17Will US Cities Become Unsafe? While this scenario is far from our base case view, it underscores how urban flight and the accompanying second round effects on commercial real estate loans and the banking system could occur following the pandemic even if not triggered by WFH policies. It also underscores the great importance of Federal fiscal relief efforts: not only to households and businesses, but as well to state & local governments. Investment Conclusions Our analysis above points to three main investment conclusions: First, while there are arguments for and against the idea of significant CRE losses stemming from the widespread adoption of permanent WFH policies and the potential for large-scale urban flight, the uncertainty surrounding the question will likely linger for the coming few months, at a minimum. This suggests that the equity risk premium applied to bank stock prices may remain elevated in the near term. Chart 18Large US Banks Unduly Cheap Second, while large-cap banks may struggle to outperform in the near term due to this elevated risk premium, it is clear that large banks are far less susceptible than small banks to not only potential CRE loan losses, but also to the severely adverse economic scenario modeled in the Fed’s recent stress test. Our calculations suggest that large bank capital ratios would only marginally decline from the ending ratios shown in the DFAST scenario even with the outsized CRE loan loss scenarios that we used to stress test small bank balance sheets, and we highlighted how the Fed’s main stress test scenario involved 2-year loan losses in excess of what occurred in 2009-2010. Consequently, the collapse in large-cap bank valuation ratios seems unwarranted (Chart 18), and we would expect large banks to outperform the broad market at some point over the coming 6-12 months (and possibly even over the coming 0-3 months). This is also consistent with our expectation that value stocks are likely to outperform growth stocks at some point over the coming year.6 Third, while investors are often right to ask what risk they are “missing,” our analysis above highlights that the impact of potential WFH-driven CRE loan losses on the banking system is minor compared with the core risk facing the economy and its capital markets: The deeply negative impact of the COVID-19 pandemic on production and spending, and the risk that fiscal relief will fall short of what is required. This need for relief extends very significantly to state & local governments, and a failure to adequately resolve the substantial state budget shortfalls that will occur due to the pandemic and its aftermath would all but guarantee a repeat of the persistent fiscal drag that contributed to the subpar nature of the recent economic expansion. Our base case view remains that US policymakers will do what is necessary to avoid a very negative economic outcome and that the hiccup in congressional negotiations is temporary, but the possibility of inadequate fiscal support is the chief risk to our positive cyclical stance towards risk assets and must be continually monitored by investors over the next several months. Stay tuned! Jonathan LaBerge, CFA Vice President Special Reports Footnotes 1  Please see Global Asset Allocation / Global Investment Strategy Special Report, “The World After COVID-19: What Will Change, What Will Not?” dated August 7, 2020. 2 “Facebook employees could receive pay cuts as they continue to work from home,” USA Today, dated May 21, 2020. 3 Please see US Investment Strategy Special Report, “Mallpocalypse, Part 1: An Overnight Collapse Decades In The Making,” dated August 17, 2020 for the first of two reports presenting a detailed analysis of the challenges facing US retail properties. 4 Elizabeth McNichol and Michael Leachman, “States Continue to Face Large Shortfalls Due to COVID-19 Effects,” Center on Budget and Policy Priorities, Updated July 7, 2020. 5 Jeff Asher and Ben Horwitz, “It’s Been ‘Such a Weird Year.’ That’s Also Reflected in Crime Statistics.,” The New York Times, Updated August 24, 2020. 6 Please see Global Investment Strategy Weekly Report, “The Return Of Nasdog,” dated August 21, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores  

Dear clients, The Foreign Exchange Strategy will take a summer break next week. We will resume our publication on September 4th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Feature The economy of Hong Kong SAR1 has been held under siege by two tectonic forces. With the highest share of exports-to-GDP in the world, and at very close proximity to China, the epicenter of the pandemic shock, economic growth has been knocked down hard. The second shock to Hong Kong’s economy has been political instability. The extradition bill that was proposed in February 2019, followed by the enactment of the national security law this past June, has been accompanied by cascading street-wide protests and social unrest. The spirit of the bill is that crimes committed in Hong Kong can be trialed in China. The US has moved to impose sanctions on Hong Kong, as it no longer sees the city-state as autonomous, the latest of which is revoking its extradition treaty with the former colony. Some commentators have defined this as the end of the one country, two systems socio-economic model that has been in place since the handover from British rule in 1997. From a currency perspective, these shocks put in question the sustainability of the Hong Kong dollar (HKD) peg. Historically, currency pegs more often than not fail, especially in the midst of both geopolitical and economic turmoil. This was the story of the Asian Financial crisis in the late 1990s, and the Mexican peso crisis earlier that decade. Is the Hong Kong dollar destined for the same fate? If so, what are the potential adjustments in the exchange rate? Finally, what indicators can investors look to as a guide for any pending adjustment? A Historical Perspective Chart 137 Years Of Stability The HKD is no stranger to shifting exchange-rate regimes. Over the last 170 years, it has been linked to the Chinese yuan, backed by silver, pegged to the British pound, free-floating, and, since 1983, tied to the US dollar. Therefore, a bet on the unsustainability of the peg is historically justified. That said, the stability of the peg to the US dollar has survived 37 years of economic volatility, suggesting the Hong Kong Monetary Authority (HKMA) has been able to successfully navigate a post-Bretton Woods currency era (Chart 1).   Beginning as a bi-metallic monetary regime in the early 19th century, the HKD was initially linked to gold and silver prices, akin to the commodity–monetary standard that dominated that era. When Britain colonized Hong Kong in 1841, and as new trade alliances developed, the drawbacks of the bi-metallic monetary standard became apparent. As bilateral trade boomed, adjustments to imbalances (surpluses or deficits) could not occur through the exchange rate since it was fixed. Therefore, they had to occur through the real economy. This led to very volatile and destabilizing domestic prices. The stability of the peg to the US dollar has survived 37 years of economic volatility. Most Anglo-Saxon countries finally converted from bi-metallic exchange rates to the gold standard in the late 1800s, and strong ties to China dictated that Hong Kong naturally adopted the silver dollar in 1863. However, the silver system had the same drawbacks as the bi-metallic standard. Specifically, when your money supply is fixed, any increase in output leads to “few dollars chasing many goods.” This is synonymous with falling prices, just as “many dollars chasing few goods” is synonymous with rising inflation. The petri dish for this phenomenon was the post-World War I construction boom. A fixed money supply under the gold (and silver) standard meant rapidly falling prices globally. By the late 1920s, most countries had overvalued exchange rates relative to gold (and silver), that exerted powerful deflationary forces on their domestic economies. This forced most Western governments to debase fiat money vis-à-vis gold to stop price deflation. Correspondingly, China had to abandon the silver standard in November 1935, with Hong Kong shortly following suit. At the time of debasement, the United Kingdom was the leading economic power. As a colony, it made sense for the Hong Kong government to link the HKD to the British pound. The established rate was GBP/HKD 16, giving birth to the currency board system (Chart 2). Meanwhile, as a trading hub, a peg with an international currency made sense. The problems there were two-fold. First, the pound was still gold-linked. And second, Britain’s subsequent decline in economic power was accompanied by a series of sudden and dramatic devaluations in the pound, which was hugely disruptive to Hong Kong’s financial system. By 1972, the British government decided to float the pound, which effectively ended the GBP/HKD peg. Chart 2A History Of The HKD Peg In July 1972, the authorities made the decision to peg the Hong Kong dollar to the US dollar at USD/HKD 5.65, which was another policy mistake. The switch made sense given the rising economic power of the US, as well as rising trade links (Chart 3). However, the dollar was also under a crisis of confidence following the Nixon devaluation in 1971. In February 1973, the HKD was freely floated. Chart 3The Peg Is Usually Against The Dominant Economic Power Counter-intuitively, the free-floating era for HKD was arguably the most volatile for its domestic economy. For one, discipline in monetary policy was gone. Money and credit growth exploded, inflation hit double-digits, home prices soared and the trade balance massively deteriorated. Political instability was also rife, given the uncertainty surrounding the end of British claims on the island. As the dialogue included China’s reclaim of political control over Hong Kong, there was uncertainty over the rule of law. This cocktail of political and economic uncertainty led to a 33% depreciation in the HKD between mid-1980 and October 1983. Panicked policymakers returned to the US dollar peg. Paul Volcker, then Federal Reserve chairperson, was establishing himself as the world’s most credible central banker, having dropped US inflation from almost 15% in 1980 to below 3% by 1983. Economic and financial links with the US also justified a peg. In August of 1983, the authorities announced a USD/HKD fixed rate of 7.80, which has remained in place since. The Current Peg: Advantages And Disadvantages Chart 4Fiscal Prudence In Hong Kong The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. First, the US dollar is an international reserve currency dominating international trade, which helps to facilitate settlements while instilling confidence among transacting participants. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor imposes fiscal discipline, since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. In the extreme case, the central bank can run out of reserves, causing the peg to collapse. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 4). The drawback of a fixed exchange rate regime is that a country or a region relinquishes control over independent monetary policy. In the case of Hong Kong, this means that interest rates are determined by the actions of the US Fed. Such a marriage was justified when the business cycles between the two economies were in sync, but in times of economic divergences, the fixed exchange rate leads to economic volatility. Chart 5Currency Peg And Internal Devaluation Chart 6Hong Kong Interest Rates In The Late 90's This divergence was clearly evident in the 1990s, as falling interest rates in the US supercharged a housing and stock market bubble in Hong Kong. When the Asian crisis finally came around in 1997, the lack of exchange-rate flexibility led to a vicious internal devaluation (Chart 5). A prolonged period of high unemployment and stagnant wages was needed for Hong Kong to finally improve its competitiveness. Most importantly, in 1998, in the depths of the Asian financial crisis, the peg attracted a concerted attack from speculators who believed a devaluation of the Hong Kong dollar alongside other regional currencies was inevitable. Their assault inflicted considerable pain, driving short-term HKD interest rates (Chart 6) and wiping out over a quarter of the local stock market in a matter of weeks. At the time, the Hong Kong government was successful in fending off the speculative attacks by intervening massively in both the foreign exchange and equity markets. Is An Adjustment Pending? If So, When?      Chart 7USD/HKD And Interest Rate Spreads As the above narrative suggests, the HKD is no stranger to socio-economic shocks and speculative attacks, and it has, more recently, weathered them pretty well. The more immediate question is whether the shift in the political landscape could be potent enough to crack the peg this time around. While plausible, it is unlikely for a few reasons. First, the HKD continues to trade on the stronger side of the peg as US interest rates have collapsed, wiping off any positive carry that would have catalyzed outflows. Fluctuations in the USD/HKD within the 7.75-7.85-band track the Libor-Hibor spread pretty closely (Chart 7). A currency board has unlimited ability to defend the strong side of the peg, since it can print currency and absorb foreign reserves (print HKDs and use these to buy USDs in this case). On the weak side, these foreign exchange reserves are drawn down. Therefore, any threat to the peg should be preceded by consistent trading on the weaker side, questioning the HKMA’s ability to keep selling FX reserves to defend the peg. Fluctuations in the USD/HKD within the 7.75-7.85-band track the Libor-Hibor spread pretty closely. Second, the Hong Kong peg remains extremely credible, since the entire monetary base is backed over two times by FX reserves (Chart 8). Even as a percentage of broad money supply, Hong Kong reserves are ample and very high by historical standards (Chart 8, bottom panel). Meanwhile, since 1983, the currency board system has undergone a number of reforms and modifications, allowing it to adapt to the changing macro environment. This represents a powerful insurance policy for the HKMA’s ability to defend the currency peg, significantly enhancing the system’s credibility. Chart 8Ample Foreign Exchange Reserves Chart 9Hong Kong Runs Recurring Surpluses Third, ever since the peg was instituted, Hong Kong has mostly run budget surpluses. As a result, government debt in Hong Kong is almost non-existent, as we illustrate above. This has removed any incentive to monetize spending, which remains an open argument in the US, Japan or even the euro area. One of our favored metrics on the health of a currency is the basic balance, and on this basis, Hong Kong scores much more favorably than the US. While Hong Kong has transitioned from being a goods exporter to that of services, it remains extremely competitive, with a healthy current account surplus of 5% of GDP (Chart 9). These recurring surpluses have propelled Hong Kong to one of the biggest creditors in the world, with a net international investment position that is a whopping 430% of GDP and rising (Chart 10).   Chart 10Hong Kong Is A Net Creditor To The World Fourth, over the past few years, productivity in Hong Kong has outpaced that of the US and most of its trading partners (Chart 11). This has lifted the fair value of the currency tremendously. This means it is more like that when the peg adjusts, the outcome will be HKD appreciation. On a real effective exchange rate basis, the HKD is not that overvalued compared to the US dollar, after accounting for the massive increase in relative productivity (Chart 12). It is notable that during the Asian financial crisis, currencies like the Thai bhat were massively overvalued, which is why the adjustment was back down toward fair value. Chart 11Hong Kong Is Highly Productive Chart 12Trade-Weighted HKD Is Slightly Expensive Fifth, there is a strong incentive for both Beijing and Hong Kong to defend the peg, because the relevance of Hong Kong is no longer as a shipping port, but as a financial center. The peg reduces volatility, as transactions are essentially dollarized. The relevance of Hong Kong in Asia can be seen by looking at the market capitalization of the Hang Seng index compared to that of the Topix index in Tokyo or the Shanghai Composite index. Any escalation in the US-China trade war, especially in the technology sphere, will only lead to more listings on the Hong Kong stock exchange. Equity flows through the HK-Shanghai and HK-Shenzhen stock connect program are rising, suggesting the market still considers Hong Kong an important intermediary in doing business with China (Chart 13).  On the political front, the most potent risk is that the US Treasury moves to unilaterally limit access to US dollars by Hong Kong banks. While this was discussed by President Trump’s top advisers, it was also dismissed as unwise due to the potential shock to the global financial system. Meanwhile, with massive swap lines with the Fed, Hong Kong’s international banks can always draw on US liquidity. Tariffs on Hong Kong goods are another option, but this again will not really deal a severe blow to the peg, since Hong Kong mainly re-exports, with very little in the way of domestic goods exports (Chart 14). Chart 13Hong Kong Is An Important Financial Center Chart 14Hong Kong Is Partially Insulated From Tariffs   Property Market Blues The property market is the one area in Hong Kong where a sanguine view is difficult to paint. Hong Kong is one of the most unaffordable cities on the planet, and high income inequality has been a reason behind resident angst. The gini coefficient, a measure of inequality in a society, is more elevated in Hong Kong compared to Singapore, China or even South Africa. After years of loose monetary policy, property prices in Hong Kong have completely decoupled from fundamentals. Housing is even more unaffordable now than it was back in 1997, and domestic leverage is very high. With such a high debt stock, even a gradual uptick in interest rates will have a significant impact on the debt service burden (Chart 15). Stocks and real estate prices are positively correlated, suggesting deleveraging pressures will likely be quite high if both unravel (Chart 16). Chart 15High Debt Service Burden##br## In Hong Kong Chart 16Hong Kong Stocks Are Tied To The Property Market However, there are offsetting factors. First, it is unlikely that interest rates in Hong Kong (or anywhere in the developed world for that matter) will rise anytime soon. COVID-19 has provided “carte blanche” in terms of global stimulus. More importantly, the US is at the forefront of this campaign, meaning interest rates in Hong Kong will remain low for a while. Second, in recent history, Hong Kong has proven that it has the resilience to handle volatility in the property markets. During the Asian crisis, property prices fell by 60%, yet no bank went bust. Share prices also collapsed but are much higher today, suggesting the drop was a buying opportunity. And with such a low government debt burden, any systemic threat to banks will nudge the authorities to bail out important companies and sectors. In terms of asset markets, the performance of the Hang Seng index relative to the S&P 500 is purely a function of interest rates. The US stock market is dominated by technology and healthcare that do well when interest rates fall, while banks and real estate dominate the Hong Kong market. So rising rates hurt the US stock market much more than Hong Kong (Chart 17). Meanwhile, the recent turmoil has made Hong Kong assets very cheap relative to its sister-city, Singapore (Chart 18). This suggests that a lot of the potential equity outflows have already occurred, based on today’s situation. Chart 17Interest Rates And The Hong Kong Stock Market Chart 18Hong Kong Has Cheapened Relative To Singapore The Future Of The Peg A peg to the Chinese RMB makes sense. The Hong Kong economy is now heavily tied to the Chinese economy, with over 50% of exports going to China (previously mentioned Chart 3). However, that will sound the death knell for Hong Kong’s status as a financial center, since the US dollar remains very much a reserve currency. There is also a risk that if Beijing uses RMB depreciation as a weapon in a blown-out confrontation with the US in the coming years, it will threaten the sustainability of the HKD peg, since it could inflate asset bubbles. What is more likely is that the option of re-pegging to the RMB comes many years down the road, when the yuan has become a fully convertible currency. The recent turmoil has made Hong Kong assets very cheap relative to its sister-city, Singapore. There is the option to assume another currency board akin to Singapore. This option makes sense, since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. Such an overhaul will require significant technical expertise and political will from both Beijing and Hong Kong. It is not very clear what the cost/benefit outcome would be of this initiative, but it is worth considering since the RMB itself is managed against other currencies. Finally, there is always the option to fully float the peg, but this is likely to increase volatility. As well, for policymakers, it makes sense to continue pegging the exchange rate to the US dollar as it depreciates against major currencies, since it ends up easing financial conditions for Hong Kong concerns.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Special Administrative Region of the People's Republic of China  Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights COVID-19 shutdowns have intensified the pressure on the original “everything stores,” … : A combination of factors has been weighing on department stores since at least the early 2000s. Pandemic store closures have turned up the heat. … and turned an unwelcome spotlight on the future of shopping malls: Bankruptcy filings by anchor tenants pose an existential threat to already struggling malls. Shelter-at-home orders and universal telecommuting have debilitated the fashion industry, further testing malls’ resilience: Apparel retailers account for an estimated 60% of leased mall space, and their struggles are ramping up the pressure on mall operators. City-to-suburb migration may act to accelerate incumbent malls’ decline: Chester County, Pennsylvania has steadily gained wealth and population since the 1970s, but all the legacy malls within a 15-mile radius of the county seat are dead or dying. Feature Dear Client, US Investment Strategy will take its second summer break next week, so there will be no publication on August 24th. We will return on the 31st with Part 2 of the Mallpocalypse series. Best regards, Doug Peta Come On. How Can It Be That Bad? The July 31st episode of BCA’s Friday Conversations webcast series featured a construction executive who expressed the view that a considerable share of America’s enclosed shopping malls has very little value.1 Many malls, he argued, are no longer viable as originally intended and a daunting mix of financial and zoning obstacles stand in the way of repurposing them for other uses. A client in attendance thought we were laying it on a little thick. “Aren’t you being extreme?” he asked. “Why won’t things go back to normal [for enclosed shopping malls] once there’s a vaccine?” Like casinos, malls created a self-contained environment where customers would spend more the longer they stayed, ...  We confess to a weakness for invented mash-up catchphrases that refer to the patently ridiculous (Sharknado) or relentlessly overhyped (the Snowmageddon build up to potential winter storms). It was with tongue in cheek that we titled the webcast “Mallpocalypse,” but this multi-part Special Report is testament to the dire prognosis for much of the stock of US malls. Malls were under pressure well before COVID-19 emerged and they would remain under pressure even if it were already in full retreat. The pandemic has dramatically accelerated weaker malls’ demise, and few of them appear to have a path back to viability. A Brief History Of The Shopping Mall The fully enclosed, temperature controlled Southdale Center in the Twin Cities suburb of Edina, Minnesota was the world’s first shopping mall. Its 1956 opening was front-page news across the national media, which greeted it with rapturous praise. It was designed by Austrian émigré Victor Gruen, who had made his name by reconfiguring New York City’s retail entryways in a way that lured prospective consumers into stores and helped to keep them there. His mall design achieved the same effect on a much greater scale. Southdale positioned 72 stores across two levels joined by escalators and bookended by two branch department store “anchors.” The open floor plan in the body connecting the anchors allowed for unimpeded views of nearly every storefront. “A ‘garden court’ under a skylight, with a fishpond, enormous sculpted trees, a twenty-one-foot cage filled with bright-colored birds, balconies with hanging plants and a café,”2 meant to evoke the feeling of a town square, was set in the center of the mall, inviting visitors to linger. Vast parking lots stood ready to accommodate thousands of their cars (Box 1). Malls revolved around the department store anchors that promised to deliver foot traffic that their rank-and-file tenants wouldn’t find on the high street or in supermarket-anchored shopping centers. Developers couldn’t get bank funding without contractually committed anchors and most mall leases today contain a provision that automatically resets rent lower, or allows tenants to exit their lease without penalty, if multiple anchors close. Per the 2019 10-K for Simon Property Group, the country’s largest mall owner, the rounded average base minimum rent for anchor tenants with leases expiring between 2020 and 2029 ranges from $4 to $8, while the average base minimum rent for inline tenants ranges from $50 to $65. Anchors are the belle of the ball and malls that lose them risk entering a death spiral. Box 1: The ‘70s: If It Ain’t Broke, Don’t Fix It Other developers faithfully followed Gruen’s initial template during the mall building boom from the mid-fifties to 1990. The three malls within a 15-mile radius of my hometown – Concord Mall (Wilmington, DE, opened 1968), Exton Square Mall (Exton, PA, 1973) and Granite Run Mall (Media, PA, 1974) – had every element but swapped out the bright-colored birds for outsized fountains. Concord Mall meant ICEEs in blue and red cups with a cartoon polar bear, Exton Square was Baskin-Robbins’ mandarin chocolate sherbet and Granite Run was large square floor tiles with a beguiling pattern of cross-sectioned stones, but this elementary schooler’s dominant mall impression was the Niagara-like roar of the fountains, which seemed to fill every cubic foot of the area outside the stores. The Long-Running Department Store Crisis The minimum base rent comparison is not quite apples-to-apples, as anchor tenants often own their own spaces, but anchors are malls’ drawing card. As Simon’s 10-K puts it, “our [properties] rely upon anchor tenants to attract customers.” Ideally, an anchor will comfortably fill the two-level bookend spaces and bring a steady stream of consumers who may spend at the stores they pass on the way. Fit is essential: dollar store customers aren’t likely to pony up for luxury brands or the merchandise on offer at high-end boutiques. Gyms and movie theaters can absorb the space, but shopping may not be on their clientele’s agenda. ... and they counted on department stores to lure them inside it. Before the advent of category-killers in the ‘90s, department stores were an ideal anchor. They were trusted well-known brands that shoppers in their area were conditioned to seek out for a broad range of purchases (Box 2). Despite their struggles, department stores remain the go-to anchors at most malls. High-end brands like Neiman Marcus, Nordstrom or Saks might anchor a mall with luxury tenants, while Dillard’s, JCPenney, Lord & Taylor or the ubiquitous Macy’s might anchor a mall seeking a more general clientele. Box 2: The ‘80s: Best. Purchase. Ever. At 19, I ventured to the massive King of Prussia Mall for a post-Christmas department store sale where I wrote my first check with a comma to purchase a floor model Sony rack system (turntable, amplifier, receiver and dual tape deck) and a CD player. The nearly three-foot-high speakers and cabinet were an early concession to marital comity (reciprocated by the gift of higher-end bookshelf speakers) but the amplifier would keep spreading joy until 2012, when it succumbed just three blocks from BCA’s Montreal office to time and the steady thump of Crazy Horse. Unfortunately for mall operators, department stores have been losing ground for at least 25 years and openly reeling for the last ten. The big-box, category-killer stores, like Home Depot, the late Circuit City, Best Buy, Barnes & Noble, Sports Authority and the late Toys ‘R’ Us, reshaped the retail landscape in the ‘90s, ushering in power centers and stealing business from department stores’ more expensive, less specialized and comparatively thinly stocked individual departments. The steady buildup of e-commerce (Chart 1), the shift in popular appeal from suburbia to urban centers and millennials’ celebrated preference for experiences over things contributed to further erosion. Private equity’s foray into the field exacerbated the other pressures. Its modus operandi of levering its portfolio companies up to the gills left the store chains it acquired dangerously unprepared to contend with falling revenues. Chart 1Perpetual Motion Machine A Rotten Time For A Pandemic Many department stores and other retail chains were staggering before a sick bat straggled into a live animal market in Hubei province. The subsequent pandemic has forced a long list of them, including Neiman Marcus, JCPenney and Lord & Taylor, into Chapter 11 to shrink their debt and their cost bases under the protection of the bankruptcy code (Table 1). Several national chains not in bankruptcy are trimming their footprints as well. Nordstrom has announced plans to close a sixth of its locations, and mall stalwart Macy’s (which also owns Bloomingdale’s) wants to shutter 125 of its 850 locations (Table 2). The pandemic has cut a wide swath through apparel retailers, department stores, gyms and restaurants and the toll continues to mount. Table 1Selected Pandemic Retail Bankruptcies Table 2Selected Store Closures Outside Of Bankruptcy Chapter 11 bankruptcy offers struggling businesses a second chance while protecting the interests of senior lenders and secured creditors, but it is cold comfort for unsecured creditors. From a landlord’s perspective at the back of the priority line, the time out that bankruptcy grants an ailing debtor is an excruciating limbo when it is enjoined from initiating eviction proceedings. The landlord collects little, if any, rent and is unable to market the space or spruce it up while the tenant is shielded by the court. The Fashion Industry Was Already A Mess The outlook for department stores is undoubtedly bleak, but the fashion industry, which has relied on department stores’ retail distribution channel, may have it worse. According to a wide-ranging New York Times Magazine cover story,3 the entire fashion ecosystem has been busily devouring itself ever since the financial crisis. Although turmoil in the fashion industry would not typically register with most non-specialist investors, apparel retailers account for around 60% of leased mall space and have become another flash point for mall distress. According to the apparel component of the consumer price index, clothing prices peaked in 1998, rebounded somewhat in 2011 and 2012, and had resumed drifting lower before plunging to 1998 levels in May. The decline in women’s clothing prices has been even more severe, falling 27% from their 1993 peak to slip all the way to 1981 levels (Chart 2). One culprit has been fast fashion. Enabled by social media’s instantaneous dissemination of runway designs, nimble non-luxury retailers like Zara and H&M are able to rush their own versions into production, front-running high-end collections and compelling department stores to discount their own inventory as soon as they receive it. Chart 2Salmon Have It Easier Discounting has been ruinous for the department stores’ apparel margins, as producers’ prices have failed to follow consumer prices lower (Chart 3). Department stores struck back by presenting designers with ridiculously one-sided vendor agreements. Designers reluctantly acquiesced, lest they lose access to the stores’ once-mighty distribution channel and fail to meet their lofty growth targets. Those targets are courtesy of a new breed of investor, eager to discover the next fashion star and ramp his/her operation up to scale immediately. The accelerated timetable pushes fledgling designers to expand well beyond the capacity of their bare-bones organizations and makes an inherently fickle business even more tenuous. Chart 3Rising Production Costs + Falling Prices = A Lot Of Red Ink E-commerce further eroded department stores’ and other brick-and-mortar retailers’ positions, a story with which investors are already familiar. The bottom line is that department stores (Chart 4) and apparel retailers (Chart 5) have been badly lagging the broader market for an extended period. Their relative market performance is consistent with their constituents’ cycling in and out of Chapter 11. Even though they shrink their debt loads and store footprints with every trip to the courthouse, they haven’t been able to do so fast enough to overcome revenue and margin headwinds that show no signs of letting up. Chart 4Gradually, Then Suddenly Chart 5Ex-The Discount Stores, Apparel Retailers Have Gotten Crushed Then the pandemic arrived and nearly the entire white-collar workforce, ex-health care professionals, ceased going to the office or traveling to meet clients in person. For five months and counting, the primary consumers of professional attire have had no reason to wear it, much less buy more. It’s no surprise that Brooks Brothers, Ann Taylor, JoS. A. Bank and Men’s Wearhouse have been among the casualties. Overall sales of clothing fell off a cliff in March, April and May (Chart 6, top panel) but clothing stores fared even worse (Chart 6, bottom panel). Chart 6Apparelocalypse With department store anchors, who occupy approximately 30% of malls’ leasable area, and apparel retailers under siege, mall operators have few places to turn to fill their space. The new breed of anchor stand-ins – fitness centers, movie theaters and entertainment spaces – are not able to open in every state and haven’t been paying rent. Gold’s Gym, 24 Hour Fitness and Chuck E. Cheese have already filed for bankruptcy and the big movie theater chains’ future is deeply uncertain. There’s Gold In Them Thar Hills, But Someone Else Has Already Staked A Claim Green Street Advisors, the leading commercial real estate research and advisory firm, estimates that half of all mall-based department stores will close by the end of 2021. Estimates of the share of malls that will close in the aftermath range from a quarter to a third. If the US has around 1,200 malls, 300 or 400 may soon disappear. Their owners and the entities that have lent to them will recoup only a fraction of their initial investments. If their losses lead to a reduction in the availability of credit, or trigger a self-reinforcing wave of defaults and bankruptcies, they could have a broader macro impact. We will explore the potential macro effects in the next installment of the series. We close this one by noting the sad fate of the ‘70s-era malls within a 15-mile radius of West Chester, Pennsylvania. Granite Run Mall was razed in 2016 and replaced with an open-air mixed-use facility that retained the original mall’s anchor spaces. Concord Mall was sold to a buyer of distressed malls in January, which has yet to disclose its plans for the site. Exton Square Mall, which underwent an ill-fated 2000 expansion that more than doubled its leasable area, is now owned by the ailing publicly traded Pennsylvania Real Estate Trust (PEI). PEI classifies the property as a non-core asset, along with the other two weakest malls in its portfolio. The Chester County mall experience bears on a client question from the July 31st webcast: “People are fleeing cities for the countryside. Isn’t that the opportunity?” Chester County, which has the highest mean household income in Pennsylvania and the 27th highest in the United States, bucks the state’s broader demographic decline. West Chester, the county seat, added a third public high school in 2006; its university has steadily grown enrollment, increasing its share of students in the 14-school State System of Higher Education consortium from 12.1% in 2010-11 to 18.5% in 2019-20; and new highway arteries and commuter rail stations have made it much more feasible for residents to work in Philadelphia, 25 miles to the east, than it was in the ‘70s and ‘80s. Chester County has been a prime suburban development opportunity for 20 or 30 years and commercial and residential developers have been making the most of it, converting acreage formerly devoted to feed corn into high-end housing, office parks, luxury auto dealerships and other commercial uses. It’s not that the market can’t support retail, it’s that it no longer wants 50-year-old spaces that were built to serve a humbler, less affluent constituency. A range of newer open-air options featuring more upscale retailers and restaurants have supplanted Concord, Exton Square and Granite Run. The area has improved; it’s the old nags that couldn’t keep up.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see BCA Research Webcast "Mallpocalypse", from July 31, 2020, available at bcaresearch.com. 2 Gladwell, Malcolm, "The Terrazzo Jungle," The New Yorker, March 15, 2004. 3 Aleksander, Irina. "Sweatpants Forever," The New York Times Magazine, August 9, 2020, pp. 28-33 and 42-43.