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Earnings season is in full swing, and rock bottom expectations for most sectors will prove once again a low bar to surpass. Earnings ultimately matter for stock returns. As a reminder the SPX drubbing in March predicted a collapse in 2020 EPS below $110, and the subsequent 1000 point S&P 500 rebound since the lows signals a return to EPS trend near $162 in 2021. The top panel of the chart shows that this is more or less what the Street expects. Our updated four-factor macro model corroborates this V-shaped rebound in profit growth and should continue to underpin stocks on a cyclical time horizon (bottom panel). In the near-term however, we would be cautious and not chase stocks higher. The steeper the short-term rise in the SPX, the steeper the eventual snapback will be. The risks we are monitoring are the high concentration of returns in a handful of tech titans, the Fed’s balance sheet leveling off, a potential fiscal cliff, and a “blue wave” risk that is not at all priced into equities as we recently posited. Bottom Line: While our cyclically sanguine broad equity market view remains intact, we are cautious in the short-term prospects of the S&P 500, until the election uncertainty lifts in November.    

Two Friday’s ago we highlighted that the tech sector’s (plus FANG: FB, AMZN, NFLX & GOOGL) market cap weight in the SPX was high and rising to uncharted territory near 40%, and such narrowing breadth was a clear risk to the market rally. Today we compare the five tech titans’ market cap weight in the SPX with five GICS1 cyclical sectors (industrials, energy, materials, financials and real estate). The results are staggering: five tech stocks are worth as much as 224 deep and early cyclical stocks in the S&P 500 (top panel). Such high concentration is worrisome and represents a near-term risk to the equity market recovery run. While the drubbing in the 10-year US treasury yield is propelling the tech titans’ forward multiple to the stratosphere (bottom panel), we fear that gravity will sooner-rather-than-later push these stocks back down to earth. NFLX recent earnings fired a warning shot that uncharacteristically high expectations are being built into tech stocks, making them vulnerable to sizable pullbacks. Bottom Line: We remain cautious on the short-term prospects of the S&P 500, until the election uncertainty lifts in November.   ​​​​​​​

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Highlights IG Energy: Investors should overweight Energy bonds within an overweight allocation to investment grade corporate bonds overall. Within IG Energy, the Independent sub-sector should perform best, and we recommend avoiding the higher-rated Integrated space. HY Energy: Investors should overweight high-yield Energy relative to the overall junk index. In particular, investors should focus their exposure on the Independent sub-sector, while avoiding the distressed Oil Field Services space. Feature This week we present part 2 of our two-part Special Report on Energy bonds. Last week’s report showed how to develop a model for Energy bond excess returns (both investment grade and high-yield) based on overall corporate bond index spreads and the oil price.1 This week, we delve deeper into the characteristics of both the investment grade and high-yield Energy indexes to better understand how both are likely to trade in the coming months. Chart 1High-Yield Energy Bond Returns Have Bottomed Chart 2Energy Index Sub-Sector Composition* In this week’s deep dive, we don’t limit ourselves to an examination of the overall Energy index. We also consider the outlooks for its five main sub-sectors: Integrated: Major oil firms that are present along the entire supply chain – from exploration and production all the way down to refined products for consumers. Independent: Exploration & production firms. Oil Field Services: Support services for the Independent sector – notably drilling. Midstream: Transportation (pipelines), storage and marketing of crude oil. Refining Chart 2 shows the share of each sub-sector in both the investment grade and high-yield Energy indexes. Midstream (46%) and Integrated (31%) are the largest sub-sectors in the investment grade index. Independent (48%) and Midstream (36%) are the heavyweights in the high-yield space. Investment Grade Energy Risk Profile Overall, investment grade Energy bonds are highly cyclical. That is, they tend to outperform the corporate benchmark during periods of spread tightening and underperform during periods of spread widening. This cyclical behavior is due to Energy’s lower credit rating compared to the Bloomberg Barclays Corporate index. Sixty five percent of Energy’s market cap carries a Baa rating compared to 59% for the overall index (Chart 3). The sector’s cyclical nature is confirmed by its duration-times-spread (DTS) ratio,2 which is well above 1.0 (Chart 4A). Interestingly, Energy has only been a highly cyclical sector since the 2014-2016 oil price crash. Prior to that, Energy mostly tracked the corporate index’s performance and only slightly underperformed the benchmark during the 2008/09 financial crisis. More recently, Energy underperformed the corporate index dramatically when spreads widened in March, but has outperformed by 936 bps since spreads peaked on March 23 (Chart 4A, panel 3). Energy has only been a highly cyclical sector since the 2014- 2016 oil price crash. Turning to the sub-sectors, the Integrated sub-sector immediately stands out as the only one with a higher average credit rating than the corporate benchmark. Ninety-two percent of Integrated issuers are rated A or Aa (Chart 3). The presence of the global oil majors (Total SA, Royal Dutch Shell, Chevron, Exxon Mobil and BP) is what gives the sub-sector its higher average credit quality and makes it the only defensive Energy sub-sector. Notice that Integrated even proved resilient during the 2014-16 Energy bond turmoil (Chart 4B). The remaining four sub-sectors (Independent, Oil Field Services, Midstream and Refining) all have lower average credit ratings than the corporate index (Chart 3) and all trade cyclically relative to the benchmark with Independent (Chart 4C) and Oil Field Services (Chart 4D) being more cyclical than Midstream (Chart 4E) and Refining (Chart 4F). Interestingly, Independent trades more cyclically than Midstream and Refining despite having a greater concentration of high-rated issuers. This is likely due the fact that Independent (aka Exploration & Production) firms are more dependent on the level of oil prices, and typically require a certain minimum oil price to support capital spending and growth. Meanwhile, crude oil is an input for Refining firms and lower oil prices can boost margins, helping offset some of the negative impact from growth downturns. Chart 3Investment Grade Credit Rating Distributions* Chart 4AIG Energy Risk Profile Chart 4BIG Integrated Risk Profile Chart 4CIG Independent Risk Profile Chart 4DIG Oil Field Services Risk Profile Chart 4EIG Midstream Risk Profile Chart 4FIG Refining Risk Profile   Valuation In terms of value, we find that the Energy sector offers a spread advantage relative to the corporate index and its equivalently-rated (Baa) benchmark (Table 1). This advantage holds up after we control for duration differences by looking at the 12-month breakeven spread. The four cyclical sub-sectors (Independent, Oil Field Services, Midstream and Refining) all also look cheap, whether or not we control for duration differences. Integrated, the sole defensive sub-sector, is roughly fairly valued compared to the equivalently-rated (Aa) benchmark. Table 1IG Energy Valuation Balance Sheet Health The par value of outstanding investment grade Energy debt jumped sharply as oil prices plunged in 2014. But the sector has barely issued any debt since the 2014-16 collapse. Instead, Energy firms have relied on capital spending reductions, asset sales, equity issuance and dividend cuts to raise cash. This shift toward austerity explains why Energy’s weight in the index fell from 11% in 2015 to 8% today (Chart 5A). The median Energy firm’s net debt-to-EBITDA consequently improved between 2017 and 2019, but has once again started to rise as earnings have struggled in recent quarters (Chart 5A, bottom panel). At the issuer level, 15 out of the investment grade index’s 56 Energy issuers currently have a negative ratings outlook from Moody’s (Appendix A). Of the 23 Energy sector ratings that Moody’s has reviewed in 2020, 12 have been affirmed with a stable outlook and 11 were assigned negative outlooks. At the sub-sector level, Integrated debt growth lagged that of the corporate index during the last recovery (Chart 5B). Though the sub-sector has an average credit rating of Aa, most issuers carry negative ratings outlooks, including four of the five global oil majors (Total SA, Royal Dutch Shell, Exxon Mobil and BP). Interestingly, Independent trades more cyclically than Midstream and Refining, despite having a greater concentration of high-rated issuers. The outstanding par value of investment grade Independent debt had been stagnant since 2015, it then plunged this year as three sizeable issuers were downgraded from investment grade to high-yield (Chart 5C). EQT Corp, Occidental Petroleum and Apache Corp were all downgraded during the past few months. They currently account for 21% of the high-yield Energy index’s market cap. Encouragingly, only two of the 16 remaining investment grade Independent issuers currently have negative ratings outlooks. The situation is less favorable for Oil Field Services. This sub-sector’s outstanding debt has remained low since the 2014-16 collapse (Chart 5D), but four of the six investment grade Oil Field Services issuers have negative ratings outlooks. Midstream (Chart 5E) and Refining (Chart 5F) both continued to grow their outstanding debt levels throughout the entirety of the last recovery, including during the 2014-16 period. At present, only three of the 23 investment grade Midstream issuers have negative ratings outlooks, while two of the four Refining issuers have negative outlooks. Chart 5AIG Energy Debt Growth Chart 5BIG Integrated Debt Growth Chart 5CIG Independent Debt Growth Chart 5DIG Oil Field Services Debt Growth Chart 5EIG Midstream Debt Growth Chart 5FIG Refining Debt Growth   Investment Conclusions As per last week’s report, we recommend that investors overweight Energy bonds within their investment grade corporate bond allocations. This recommendation stems from our view that corporate bond spreads will tighten during the next 12 months and that the oil price will rise. As such, we want to favor cyclical investment grade bond sectors that will outperform during periods of spread tightening. With that in mind, we would advise investors to focus their investment grade Energy allocations on the most cyclical sub-sector: Independent. Not only does the Independent sub-sector have the highest DTS ratio of the five sub-sectors, but its weakest credits have already been purged from the index and further downgrades are less likely. Oil Field Services offer less spread pick-up than Independent, and also have a higher proportion of issuers with negative ratings outlooks.  By similar logic, we would avoid the Integrated sub-sector. This sub-sector trades defensively relative to the corporate benchmark and a high proportion of its issuers have negative ratings outlooks. High-Yield Energy Bonds Risk Profile On average, the High-Yield Energy index and the overall High-Yield corporate index have very similar credit ratings. However, the Energy sector has a more barbelled credit rating distribution with a greater proportion of Ba-rated securities (64% versus 55%) and a greater proportion of Ca-C rated issuers (8% versus 1%) (Chart 6). Chart 6High-Yield Credit Rating Distributions* Chart 7AHY Energy Risk Profile It is likely some combination of the larger presence of very low-rated credits and increased oil price volatility that has caused the sector to trade cyclically versus the junk benchmark since 2014 (Chart 7A). Notice that Energy outperformed the junk index during the 2008 sell off, but has since turned cyclical, underperforming in both the 2015/16 and 2020 risk-off episodes. At the sub-sector level, there is currently only one high-yield rated Integrated issuer (Cenovus Energy Inc., Ba-rated, negative outlook). Based on their DTS ratios, the Independent and Oil Field Services sub-sectors are the most cyclical (Charts 7B & 7C). This is because the lower-rated (Caa & below) issuers are concentrated in the these spaces. This is particularly true for Oil Field Services where 41% of the sub-sector’s market cap is rated Caa or below. The Midstream sub-sector also trades cyclically relative to the junk benchmark, but with somewhat less volatility than Independent and Oil Field Services, as evidenced by its DTS ratio of 1.2 (Chart 7D). Refining has traded like a cyclical sector so far this year, but that may not continue now that its DTS ratio has fallen close to 1.0 (Chart 7E). Chart 7BHY Independent Risk Profile Chart 7CHY Oil Field Services Risk Profile Chart 7DHY Midstream Risk Profile Chart 7EHY Refining Risk Profile   Valuation The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes Energy look even more attractive. Energy spreads need to widen by 189 bps during the next 12 months to underperform duration-matched Treasuries. This compares to 93 bps for other Ba-rated issuers and 150 bps for the overall junk index. Table 2HY Energy Valuation Four of the five Energy sub-sectors (Integrated being the exception) also offer attractive value relative to the overall index and their equivalently-rated benchmarks. This remains true after adjusting for duration differences. Balance Sheet Health The high-yield Energy sector has added much more debt than the overall junk index since 2010 (Chart 8A). But of greater concern is that Moody’s has already changed its ratings outlook from stable to negative for 58 Energy issuers since the start of the year. Meanwhile, only 17 high-yield Energy issuers have seen their ratings outlooks confirmed as stable in 2020. Nevertheless, we take some comfort knowing that the Energy sector should benefit from having a large number of issuers able to take advantage of the Federal Reserve’s Main Street Lending facilities. As a reminder, to be eligible for the Main Street facilities issuers must have fewer than 15000 employees or less than $5 billion in 2019 revenue. They must also be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Barated issuers. Of the 61 US high-yield Energy issuers with available data (we exclude 23 foreign issuers that won’t have access to US programs), we estimate that at least 48 are eligible to receive support from the Main Street facilities (Appendix B). This not only includes 15 out of 20 B-rated issuers, but also 12 out of 15 Caa-rated issuers and 4 out of 7 issuers rated below Caa. This broad access is the result of deleveraging that has occurred since the 2014-16 bust (Chart 8A, bottom panel) and it should go a long way toward limiting defaults in the Energy space. The Independent sub-sector’s weight in the index jumped sharply this year, the result of adding three sizeable fallen angels (Chart 8B). Importantly, 24 out of the 28 US Independent issuers appear eligible for Fed support. In contrast, the Oil Field Services sector is in distress. Its weight in the index has been declining for more than a year (Chart 8C), and a large proportion of its issuers are concentrated in lower credit tiers. However, we estimate that out of 19 issuers with available data, 13 are eligible for the Fed’s Main Street Lending facilities. Both Midstream and Refining have high concentrations of Ba-rated issuers and neither has aggressively grown its presence in the index during the past decade (Charts 8D & 8E), though Midstream’s index weight did jump this year. The high credit quality of both indexes means that most issuers will have access to the Main Street facilities, though three of the five Refining issuers are not US based. Chart 8AHY Energy Debt Growth Chart 8BHY Independent Debt GrowthChart 8CHY Oil Field Services Debt Growth Chart 8DHY Midstream Debt Growth Chart 8EHY Refining Debt Growth   Investment Conclusions The conclusion from the model we presented in last week’s report was that high-yield Energy should outperform the junk index during the next 12 months, assuming that overall junk spreads tighten and the oil price rises. However, we remain concerned that, despite the nascent economic recovery, some low-rated Energy names will go bust during the next few months, weighing on index returns. The pattern from the 2014-16 default cycle argues that our concerns may be overblown. In February 2016, high-yield Energy started to outperform the overall junk index slightly after the trough in oil prices and eleven months before the peak in the 12-month trailing default rate (Chart 1 on page 1). If oil prices are indeed already past their cyclical trough, then it may already be a good time to bottom-fish in the high-yield Energy space. The fact that the bulk of high-yield Energy issuers are eligible for support through the Main Street lending facilities tips the scales, and we recommend that investors overweight high-yield Energy relative to the overall junk index. In particular, we think investors should focus on the Independent sub-sector where value is very attractive and most issuers can tap the Fed for help if needed. We would, however, avoid the Oil Field Services sector where the bulk of Energy defaults are likely to come from. Midstream and Refining should perform well, but are less cyclical and less attractively valued than the Independent sub-sector. Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, available at usbs.bcaresearch.com 2 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007.   Appendix A Investment Grade Energy Issuers Appendix B High-Yield Energy Issuers  

Highlights The ultimate extent of credit losses in this cycle is unknown, … : Conventional models are ill-equipped to project the damage that the pandemic will inflict on the economy when monetary and fiscal policymakers are doing all they can to mitigate it. … but household borrowers have held up quite well so far and business borrowers have benefitted from a flood of liquidity: Generous transfer payments have kept household delinquencies in check, the capital markets have allowed bigger companies to pre-fund themselves, and a combination of forbearance and PPP loans has given smaller companies a lifeline. Cash hoards have protected households and businesses, but it is not yet clear when they’ll feel secure enough to spend them: Consumer spending had been on an upward trajectory before rising infection rates forced states to pause or reverse re-opening plans. We remain bullish on the SIFI banks, despite the uncertainty surrounding their outlook: The earnings power of the SIFIs’ franchises has allowed them to build up considerable loan-loss reserves without depleting their capital (ex-Wells Fargo). Stable book values make them too cheap to pass up in an otherwise pricey equity market. Clear As Mud The five largest banks reported their second quarter earnings last week. From the perspective of investing in the banks, the news wasn’t too bad. Excepting beleaguered Wells Fargo (WFC), the SIFI banks and U.S. Bancorp (USB) were able to maintain their per-share book values despite loan-loss reserve increases that exceeded the first quarter’s sizable builds. The results supported our investment thesis: as long as monetary and fiscal policy makers are able to limit the credit fallout from the pandemic, the earnings power of the SIFIs’ franchises can fully offset COVID-19 credit costs, preserving their book values and making their stocks compellingly cheap versus the broad market. Our current investment view aside, we monitor the banks’ calls for insight into the future direction of the economy. The largest banks are always well positioned to observe budding trends in consumption, borrowing and credit performance. They currently also offer a window into the success of policy measures intended to prevent the pandemic from catalyzing a negatively self-reinforcing default spiral. The economic picture the banks painted this quarter was murky, befitting the uncertainty surrounding the virus. They saw activity pick up as social distancing restrictions began to be eased in much of the country in May and June, but the virus’ resurgence (Chart 1) had them stressing that the immediate future is especially uncertain. The tone on this round of calls tended to be cautious, though the CEOs and CFOs acknowledged the potential for positive surprises and allowed that they may well be done building up loan-loss reserves. Chart 1US Daily New Infections The banks’ big-picture observations tended to reinforce each other. One view that they unanimously expressed in their first quarter calls was borne out in the second quarter: the March-April drawdown of corporate credit lines was indeed precautionary, as the draws were largely repaid at every bank once the corporate bond market was able to accommodate new issuance. Debit and credit card spending troughed at all the banks around mid-April and then rose steadily across May and June. Bank of America reported that its customers’ spending had increased on a year-over-year basis over the first two weeks of July. All the banks have been encouraged by the performance of consumer borrowers who have requested deferments or other forbearance measures. It is way too early for conclusions, but lenders have been pleasantly surprised by the sizable share of forbearance borrowers who have managed to keep making payments and the modest share who have requested additional deferments. Perhaps the consumer deferments are analogous to businesses’ drawdowns of credit lines in March and April – an emergency precaution unwound once other help, like aid from the CARES Act, arrived. All the banks set aside more money for future loan losses in the second quarter than they did in the first, and their aggregate reserve build rose by 50% quarter-on-quarter (Table 1). Vigorous reserving hurt this quarter’s earnings, but it will help gird the banks for a more protracted downturn than they foresaw on March 31st. Table 1Stacking Up The Loan Loss Reserve Sandbags The news was very good from an operational standpoint, though it may herald future softness for airlines, hotels and the owners of office and retail space. No bank reported any hiccups in transitioning to servicing their clients and customers remotely. Capital markets activity surged, even as trading floors were empty and million-mile-club investment bankers hunkered down at home. Pandemic shutdowns may point the way to a reduced-overhead future, as banks shrink their branch footprints, lease less office space, trim headcount and pare travel and entertainment budgets. 2Q20 Big Bank Beige Book Household Borrowing (Chart 2) And Spending (Chart 3) Chart 2Consumers Are Paying Down Their Debt Chart 3Whiplash Debit and credit sales volumes … consistently trended upward since the trough in the second week of April to down just 4% year-on-year in the last two weeks of June. T[ravel]&E[ntertainment] and restaurant spend continue to be down meaningfully. The most significant improvement … was in retail, with a strong recovery in credit card volume in the second half of the quarter and consistently strong growth in card-not-present1 volume throughout the quarter. (Piepszak, JPM CFO) [In April, our consumers’] spending was down 26% compared to April of 2019. However, for … June, that spending was relatively flat to 2019. [T]hrough the first couple weeks of July, we’re seeing … spending … above what it was last year. (Moynihan, BAC CEO) All big banks saw similar performance trends from participants in their consumer loan forbearance programs. It's too early to make conclusions, but the preliminary data are encouraging. April saw the lowest level of [auto] loan and lease originations since the financial crisis, but activity rebounded sharply in May and June, and … June [was] the best month for auto originations in our history. (Piepszak, JPM) [R]etail [mortgage] purchase applications … recover[ed] to well above pre-COVID levels in June due to a strong and broad market recovery. (Piepszak, JPM) [A]uto lending … [is] going to be a bright spot [in] the third quarter, but overall consumer lending is likely to be down simply because consumer spending has been down. (Dolan, USB CFO) Consumer credit card spend improved steadily starting in mid-April, but was still down approximately 10% from a year ago as of the end of June. (Shrewsberry, WFC CFO) Lower interest rates drove strong industry [mortgage] volume, with [the] second quarter estimated to [have] the largest origination … since the third quarter of 2003. (Shrewsberry, WFC) Consumer Forbearance Relative to peak levels … at the beginning of April, we’ve seen a significant decline in new [assistance] requests. … [A majority of borrowers requesting assistance] hav[e] made at least one payment while in the forbearance period. … [L]ess than 20% of [credit card] accounts [have] request[ed] additional assistance [after reaching the end of the initial 90-day deferral period]. (Piepszak, JPM) [F]irst-time enrollment volumes have come down significantly. … [R]e-enrollment … rates are running below expectation, … right around … the mid-teens. … [W]e’re seeing good signs of those rolling off [of forbearance] continuing to remain current. (Mason, C CFO) In the last few weeks, [loan deferral requests] have been … 98% below [the] peak [in the first week of April]. … More than 60% of the … card deferrals have made at least one payment[;] [o]ne-third have made every payment every month. (Donofrio, BAC CFO) 70% of customers [with credit card deferrals] have started to make normal payments after [the deferral periods end], … [and] about 20% [have] re-enroll[ed]. … So, so far, so good on the [card deferral] performance. (Runkel, USB Chief Credit Officer) Business (And Bank) Caution [Last quarter’s debt and equity issuance] is pre-funding. This is not capital. All this [cash] is not being raised to go spend. It’s being raised to sit [on] the balance sheet, so that you’re prepared for whatever comes next. And you’ve heard a lot of companies make statements [like] … we’ve got two years of cash, we’ve got three years of cash. [P]eople want to be prepared [for anything]. (Dimon, JPM CEO) [T]he commercial spend has been pretty cautious. It was down [around] … 30-35% in … April … , and it’s still down around somewhere between 25 and 30%. (Cecere, USB CEO) Commercial card spend remained significantly lower throughout the second quarter and was still down over 30% in the last full week of June compared to the same week a year ago, with declines across industry segments. (Scharf, WFC CEO) We’ve added $284 billion in deposits since year-end, [and] all of that has gone into cash, earning 10 basis points. [A]s we assess the future of this pandemic, as we … assess how much of [those deposits] is going to stick around, and we get a little bit more confident … , a portion of that … could be deployed into securities. (Moynihan, BAC) It’s Uncertain Out There [T]he extraordinary actions of the Fed and the Treasury leave … industry models kind of wanting for more insight, [because] we’ve never seen this type of action whether it’s the checks people receive, whether it’s … $500-plus billion [of the PPP], whether it’s the income tax payment holiday. (Corbat, C CEO) We cannot forecast the future. We don’t know. I think you’re going to have a much murkier economic environment going forward than you had in May in June, … which is why … the base case, an adverse case, an extreme adverse case … are all possible. And we’re just guessing the probabilities of those things. That’s what we’re doing. (Dimon, JPM) All the big banks reported that their business clients were proceeding cautiously; the banks themselves are, too, leaving their deposit windfalls in cash until they have a better sense of what's to come. [W]e go in feeling very well positioned against this. But we don’t want people leaving the call simply thinking that the world is a great place and it is a V-shaped recovery. … I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst is absolutely behind us and it’s a rosy path ahead. (Corbat, C) Buy The SIFIs As every SIFI management team stressed on last week’s calls, the environment is extremely uncertain. We are in unchartered waters and regression models can do no more than guess at how monetary accommodation, fiscal aid and lender forbearance will interact with COVID-19 transmission patterns, improved treatments and vaccine development efforts to influence credit performance. Investing in the SIFIs is by no means a slam dunk. The equity market is clearly skeptical about their prospects and our BCA colleagues are in no hurry to join us on the SIFI bandwagon. The group’s unpopularity, however, is precisely why it offers outsized prospective returns. As the longtime investment counselor for one of New York’s wealthiest families put it, “you can have cheap stocks or you can have good news, but you can’t have both.” The news is fraught right now, but we think a critical story line will take a turn for the better once Washington comes through with another major phase of fiscal aid. Given the hole left by consumption (Chart 4) and businesses’ suspended animation, government spending is the only way to keep the economy – and the administration’s faltering re-election prospects – afloat. Chart 4Plunging Consumption Has Left A Gaping Hole In The Economy We are well aware that investors are leery of the banks when low interest rates and a flat yield curve are depressing net interest income, but it’s far more of an issue for community banks that do nothing more than take deposits and make loans than it is for the SIFIs, which generate gobs of fee income and match the duration of their assets and liabilities to the first decimal place. Even the narrow relationship between bank net interest margins and the yield curve is greatly exaggerated (Chart 5), and relative equity returns have had no relationship with the yield curve since the crisis (Chart 6). Banks do not need a major rise in the 10-year yield to outperform; they just need to demonstrate that the earnings power of their franchises is enough to overcome the drag from projected credit losses. Chart 5Little Fundamental Relationship ... Chart 6... And No Market Relationship From our perspective, second quarter earnings provided just that demonstration, at least away from woebegone WFC, which has a raft of intrinsic issues to overcome. Despite two quarters of huge loan-loss reserve builds, the SIFI banks’ book values have emerged unscathed (Table 2). Pre-provision net revenue (PPNR) has been up to the task of absorbing massive write-downs so far this year (Table 3). If the base-case scenarios hold (unemployment doesn’t move materially higher and GDP has begun slowly recovering), the SIFI banks as a group have already accomplished the bulk of their reserve2 building and their per-share book values will grow at a healthy clip for as long as buybacks remain suspended. Table 2SIFI Book Values Table 3Taking The Reserve Builds In Stride Additional credit costs are a legitimate concern, but the banks can earn enough to keep from having to eat into their equity capital. The banks trade off of their book values, and book value gains should feed higher stock prices given that their multiples are already at bombed-out levels. It is unusual to have the chance to buy sound banks at or around their book value, and we expect that investors who buy them now and hold them for at least a year will be amply rewarded in relative performance terms. The SIFIs’ soundness will not be in doubt if Congress delivers a meaningful fourth phase of aid by early August. We believe Citi’s CEO had it right on its first-quarter call in mid-April, and we think his conclusion applies to all the SIFIs, even WFC: [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from [a] capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 A transaction in which the purchaser does not present his/her card to the merchant, typically conducted over the phone or the internet. 2 We are confident that policy makers will be able to continue propping up consumer borrowers, but the business borrower outlook is considerably more uncertain. However, the banks’ earnings calls contained a detail that may suggest that their aggregate loans to businesses got stronger last quarter. Bank loans are typically senior to bonds, and to the extent that last quarter’s massive issuance was aimed at proactively addressing future funding needs, rather than plugging a leak, it made obligations senior to the new bonds better credits. Bank loans to large investment-grade borrowers may be worth a little more than they were at the end of the first quarter.