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Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for 2021 and beyond. Next week, please join me for a webcast on Thursday, December 17 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook. Our publishing schedule will resume early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: The global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain well contained for the next 2-to-3 years before moving sharply higher by the middle of the decade. Global asset allocation: Stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should favor equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. Equities: This year’s losers will be next year’s winners. In 2021, international stocks will outperform US stocks, small caps will outperform large caps, banks will outperform tech, and value stocks will outperform growth stocks. Fixed income: Bond yields will rise modestly next year, implying that investors should maintain below average duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: The US dollar will continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Investors should favor gold over bitcoin as a hedge against long-term inflation risk. I. Macroeconomic Outlook V Is For Vaccine Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Well Below Those Of The Covid-19 Vaccines Ten months after the start of the pandemic, there is a light at the end of the tunnel. Both of the vaccines developed by Pfizer-BioNTech and Moderna using mRNA technology have demonstrated efficacy rates of around 95%. AstraZeneca’s vaccine, produced in collaboration with Oxford University, showed an efficacy rate of 90% in one of its clinical arms. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine (Chart 1). Inoculating most of the world’s population will not be easy. Nevertheless, large-scale vaccine production has already begun. More than half of the professional forecasters enrolled in the Good Judgement Project expect enough doses to be available to vaccinate 200 million Americans (about 60% of the US population) by the end of the second quarter of 2021 (Chart 2). Chart 2Mass Distribution Of Covid-19 Vaccines Expected By Mid-2021 According to opinion polls, public concern about the potential side effects from the vaccines, while still high, has diminished over the past few weeks (Chart 3). Most countries will start by vaccinating health care workers and other at-risk groups. Assuming no major side effects are reported, the successful deployment of the vaccines among health care professionals should bolster confidence within the general public. Chart 3The Public Is Slowly Becoming Less Worried About Covid-19 Vaccines Vaccines And Growth: A Short-Term Paradox? There is no doubt that the availability of a safe and effective vaccine will bolster economic activity over the medium-to-long term. The short-term impact, however, is ambiguous. On the one hand, vaccine optimism could reduce household precautionary savings. It could also prompt more firms to invest in new capacity. On the other hand, the expectation that a vaccine is coming could motivate people to take even greater efforts to avoid getting sick in the interim. Think about what happens when you take cover under a tree after it starts to rain. Your decision to stay under the tree depends on how long you expect the rain to continue. If the rain will last for only 10 minutes, staying put makes sense. However, if it will rain continuously for the next two days, you are better off going home. You are going to get wet anyway. Who wants to get sick just as the pandemic is winding down? It is like being the last soldier killed on the battlefield. Growth In Europe Suffering More Than In The US… So Far The number of new daily cases has declined by 45% in the EU from the highs reached in the second week of November. That said, progress on the disease front has come at a cost. As Covid infections surged, European governments were forced to reimplement a variety of lockdown measures (Chart 4). Correspondingly, growth indicators have weakened across the region (Chart 5). At this point, it looks highly likely that GDP will contract in the euro area and the UK in the fourth quarter. Chart 4The Latest Viral Surge Led To Lockdowns In Europe   In contrast to Europe, the US economy should expand in the fourth quarter. The Atlanta Fed’s GDPNow model is pointing to growth of 11.2% in Q4, led by a recovery in personal consumption, strength in residential and nonresidential investment, and inventory restocking. Nevertheless, dark clouds are forming. After a short-lived dip in late November, the number of new daily cases in the US is on the rise again. The 7-day average of confirmed new cases has jumped to around 200,000. The Centers for Disease Control  (CDC) estimates that for every single case that is caught, seven go undiagnosed.1 This implies that over 11 million people are being infected each week, or about 3% of the US population. With the weather getting colder and the Christmas holiday season approaching, a further viral surge looks probable. Just as in Europe, we may see more lockdowns and more voluntary social distancing in the US over the coming weeks. Building A Fiscal Bridge To A Post-Pandemic World Lockdowns would be less of a problem if governments provided enough income support to struggling households and businesses. Unfortunately, at least in the US, considerable uncertainty remains about whether such support will be forthcoming. After a burst of stimulus earlier this year, US fiscal policy has tightened sharply. Since peaking in April, real disposable personal income has dropped by 9%, reflecting a steep decline in government transfer payments (Chart 6). The latest data suggest that real disposable income will be down in Q4 compared to the preceding quarter. Chart 5Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Chart 6Less Transfers Mean Less Income   President Trump tried to offset some of the sting from the expiration of emergency unemployment benefits in the CARES Act by diverting funds from the Federal Emergency Management Agency (FEMA) to support jobless workers. However, this money has now run out (Chart 7). Likewise, the resources in the Paycheck Protection Program for small businesses have been depleted, and many state and local governments are facing a cash crunch. Chart 7Drastic Drop In Unemployment Insurance Payments Chart 8People Are Eager For More Stimulus The US Congress has been squabbling over a new stimulus bill since May. Ultimately, we think a bill will be passed, potentially as part of a year-end omnibus spending package. Public opinion still very much favors maintaining stimulus. A survey conducted by Pew Research after the election found that about 80% of respondents supported passing a new stimulus package (Chart 8). Similarly, according to a recent NY Times/Siena College poll, 72% of voters supported a hypothetical $2 trillion stimulus package that would extend emergency unemployment insurance benefits, distribute direct cash payments to households, and provide financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Even Republicans Want More Stimulus Peak Chinese Stimulus Even though it originated there, China has weathered the pandemic better than any other major country. Chinese export growth accelerated to 21.1% year-over-year in November. The Caixin manufacturing PMI rose to 54.9 on the month, the strongest reading since November 2010. The service sector PMI increased to a healthy 57.8. The “official” PMIs published by the National Bureau of Statistics also rose. Chinese growth will moderate over the coming months. The magnitude of China’s policy support has peaked, as evidenced by the rise in bond yields and interbank rates (Chart 9). The authorities have also permitted more corporate issuers to default, while tightening rules on online lending. Turning points in Chinese domestic demand and imports tend to lag policy developments by about 6-to-9 months (Chart 10). Thus, the tailwind from Chinese stimulus should fade by the middle of next year, hopefully just in time for the baton to be passed to a more organic, vaccine-driven global growth recovery. Chart 9China: Bond Yields And Interbank Rates Have Been Rising Chart 10Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Japan: Near-Term Wobbles Japan is in the midst of its third wave of the pandemic. While not as bad as the latest waves in the US and Europe, it has still been disruptive enough to slow the economy. Although it did tick up in November, the manufacturing PMI remains below the crucial 50 boom/bust line, notably weaker than in other APAC countries. The outlook component of the Economy Watchers Survey fell to 36.5 in November (from 49.1), while the current situation component slid to 45.6 (from 54.5). Nevertheless, there are some encouraging signs. The number of new Covid cases seems to be stabilizing. Machine tool orders rose to 8% year-over-year in November, the first positive print since September 2018. Retail sales have recovered from a low of -14% year-over-year in April to around +6% in October. Broad money growth has reached a record high. The Japanese government is also considering a new ¥73 trillion fiscal stimulus package to fight the pandemic. Global Monetary Policy To Stay Accommodative Chart 11Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Could a vaccine-led economic recovery cause central banks to remove the punch bowl? We think not. Inflation is likely to rise in the first half of 2021 as the “base effects” from the pandemic-induced drop in prices reverse. However, central banks will see through these short-term oscillations in inflation. Inflation in modern economies is largely driven by services and shelter (goods account for only 25% of the US core CPI and 37% of the euro area core CPI). Both service inflation and shelter inflation tend to be largely determined by labor market slack (Chart 11). In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the main developed economies would fall back to its full employment level by around 2025 (Chart 12). While this is too pessimistic in light of the subsequent progress that has been made on the vaccine front, it is probable that unemployment will remain too high to generate an overheated economy for the next 2-to-3 years. Chart 12Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Chart 13Long-Term Inflation Expectations Are Still Subdued   Moreover, despite vaccine optimism, long-term inflation expectations are still below target in most of the major economies (Chart 13). Not only do central banks want inflation to return to target, they want inflation to overshoot their targets in order to make up for the shortfall in inflation in the post-GFC era. Had the core PCE deflator in the US risen by 2% per year since 2012, the price level would be about 3.3% higher than it currently is. In the euro area, the price level is about 9.5% below where it would have been if consumer prices had risen by 2% over this period. In Japan, the price level is 11.6% below target (Chart 14). Chart 14Central Banks Have Missed Their Inflation Targets II. Financial Markets A. Global Asset Allocation Remain Overweight Equities Versus Bonds On A 12-Month Horizon Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 15). This makes equities vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Stronger economic growth should lift earnings estimates. Stocks have usually outperformed bonds when growth has been on the upswing (Chart 16). Chart 15A Lot Of Bullishness Chart 16Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Valuations also favor stocks. As Chart 17 illustrates, the global equity risk premium – which we model by subtracting real bond yields from the cyclically-adjusted earnings yield – remains quite high. Along the same lines, dividend yields are above bond yields in the major markets. Even if one were to pessimistically assume that nominal dividend payments stay flat for the next 10 years, real equity prices would have to fall by 24% in the US for stocks to underperform bonds (Chart 18). In the euro area, real equity prices would need to tumble 32%. In Japan, they would have to drop 20%. Chart 17Equity Risk Premia Remain Elevated Chart 18Stocks Would Need To Fall A Lot For Equities To Underperform Bonds As such, investors should overweight global equities relative to bonds. We recommend a neutral allocation to cash to take advantage of any short-term dip in stock prices. Our full suite of asset allocation and trade recommendations are shown at the back of this report.   B. Equity Sectors, Regions, Styles This Year’s Losers Will Be Next Year’s Winners The “pandemic trade” is giving way to the “reopening trade.” We are still in the early innings of this transition. Hence, going into next year, it makes sense to favor stocks that were crushed by lockdown measures but could thrive once restrictions are lifted. Chart 19 shows relative 12-months forward earnings estimates for US/non-US, large caps/small caps, and tech/overall market. In all three cases, the tables have turned: Estimates are now rising more quickly for non-US stocks, small caps, and non-tech sectors. Non-US Stocks To Outperform Stocks outside the US are significantly cheaper than their US peers based on price-to-earnings, price-to-book, price-to-sales, and dividend yields (Chart 20). The macro outlook also favors non-US stocks, which tend to outperform when global growth is strengthening and the US dollar is weakening (Chart 21). Chart 19Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving   Chart 20Non-US Stocks Are Cheaper Chart 21Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening As we discuss below, the dollar is likely to depreciate further over the next 12 months. A weaker dollar benefits cyclical sectors of the stock market more than defensives (Chart 22). Deep cyclicals are overrepresented outside the US (Table 2). Being more cyclical in nature, small caps usually outperform when the dollar weakens (Chart 23). Chart 22Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Chart 23Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens   Chart 24Banks’ Net Interest Margins Will Receive A Boost Buy The Banks Banks comprise a larger share of non-US stock markets. Stronger growth in 2021 will put upward pressure on long-term bond yields. Since short-term rates will stay where they are, yield curves will steepen. Steeper yield curves will boost banks’ net interest margins (Chart 24).   In addition, faster economic growth will put a lid on defaults. Banks have set aside considerable capital for pandemic-related loan losses. Yet, the wave of defaults that so many feared has failed to materialize. According to the American Bankruptcy Institute, commercial bankruptcies are lower now than they were this time last year (Chart 25). Personal loan delinquencies have also been trending down. The 60-day delinquency rate on credit card debt fell to 1.16% in October from 2.02% a year earlier. The delinquency rate for mortgages fell from 1.54% to 0.98%. Only auto loan delinquencies registered a tiny blip higher (Table 3). Chart 25Commercial Bankruptcies Are Well Contained Table 3Personal Loan Delinquencies Have Also Been Trending Lower Just A “Value Bounce”? In our conversations with clients, many investors are open to the idea that value stocks are due for a cyclical bounce. However, most still believe that growth stocks will fare best over a longer-term horizon. Such a view is understandable. After all, profit growth is the principal driver of equity returns. If, by definition, growth companies enjoy faster earnings growth, does it not stand to reason that growth stocks will outperform value stocks over the long haul? Well, actually, it doesn’t. What matters is profit growth relative to expectations, not absolute profit growth. If earnings rise quickly, but by less than investors had anticipated, stock prices could still go down. Historically, investors have tended to extrapolate earnings trends too far into the future, which has led them to overpay for growth stocks. Chart 26 demonstrates this point analytically. It features the results of a study by Louis Chan, Jason Karceski, and Josef Lakonishok. The authors sorted companies by projected five-year earnings growth and then compared the analysts’ forecasts with realized earnings. For the most part, they found that there was no relationship between expected profit growth and realized profit growth beyond horizons of two years. In general, the higher the long-term earnings growth estimates, the more likely actual earnings were to miss expectations. Chart 26Investors Tend To Overpay For Growth The Paradox Of Growth Given the difficulty of picking individual stocks that will consistently surpass earnings estimates, should investors simply allocate the bulk of their capital to sectors such as technology that have the best long-term growth prospects while eschewing structurally challenged sectors such as energy and financials? Again, the answer is not as obvious as it may seem. As Chart 27 illustrates, stocks in industries that experience a burst of output growth do tend to outperform other stocks. However, over the long haul, companies in fast growing industries do not outperform their peers (Chart 28). In other words, stock prices seem to respond more to unanticipated changes in industry growth rather than to the trend level of growth. Chart 27Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … Chart 28… But Over The Long Haul, Companies In Fast-Growing Industries Do Not Outperform Their Peers Explaining Tech Outperformance In this vein, it is useful to examine what has powered the performance of US tech stocks over the past 25 years. Chart 29 shows that faster sales-per-share growth explains less than half of tech’s outperformance since 1996 and none of tech’s outperformance in the period up to 2011. The majority of tech’s outperformance is explained by greater margin expansion and an increase in the P/E ratio at which tech stocks trade relative to the rest of the stock market. Chart 29Decomposing Tech Outperformance What accounts for the significant increase in tech profit margins? In two words, the answer is “monopoly power.” Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. Normally, structurally fast-growing industries attract more competition, which increases the odds that up-and-coming firms will displace incumbents. The growth of tech monopolies has subverted that process, allowing profits to rise significantly. A Tougher Path Forward For Tech A key question for investors is how much additional scope today’s tech monopolies have to expand profits. While it is difficult to generalize, two broad forces are likely to curtail future earnings growth. First, many tech titans have become so big that their future growth will be driven less by their ability to take market share from competitors and more by the overall size of the markets in which they operate. As it is, close to three-quarters of US households have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Second, the monopoly power wielded by tech companies makes them vulnerable to governmental action, including higher taxes, increased regulation, and stronger anti-trust enforcement. Importantly, it is not just the left that wants greater scrutiny of tech companies. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of the tech sector (Chart 30). Chart 30Conservatives Favor Increased Government Regulation Of Big Tech Companies We do not expect tech stocks to decline in absolute terms since they still have a variety of tailwinds supporting them. Nevertheless, our bet is that the cyclical shift in favor of value stocks we are seeing now will usher in a period of outperformance for value names that could last for much of this decade. Not only are value stocks exceptionally cheap compared to growth stocks (Chart 31), but as we discuss below, bond yields likely reached a secular bottom this year. This could set the stage for a period of lasting outperformance for value plays. Chart 31Value Stocks Are Extremely Cheap Relative To Growth Stocks C. Fixed Income Position For Steeper Yield Curves As discussed earlier, central banks are unlikely to raise rates over the next 2-to-3 years. In fact, short-term real rates will probably decline further in 2021 as inflation expectations rise towards central bank targets. What about longer-term bond yields? Chart 32 displays the expected path of policy rates in the major developed economies now and at the start of 2020. The chart suggests that there is still scope for rate expectations in the post-2023 period to recover some of the ground they have lost since the start of the pandemic. This implies that bond investors should position for steeper yield curves, while keeping duration risk at below-benchmark levels. They should also favor inflation-linked securities over nominal bonds. Chart 32Policy Rate Expectations Remain Below Pre-Pandemic Levels Avoid “High Beta” Government Bond Markets The highest-yielding bond markets tend to have the highest “betas” to the general direction of global bond yields (Chart 33). This means when global bond yields are rising, higher-yielding markets such as the US usually experience the biggest selloff in bond prices. Chart 33High-Yielding Bond Markets Are The Most Cyclical This pattern exists because faster growth has a more subdued impact on rate expectations in economies such as Europe and Japan where the neutral rate of interest is stuck deep in negative territory. For example, if stronger growth lifts the neutral rate in Japan from say, -4% to -2%, this would still not warrant raising rates. In contrast, if stronger growth lifts the neutral rate from -1% to +1% in the US, this would eventually justify a rate hike.  As such, we would underweight US Treasurys in global government bond portfolios. We expect the 10-year Treasury yield to increase to around 1.3%-to-1.5% by the end of 2021, which is above current expectations of 1.15% based on the forward curve. Conversely, we would overweight European and Japanese government bond markets. After adjusting for currency-hedging costs, US Treasurys offer only a small yield pickup over European and Japanese bonds but face a much greater risk of capital losses as rate expectations recover (Table 4). Table 4Bond Markets Across The Developed World BCA’s global fixed-income strategists have a neutral recommendation on Canadian and Australian bonds. While Canadian and Australian yields are also “high beta,” both the BoC and the RBA are very active purchasers in their domestic markets. Stay Overweight High-Yield Developed Market Corporate Debt In fixed-income portfolios, we would overweight corporate debt relative to safer government bonds. In an economic environment where monetary policy remains accommodative and growth is rebounding, corporate default rates should remain contained, which will keep spreads from widening. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over euro area bonds. The former trade with a higher yield and spread than the latter (Charts 34A & B). Chart 34AFavor High-Yield Bonds Over Investment-Grade ... Chart 34B… And US Corporates Over Euro Area One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit product starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the 62nd percentile, which is quite enticing. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 35). Chart 35Corporate Bond Breakeven Spread Percentile Rankings Outside the corporate sector, our US bond strategists like consumer ABS due to the strength of household balance sheets. They also see value in municipal bonds. However, they would avoid MBS, as prepayment risks are elevated in that sector. EM credit should also benefit from the combination of stronger global growth and a weaker US dollar. Long-Term Inflation Risk Is Underpriced As noted earlier in the report, inflation is unlikely to rise significantly over the next three years. Beyond then, a more inflationary environment is probable. Chart 36 shows that the wage-version of the Phillips curve in the US is alive and well. It just so happens that over the past three decades, the labor market has never had a chance to overheat. Something always came along that derailed the economy before a price-wage spiral could develop. This year it was the pandemic. In 2008 it was the Global Financial Crisis. In 2000 it was the dotcom bust and in the early 1990s it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a true “exogenous” shock. The prior three recessions were endogenous in nature to the extent that they were preceded by growing economic imbalances, laid bare by a Fed hiking cycle. One can debate the degree to which the global economy is suffering from imbalances today, but one thing is certain: no major central bank is keen on raising rates anytime soon. Central banks want higher inflation. They are likely to get it. D. Currencies, Commodities, And Yes, Bitcoin Dollar Bear Market To Continue In 2021 The dollar faces a number of headwinds going into next year. First, interest rate differentials have moved significantly against the greenback. At the start of 2019, US real 2-year rates were about 190 basis points above rates of other developed economies; today, US real rates are around 60 basis points lower than those abroad. In fact, as Chart 37 shows, the trade-weighted dollar has weakened less than one would have expected based on the decline in interest rate differentials. This suggests that there could be some “catch-up” weakness for the dollar next year even if rate differentials remain broadly stable. Chart 36Is The Phillips Curve Really Dead? Chart 37A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Second, the US dollar is a counter-cyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 38). If the global economy strengthens next year thanks to an effective vaccine, the dollar should weaken. Chart 38The Dollar Is A Countercyclical Currency Chart 39USD Remains Overvalued Third, the US dollar remains about 13% overvalued based on Purchasing Power Parity (PPP) exchange rates (Chart 39). This overvaluation is also reflected in the large US current account deficit, which rose in the second quarter to the highest level since 2008 and is on track to swell even further in the second half of the year. Technicals Are Dollar Bearish Admittedly, many investors are now bearish on the dollar. Shouldn’t one be a contrarian and adopt a bullish dollar view? Not necessarily. In most cases, being contrarian makes sense. However, this does not apply to the dollar. The dollar is a high-momentum currency (Chart 40). When it comes to trading the dollar, it pays to be a trend follower. Chart 40The Dollar Is A High Momentum Currency One of the simplest and most profitable trading rules for the dollar is to go long the greenback when it is trading above its moving average and go short when it is trading below its moving average (Chart 41). Today, the trade-weighted dollar is trading below its 3-month, 6-month, 1-year, and 2-year moving averages. Along the same lines, the dollar performs best when sentiment is bullish and improving. In contrast, the dollar does worse when sentiment is bearish and deteriorating, as it is now (Chart 42). Chart 41Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Chart 42Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (II) The bottom line is that both fundamental factors – interest rate differentials, global growth, valuations, current account dynamics – and technical factors – moving average rules and sentiment – all point to dollar weakness next year. Top Performing Currencies In 2021 EUR/USD is likely to rise to 1.3 by the middle of next year. The ECB does not want a stronger currency, but with euro area interest rates already in negative territory, there is not much it can do. The Swedish krona, as a highly cyclical currency, should strengthen against the euro. In contrast, the Swiss franc, a classically defensive currency, will weaken against the euro. It is more difficult to forecast the direction of the pound given uncertainty about ongoing Brexit talks. The working assumption of BCA’s geopolitical team is that Prime Minister Boris Johnson has sufficient economic and political incentives to arrive at a trade deal, a parliamentary majority to get it approved, and a powerful geopolitical need to mollify Scotland. This bodes well for sterling. The yen is a very defensive currency. Thus, in an environment of strengthening global growth, the yen is likely to trade flat against the dollar, and in the process, lose ground against most other currencies. We are most bullish about the prospects for EM and commodity currencies going into next year. China is likely to let its currency strengthen further in return for a partial rollback of tariffs by the Biden administration. A stronger yuan will allow other currencies in Asia to appreciate. Stay Bullish On Commodities And Commodity Currencies The combination of a weaker US dollar and stronger global growth should support commodity prices in 2021. Industrial metals outperformed oil this year, but the opposite should be true next year. Chart 43Oil Prices Are Expected To Recover While the long-term outlook for crude is murky in light of the shift towards electric vehicles, the near-term picture remains favorable due to the cyclical rebound in petroleum demand and ongoing OPEC and Russian supply discipline. BCA’s commodity strategists expect the average price of Brent to exceed market expectations by about $14 in 2021, which should help the Norwegian krone, Canadian dollar, Russian ruble, Mexican peso, and Colombian peso (Chart 43). Favor Gold Over Bitcoin As An Inflation Hedge Gold has traditionally served as the go-to hedge against inflation. These days, however, there is a new competitor in town: bitcoin. In traditional economic parlance, money serves three purposes: as a medium of exchange; as a unit of account; and as a store of value. Both gold and bitcoin flunk the test for the first two purposes. Few transactions are conducted in either gold or bitcoin. It is even rarer for prices of goods and services to be set in ounces of gold or units of bitcoin. Gold arguably does better as a store of value. It has been around for a long time and if all else fails, it can always be melted down and turned into nice jewelry. Bitcoin’s Achilles Heel Bitcoin’s defenders argue that the cryptocurrency does serve as a store of value because one day, it will reach a critical mass that will make it a viable medium of exchange and a functional unit of account. Yet, this argument is politically naïve. Countries with fiat currencies derive significant benefits from their ability to create money out of thin air that can then be used to pay for goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. The existence of fiat currencies also gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin’s ability to facilitate anonymous transactions is also its Achilles heel. The widespread use of bitcoin would make it more difficult for governments to tax their citizens. All this suggests that bitcoin will never reach a critical mass where it becomes a viable medium of exchange or functional unit of account. Governments will step in to ban or greatly curtail its usage before then. And without the ability to reach this critical mass, bitcoin’s utility as a store of value will disappear. Hence, investors looking for some inflation protection in their portfolios should stick with gold. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Heather Reese, A. Danielle Iuliano, Neha N. Patel, Shikha Garg, Lindsay Kim, Benjamin J. Silk, Aron J. Hall, Alicia Fry, and Carrie Reed, “Estimated incidence of COVID-19 illness and hospitalization — United States, February–September, 2020,” Clinical Infectious Diseases (Oxford Academic), November 25, 2020. Global Investment Strategy View Matrix Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Current MacroQuant Model Scores

Highlights According to betting markets, Joe Biden is likely to become the 46th US president, with the Republicans maintaining control of the Senate. Such a balance of power could produce less fiscal stimulus than any of the other possible outcomes that were in play on Tuesday. Nevertheless, public opinion still favors a more expansionary fiscal policy. There is also an outside chance that Republicans in the Senate and Democrats in the House could craft a “grand bargain” that raises spending while making Trump’s corporate tax cuts permanent. The combination of continued easy monetary policy, modestly looser fiscal policy, and progress on a vaccine should be enough to keep global growth on an above-trend path next year. Bank shares have been the big losers since the election, but should start to outperform as yield curves re-steepen, worries about soaring bad loans subside, and lending growth outpaces bleak expectations. Investors should remain overweight global equities versus bonds. Be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting. Another Election Rollercoaster Last week, we highlighted that BCA’s geopolitical quant model was predicting a much closer election than most pundits were expecting. This indeed turned out to be the case. For a brief while on Tuesday night, betting markets were giving Donald Trump a greater than 75% chance of being re-elected. Unfortunately for the president, the good news did not last long. As more mail-in ballots and ballots cast in large urban areas were counted, the needle began to swing towards Joe Biden. At the time of writing, betting markets are giving Biden an 88% chance of becoming President. Trump still has a chance of winning, but assuming he loses Nevada, Michigan, and Wisconsin, he would need to win Pennsylvania, Arizona, and Georgia. That is a tall order. According to PredictIt, the latter three states are all leaning towards Biden (Chart 1). Chart 1The Distribution Of Electoral College Votes According To Betting Markets More positively for the GOP, the Republicans gained a net six seats in the House of Representatives, and held onto the Senate thanks to surprise victories for their candidates in Maine and North Carolina. That said, the Senate could still revert to Democratic hands depending on the final vote tally in Georgia, North Carolina, and Alaska; PredictIt assigns a 22% probability to the Democrats taking the Senate. Moreover, even if they fall short this time around, the Democrats still have a chance of winning a 50-seat de facto majority in the Senate if both Georgia races go to a run-off election on January 5. Stimulus In Peril? Assuming that Republicans maintain their majority in the Senate, tax hikes will remain off the table. This is good for stocks. Joe Biden would also lower the temperature on trade tensions with China. This, too, is good for stocks. Conversely, the odds of a major fiscal stimulus package have dropped. Donald Trump is not averse to big spending programs. In contrast, the Republicans in the Senate have rejected calls for a large stimulus bill. With Joe Biden as President, Republican senators would have even less incentive to give the Democrats what they want. Nevertheless, there are three reasons to think that Republicans will agree on a new stimulus bill. First, the economy needs it. While US growth should remain reasonably firm in the fourth quarter, this is only because households were able to build up some savings earlier this year which they can now draw on. As Chart 2 shows, since April, labor earnings have only grown one-third as much as personal spending. Transfer income has also plunged, resulting in a renewed drop in savings. Once households run out of accumulated savings, there is a risk that they will cut back on spending. Second, government borrowing rates remain extremely low by historic standards. Real rates are negative across the entire yield curve (Chart 3). Chart 2Savings Have Dropped Since April As Transfers Declined Chart 3Real Rates Are Negative Across The Entire Yield Curve   Third, and perhaps most politically salient, public opinion favors more expansionary fiscal policy. About 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. It is noteworthy that when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Strong Support For Stimulus All this suggests that Republicans will accede to a medium-sized stimulus bill in the neighbourhood of $700 billion-to-$1 trillion in order to avoid being perceived as stingy and obstructionist. Senate Majority Leader Mitch McConnell noted on Wednesday that getting a deal done was “job one.” While not our base case, a significantly larger bill is also possible. Most Republicans are not opposed to bigger budget deficits per se. It is increased social spending that they do not like. Budget deficits in the service of tax cuts are perfectly acceptable to the majority of Republicans. This raises the possibility that Republicans in the Senate and Democrats in the House could strike a grand bargain that raises spending while also promising additional tax relief. Most of Trump’s corporate tax cuts expire in 2025. A sizeable stimulus bill that makes these tax cuts permanent while increasing long-term spending on infrastructure, health care, education, and other Democratic priorities could still emerge from a divided Congress.   Wall Street Versus Main Street If one needed any more proof that what is good for Wall Street is not necessarily good for Main Street, the last three trading days provided it. The S&P 500 is up 6% since Monday’s close, spurred on by the reassurance that corporate taxes will not rise. In contrast, the 10-year bond yield has fallen 8 basis points on diminished prospects for a big stimulus package. The drop in bond yields since the election has raised the present value of corporate cash flows, leading to higher equity valuations. Growth companies have benefited disproportionately from falling bond yields. In contrast to value companies, investors expect growth companies to generate the bulk of their earnings far in the future. This makes their valuations highly sensitive to changes in discount rates. It is not surprising that tech shares – the FAANGs in particular – soared following the election (Chart 4). Chart 4Growth Equities Benefited Disproportionately From A Post-Election Drop In Yields A Bottom For The Big Banks? Bank shares tend to be overrepresented in value indices. Unlike tech, banks normally lose out when bond yields fall. As Chart 5 shows, net interest margins have collapsed for banks this year as bond yields have cratered. The drop in yields since the election has further punished bank shares. Chart 5Bank Net Interest Margins Have Collapsed As Bond Yields Have Cratered This Year Chart 6Commercial Bankruptcy Filings Remain In Check Yet, as our earlier discussion suggests, bond yields could rise again if the US Congress delivers more stimulus than currently expected. This would help banks, while potentially taking some of the wind from the sails of tech stocks. The combination of further fiscal easing and a vaccine next year could help banks in another way. If the global economy bounces back, banks would suffer fewer loan defaults. The biggest US banks have set aside more than $60 billion to cover potential loan losses. They have done so even though commercial bankruptcies have declined so far this year (Chart 6). A stronger economy would allow banks to release some of those provisions back into earnings.   Bank Regulation Is Not A Major Worry Anymore Wouldn’t the potential benefits to banks from more fiscal support and higher bond yields be outweighed by a greater regulatory burden under a Biden administration? Probably not. For one thing, a Republican Senate could block legislation that expanded regulation. Moreover, Biden hails from Delaware, a state that derives more than a quarter of its GDP from the finance and insurance sectors. He was only one of two Democrats on the Senate Judiciary Committee to vote in favor of the 2005 bankruptcy bill that made it more difficult for households to discharge their debts. It should also be stressed that most of the regulatory reforms that the Democrats sought after the financial crisis have already been encoded in the Dodd-Frank Act. The Act was passed during the Obama administration. While the Trump administration did water down some of its provisions, the changes were modest and had bipartisan support. Big Banks Are More Resilient Than Small Ones Today, US banks are better capitalized than they were in the years leading up to the financial crisis (Chart 7). The largest banks – the so-called Systemically Important Financial Institutions (SIFIs) – are required to hold an additional capital buffer, which arguably makes them even safer. Unlike the smaller regional banks, the SIFIs have only modest exposure to the troubled commercial real estate sector. As my colleague Jonathan LaBerge has documented, big banks have only 6% of their assets tied up in commercial real estate compared to 25% for smaller banks (Table 2). Chart 7US Banks: Better Capitalized Today Than Right Before The Financial Crisis Table 2Most US Commercial Real Estate Loans Are Held By Small Banks The largest US banks have more exposure to residential real estate than to commercial real estate. The US housing market has been firing on all cylinders recently. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales are near cycle highs. The S&P/Case-Shiller 20-city home price index rose 5.2% in August, up from 4.1% in July. The FHFA index surged 8.1% in August over the prior year. Homebuilder confidence hit a new record in October (Chart 8). Homebuilder stocks are up more than 20% versus the broad market this year. Chart 8US Housing Market: Firing On All Cylinders According to TransUnion, consumer delinquencies have been trending lower across most loan categories (Table 3). Notably, the 60-day delinquency rate on residential mortgages stood at 1% in September, down from 1.5% the same month last year. Table 3A Snapshot Of Consumer Delinquencies The Forbearance Time Bomb? Some investors have expressed concern that various pandemic-related forbearance programs are distorting the delinquency data. Reassuringly, that does not appear to be the case. Summarizing the results from the latest round of earnings calls with top bank executives, BCA’s Chief US Investment Strategist Doug Peta wrote: “Last week’s calls assuaged our concerns … It now appears that consumer requests for forbearance at the outset of the COVID-19 outbreak were analogous to businesses’ credit line draws: exercises of emergency options that turned out not to be necessary, and are on their way to being unwound with little ado.”1 Banks Are Cheap From a valuation perspective, relative to the broad market, US banks trade at one of the largest discounts on record on both a price-to-book and price-to-earnings basis (Chart 9). Earnings estimates are also starting to move in the banks’ favor. Relative 12-month forward earnings estimates for US banks are trending higher even against the tech sector (Chart 10). This largely reflects the expectation that bank earnings will grow more quickly than other sectors in 2021/22. Chart 9Bank Stocks Are Cheap Chart 10Bank Earnings Estimates Are Catching Up   A Few Words About Global Banks Chart 11Euro Area Banks Have Fared Especially Badly Since The GFC Chart 12Banks: A Low Bar For Success Banks in a number of markets outside the US face greater structural challenges than their US counterparts. Most notably, euro area bank earnings remain well below their pre-GFC highs (Chart 11). That said, investors are not exactly expecting European bank profits to recover to their glory days anytime soon. Chart 12 shows that if euro area bank EPS were to simply go back to last year’s levels, banks would trade at 5.4-times earnings. This implies a very low bar for success. Investment Conclusions Stocks have run up a lot over the past few days on fairly weak breadth. A short-term pullback would not be surprising. Nevertheless, investors should remain overweight global equities versus bonds over a 12-month horizon. The combination of ongoing fiscal and monetary support, together with a vaccine, will buoy global growth. As Chart 13 shows, it’s rare for stocks to underperform bonds when the global economy is strengthening. Chart 13Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 14Value Stocks Typically Do Well When Economic Activity Is Picking Up   Value stocks typically do well when economic activity is picking up (Chart 14). That said, we are less sure about when the inflection point in the value/growth trade will arrive. As we have noted before, the “pandemic trade” benefits growth stocks, while the “reopening trade” benefits value stocks. For now, the number of new infections has not shown signs of peaking in either the US or Europe (Chart 15). Investors should continue monitoring the daily Covid data and be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting.   Chart 15The Number Of New Cases Continues To Rise Globally... But Mortality Rates Are Lower Than Earlier This Year Chart 16The Dollar Is A Countercyclical Currency As a countercyclical currency, the dollar should weaken next year as policy remains accommodative and pandemic risks recede (Chart 16). EM Asian currencies are especially appealing. A hiatus in the trade war should allow the Chinese yuan to strengthen even further. This will drag other regional currencies higher. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, October 2020,” dated October 19, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Neutral – Downgrade Alert Banks hit all-time lows again this week on the back of mixed profit results. While Q3 loan loss reserves will rise albeit at a slower pace than H1/2020, net interest income ails and difficulty in growing revenues are significant offsets. This backdrop makes banks hostage to the 10-year US Treasury yield (top panel). With regard to fiscal stimulus and economic uncertainty, Jamie Dimon recently warned that “If the double-dip (recession) happens, we would be under-reserved by $20 billion.” Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket. Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watchlist. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT. For more details, please refer to this Monday’s Weekly Report.  

Dear client, Next Monday, October 19, we will be hosting our quarterly webcast, “From Alpha To Omega With Anastasios”, at 10am EST; Matt Gertken, BCA’s Geopolitical Strategist will be our guest on the eve of the US Presidential Election. Our regular weekly publication will resume on Monday October 26, 2020. Kind Regards, Anastasios Highlights Portfolio Strategy Homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. While the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index.  Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities seesawed last week as President Trump returned to the White House (WH) and injected fresh volatility in markets signaling that there will be no fiscal deal prior to the elections. The SPX immediately gapped down and we cannot stress enough the importance of our newly configured Fiscal Policy Loop: fiscal hawkishness causes skittishness in markets culminating to a classic BCA riot point and then policymakers relent and fiscal dovishness restores the equity bull market (Figure 1). While we cannot rule out a slimmed-down stimulus package deal by later this month, fiscal policy- and election-related uncertainties remain elevated. The daily back-and-forth on where Congress and the WH stand with passing a new stimulus bill coupled with the prospects of a contested election that would drag on the presidential race likely into December, have caused investor fatigue. The sooner both of these uncertainties recede, the quicker the SPX will climb to fresh all-time highs (Chart 1). Figure 1The Fiscal Policy Loop Chart 1Receding Uncertainty Will Boost Stocks   We have shown in recent research, and update today, that the fourth year of presidential cycles finds the SPX ending the year on average in the green with a calendar return in the high single digits (Chart 2). Peering back in 2016 is instructive as that presidential election cycle year was in some ways similar to the current one. The economy, in particular, was fighting off a manufacturing recession that spread and infected the services sectors as the vast majority of S&P GICS1 sectors saw profit contraction and more importantly revenue declines. Chart 3 shows a number of asset classes and compares 2016 with 2020. The 10-year US Treasury yield appears poised to rebound significantly, especially if Congress passes a fresh fiscal package that aides the parts of the economy that need the stimulus checks most. Fiscal easing uncertainty remains a thorny issue across different markets and if history is an accurate guide, the SPX could glide lower into the November election before rallying into year-end. Chart 2Back Up Near The Average Profile Meanwhile, a number of investors we talk to also experience COVID-19 fatigue (Chart 4). For the better part of the last 10 months media has constantly bombarded the world with pandemic news, and rightly so. However, all this seems dystopian by now, and we cannot wait for a semblance of normality to make a comeback, which a vaccine will definitively bring about. The equity market has been indurated to this news-flow and has shaken-off the recession. When the vaccine does arrive likely next year, profits will also return back to trend, as we have been arguing for some time, because the global economy will fully reopen. Chart 32016 Versus 2020 Already, if we juxtapose leading soft economic data surprises with lagging hard economic data surprises, it is clear that a stellar profit recovery looms (second panel, Chart 5). Similarly, within soft the data universe, the ISM new orders-to-inventories ratio paints a rosy picture for an earnings recovery in 2021 (third panel, Chart 5). Even within hard economic data, a simple liquidity indicator we have used in the past comparing industrial production (IP) with M2 money stock signals that S&P profits have troughed (IP vs. M2 shown advanced, bottom panel, Chart 5) Chart 4COVID Fatigue Finally, the US Equity Strategy’s four-factor macro profit growth model has slingshot higher recently and signals that a return to $162 level of EPS in calendar 2021 is a high probability outcome (Chart 6). Netting it all out, we are in the tail end of the equity market correction and as election and fiscal policy uncertainties ebb, they will pave the way for a robust SPX rally. Chart 5Profit Recovery On Track   Chart 6EPS Model Concurs This week, we continue with our strategy of preferring beaten-down cyclicals to defensives and steer the portfolio away from another safe haven staples industry via downgrading a consumer goods subgroup to underweight. We also delve deeper into the banking industry highlighting some cracks in small commercial banks. Put Homebuilders On Downgrade Alert Homebuilders have had a monster run since the depths of the recession back in March and the question a lot of our clients are now asking is: does it make sense to chase them higher at the current juncture? The short answer is no. Before we get into the details of our analysis a brief recap of our recent residential real estate-related moves is in order. Going into the March carnage we were cyclically underweight the niche homebuilding index. Moreover, last December we had identified homebuilders as a high-conviction underweight in our annual Key Views report. We monetized relative gains of 41% and 43%, respectively from both positions and lifted exposure to a benchmark allocation. While in retrospect we should have upgraded all the way to overweight, we did manage to participate in the V-shaped housing-related returns by opting to go overweight the mega cap home improvement retail index instead. In addition, this summer we eked out another 10% return from a long homebuilders/short REITs pair trade. Homebuilders are enjoying the single family home renaissance as the pandemic has turbo-charged the work from home movement and employees are rushing to move into comfortable spaces in the suburbs as the traditional office is literally declared dead. Indeed, housing starts and permits have renormalized, the drubbing in interest rates has boosted affordability and caused a knee jerk reaction in the mortgage application purchase index, and sell-side analysts are fighting hand-over-fist to upgrade profit projections for the homebuilding group (Chart 7). The end result has been a boom in new home sales that are trouncing existing home sales, and the NAHB’s survey of prospective homebuyers continues to paint a rosy picture for additional demand for new single family homes especially given the low inventory of homes (top & third panels, Chart 8). Chart 7Housing Tailwinds Chart 8Price Concessions Generate Volume This is where all the good news ends. With respect to selling prices, homebuilders are making price concessions compared with existing homes and also in absolute terms new home prices are deflating (second & bottom panels, Chart 8). Therefore, at close to 15%, homebuilding profit margins are near all-time highs and under threat especially from a firming industry wage bill (second & third panels, Chart 9). Tack on surging lumber inflation and a profit margin squeeze is a high probability outcome (bottom panel, Chart 9). As a reminder framing lumber, on average, comprises 15% of a new single family home’s total input costs. While the NAHB survey points to brisk demand for new homes, the sister Conference Board survey shows that consumers’ appetite for a new home has crested (second & third panels, Chart 10). With consumers rushing to move to the suburbs due to the pandemic, there is an element of bringing housing demand forward. Chart 9Beware Margin Squeeze Chart 10Good News Fully Priced Worrisomely, if the economy continues to open up then interest rates should continue to back up. From all the major asset classes the 10-year Treasury yield is the one that has yet to discount a V-shaped economic recovery. The implication is that rising interest rate would dent affordability and at the margin weigh on housing demand (10-year Treasury yield shown inverted, top panel, Chart 10). Moving on to the credit backdrop, while demand for residential real estate loans has recovered, bankers refuse to extend mortgage credit (second & third panels, Chart 11). According to the latest Fed H8 weekly credit release, residential real estate loans are on the verge of contraction (bottom panel, Chart 11). Finally, the tug-of-war on the fiscal package front is also threatening to sustain the unemployment rate near double digits, which could jeopardize the housing recovery. Historically, housing starts have been near perfectly inversely correlated with the unemployment rate and the current message is for a leveling off in residential construction activity (middle panel, Chart 12). The recent homebuilding run has pushed relative valuations from undervalued to overvalued. The relative P/S ratio trades roughly 30% above the historical mean (a three-year high), and leaves no cushion for any mishaps (bottom panel, Chart 12). Chart 11Bankers Refusing To Dole Out Loans Chart 12In Desperate Need Of Fiscal Help Netting it all out, homebuilders are more than fully priced, discounting high margins as far as the eye can see and no end to demand. The specter of higher interest rates, lumber inflation, stealing demand from the future, unfriendly bankers and uncertainty with regard to a fresh stimulus package more than offset the positives, and compel us to issue a downgrade alert for the S&P homebuilding index. Bottom Line: Stay neutral the S&P homebuilders index, but it is now on our downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. A Few Words On Banks Pundits around the globe focus on Eurozone and pan-European banks and argue that these outfits have been value destroyers since the history of the data series in late-1986 (bottom panel, Chart 13). Similarly, US banks relative share prices peaked in the mid-1970s and have never looked back, and very recently have tumbled to fresh all-time lows whether one uses monthly, weekly or daily data (top panel, Chart 13). Meanwhile, the recent drubbing in relative share prices suggests that loan loss provisioning is not over. In fact, Q3 loan loss reserves will surpass the level hit in the GFC, and likely close in on the $300bn mark (provisions shown inverted, Chart 14). Chart 13Banks, The World Over, Are Value Destroyers Chart 14More Loan Losses Loom… Historically, loan loss provisions are the mirror image of bank net operating income and most importantly bank profits decline as provisioning increases (Chart 15). Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket (bottom panel, Chart 16). Chart 15…Which Will Weigh On Profits Chart 16Fiscal Policy Easing To The Rescue? Tack on the year-to-date more than halving in the 10-year US Treasury yield and the earnings outlook remains grim for banks (top & middle panels, Chart 17). The transmission mechanism is through net interest margins (NIMs). The fourth panel of Chart 17 highlights that the pair have been joined at the hip and all-time lows in the 10-year US Treasury yield have sank bank NIMs below 3%, which is another all-time low since the history of the FDIC data. Credit growth has crested and our loans and leases model suggests that loan growth will continue to decelerate into 2021 (second panel, Chart 17). Not only is there lack of appetite for new overall loan uptake, but bankers are stringent with extending credit to businesses and consumer alike, according to the most recent Fed Senior Loan Officer survey (Chart 18). Chart 17Credit Growth Blues Chart 18Lack Of Loan Demand And Tightening Credit Supply However, there are three significant offsets to all these stiff headwinds that prevent us from downgrading banks to an underweight stance. First, the 10-year US Treasury yield is one of the few assets that has yet to discount any economic recovery. Thus, as uncertainty lifts post the November election, the economy continues to open up and Congress and the new President manage to pass a fresh fiscal stimulus bill, all this could catalyze a catch up phase in the long bond yield. Second, valuations offer a deep enough discount to absorb a little bit of more negative news as analysts and investors alike have thrown in the towel in banks (bottom panel, Chart 19). Finally, the credible Fed’s stress test loom by year-end and assuming banks pass them with flying colors a resumption of shareholder friendly activities will boost the allure of owing banks and unwind extremely oversold conditions (middle panel, Chart 19). In sum, while the price of credit, loan growth prospects and credit quality all weigh on relative bank performance. A fiscal stimulus bill, depressed valuations and a Fed induced resumption of dividend hikes and share buybacks keep us on the sidelines in the S&P banks index. Chart 19Unloved And Under-owned Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps 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

Neutral - Downgrade Alert Absent another fiscal package, banks risk digesting a new wave of credit defaults, further increasing their loan loss provisions as pandemic wounds remain open. Importantly, according to the latest Fed data, small banks1 are at the forefront of sloppy lending activity, warning that those weaker banks have higher exposure to defaults than large banks.2 Small bank C&I loan growth reached a whopping 50% per annum growth rate (second panel). Commercial real estate (CRE) loans are also expanding at a higher rate in small banks compared with large banks (third panel). With regard to concentration, small banks have been making inroads in feverishly doling out loans versus large banks. The former now comprise 40% of total C&I loan books (the largest credit category, bottom panel) and 2/3 of CRE loans – the second largest loan category with $2.4tn outstanding. Inevitably, some loans will sour because of the pandemic and the longer it takes Congress to pass a fresh stimulus bill the higher the pain for banks. One way out of this mess will likely be via much needed industry consolidation. As a reminder the US still has 4,400 banks. Bottom Line: We remain neutral the S&P banks index, which is also on our downgrade watchlist since early September. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.    Footnotes 1 Small banks are defined as all commercial banks excluding top 25 banks ranked by domestic assets. 2 Large banks are defined as top 25 commercial banks ranked by domestic assets.

Highlights Overweighting the SIFI banks is our highest-conviction call, … : Our enthusiasm for the four banks deemed to be systemically important financial institutions is founded on the view that generous monetary and fiscal policy will lead to considerably smaller credit losses than the SIFIs’ depressed valuations imply. … but investors are none too sure of it, inside and outside of BCA: The SIFIs have underperformed the broad market since we overweighted them in late April, and they will likely run in place until our mild-credit-loss thesis can be borne out. Banks’ fortunes are not tied to the slope of the yield curve … : Banks do not borrow short to lend long and the widespread belief that their stocks are hostage to the yield curve has no empirical support. … and the US banking industry is not in structural decline: US banks have experienced steady growth in real loans, net interest income and net income. Their businesses have yet to be disrupted by new entrants; so far, technology has increased profitability and we expect that the pandemic will point the way to future efficiency improvements. Feature In response to ongoing client questions and a lively internal debate, we are devoting this week’s report to reviewing our highest-conviction call: overweighting the SIFI banks.1 After restating our thesis and what it would take to get us to abandon it, we challenge two arguments that have been cited in support of a bearish view. We hold fast to our underlying rationale, though we concede that it will likely take more time for the call to pan out. We always recommended it for investors with a time frame of at least a year, and it may take until first quarter 2021 earnings to start generating alpha, but we still believe it will. A Feature, Not A Bug Our entire editorial staff gathers every month to define the consensus view on all the major asset classes, which becomes the BCA House View until we revisit it the next month (or sooner, if need be). The House View is not a party line that we all parrot; any individual managing editor is free to express an opposing view, provided s/he clearly states that s/he is departing from the House View and, ideally, explains why. Although this policy does not always lead to neatly packaged views, it affords clients a window on our internal debates, allowing them to evaluate the merits of opposing points of view for themselves. It also helps us attract and retain the informed, opinionated researchers we seek. Banking On Washington The pandemic, and the lockdown measures imposed to limit its spread, tore a huge hole in the economy. Policymakers swiftly mobilized to build a bridge across the hole until the virus could be contained. Before March was out, the Fed had soothed the Treasury market, prized open the corporate bond market and had set bond spreads on a path to tighten. Congress passed measures providing nearly $3 trillion of aid, highlighted by the massive CARES Act. Although another significant round of federal aid is not assured, it would be in the House's, the Senate's and the White House's interest, so we expect it will eventually materialize. Thanks to the CARES Act’s copious household support, personal income reversed its March slide and comfortably exceeded February's pre-pandemic level in April, May, June and July (Chart 1). With much of the economy still in suspended animation, absent another round of direct payments to households, unemployment insurance benefit supplements, support for badly disrupted businesses and aid to state and local governments facing severe revenue shortfalls, potentially dire economic consequences loom. With even run-of-the-mill recessions dooming incumbent administrations’ election prospects, it is in the White House’s best interests to advocate for more spending to hold back the flood. Republican control of the Senate also lies in the balance. Chart 1Fiscal Transfers Have Kept Households Afloat With the Democrats seeking to demonstrate that bigger government is the solution, House, Senate and White House interests all align with the passage of a major new aid package ahead of the election. Despite the worsening climate, we expect that elected officials’ self-interest will carry the day. All creditors stand to benefit, since fiscal transfers have been vital to limiting bankruptcies and defaults, and the SIFIs would get a major boost as we attribute their dreadful year-to-date performance to market fears of credit losses well in excess of the loan loss reserves they’ve already set aside. The key to our pro-SIFIs call is that we see them as the foremost beneficiary of continued fiscal largesse. Just The SIFIs, Please We are not enamored of the entire banking industry. Low rates are likely to undermine net interest margins for an extended period and weakening loan growth, a function of borrower and lender caution, will hurt lending volumes. Banks that principally take deposits and make loans to the households and businesses within their geographic footprint will suffer. Several community banks face stiff headwinds as do some regionals. The SIFIs have quite a few earnings streams, though, and only get around half of their revenues from net interest income. They are hybrids that combine investment banks boasting bulge-bracket underwriting, top-tier sales and trading, and formidable wealth management businesses with a nationwide commercial banking footprint. These companies do not live and die by loan volumes and interest rate spreads, as much of their loan originations are securitized and their loan books are not bound to the intrinsic risk of their local economies. The SIFIs trade slightly below book value and only slightly above tangible book value (Table 1, left panel). This would be cold comfort if their book values were at risk of falling because of optimistic carrying values for their assets or impending reserve builds that would eat away at retained earnings. We are not at all worried about bad marks, however – post-GFC regulation kept the SIFIs from getting out over their skis in the just-concluded expansion – and we think that they are adequately reserved in the aggregate. Assuming that the virus will be contained by the end of the year, we stick to our initial projection that they would need to build sizable loan loss reserves only through this year's first three quarters. Table 1SIFI Book Values On their second quarter earnings calls, the SIFIs were of the view that their reserve building was nearly complete. National infection rates have remained high, however, and the supplemental federal unemployment insurance benefit has since lapsed. We expect that the rollback of re-opening measures and the interruption of CARES Act relief provisions will force the SIFIs to add to their reserves this quarter in amounts approaching first and second quarter levels, but if Congress does provide another round of meaningful aid this month or next, we think that will be the end of the big builds. Equity investors do not seem to have recognized that the SIFIs’ earnings power has allowed them to take their sizable reserve builds in stride. Book values didn’t budge in the first two quarters (Table 1, right panel), and if they continue to hold their ground, the selling in their stocks is way overdone. We are quite happy to find a group that’s so inexpensive against a backdrop in which nearly every public security is trading at elevated levels relative to history, especially when that group will be a clear winner from continuing fiscal support. If further aid on a meaningful scale is not forthcoming, however, we will exit our SIFI overweight. We are not irresolute, but we close out positions when their underlying rationale no longer applies. Psst. The Yield Curve Doesn’t Matter Old superstitions die hard. US Investment Strategy has been presenting evidence for ten years that the yield curve does not drive bank earnings.2 Although the intuition behind the view is logical, it fails to acknowledge that banks do not borrow short to lend long. As the gargantuan interest rate swap market and the FDIC’s Quarterly Banking Profile demonstrate, all but the smallest community banks rigorously match the duration of their assets and liabilities. We typically show line charts overlaying the slope of the yield curve (the 10-year Treasury yield less the 3-month T-bill rate) with aggregate net interest income or net income, showing that there has been no consistent relationship between the two series. We’ve even shown that the yield curve is largely uncorrelated with bank net interest margins. Alas, one may as well try to convince a native New Yorker that s/he is not the most important element of the universe, or an English soccer fan that his/her side is not among the favorites to capture the next World Cup. Fiscal aid has held defaults way below levels that would typically be associated with such a severe economic shock and another hearty round of it would position SIFI credit losses to come in way below the market's worst fears. This time around, we present over 60 years of monthly data in one scatterplot after another that takes the shape of an amorphous blob. They demonstrate that there is no coincident relationship between the level of the slope of the yield curve and bank stocks’ performance relative to the S&P 500 (Chart 2), or the change in the slope of the yield curve and bank stocks’ relative performance (Chart 3). They also show that there is no leading relationship over six- (Chart 4A) or twelve-month periods (Chart 4B) between the level of the slope of the yield curve and bank stocks’ relative performance. The change in the slope of the yield curve also comes a cropper with six- (Chart 5A) and twelve-month lead times (Chart 5B). With every one of the six regressions generating r-squareds below 1%, we conclude that neither the level of the slope of the yield curve, nor its direction, explains any element of relative bank stock performance. Chart 2The Steepness Of The Yield Curve Does Not Influence Bank Stocks' Relative Performance Chart 3The Change In The Steepness Of The Yield Curve Does Not Influence Bank Stocks' Relative Performance Chart 4AThe Steepness Of The Yield Curve Does Not Lead Bank Stocks' Relative Performance Over 6 Months Chart 4BThe Steepness Of The Yield Curve Does Not Lead Bank Stocks' Relative Performance Over 12 Months Chart 5AChanges In Yield Curve Steepness Do Not Lead Bank Stocks' Relative Performance Over 6 Months Chart 5BChanges In Yield Curve Steepness Do Not Lead Bank Stocks' Relative Performance Over 12 Months Rumors Of The Banks’ Structural Decline Have Been Greatly Exaggerated We submit that US banks are not in the throes of a structural decline. Adjusted for inflation, growth in their core lending business has been steady, except during recessions and their aftermath, for 70 years (Chart 6). Despite a persistent trend toward increasing non-bank intermediation that has reduced the industry’s market share, loan volumes continue to expand. Chart 6Real Bank Loan Balances Have Steadily Grown For 70 Years Industry viability is not only about sales volume, however. Participants in a declining industry could retain or even grow volumes, only to see their profits shrink in the face of competition from incumbents or new entrants. Real net interest income has continued to grow, however, more or less in line with real loan growth (Chart 7), demonstrating that margins have not eroded. Real net income, which includes credit costs and fees and other non-interest items that are more sensitive to the business cycle, is much more volatile, but has also followed a broad upward trend (Chart 8). Chart 7Real Net Interest Income Growth Has Decelerated, But It's Still Positive ... Chart 8... While Real Net Income Quickly Surpassed Its Pre-GFC Peak Futurists see fintech and cryptocurrencies as looming disruptive threats to the banking industry, but they have yet to make a significant dent in its volumes or its profits. To this point (Chart 9), technological advances have done more to reduce the industry’s operating costs than they have to undermine its moat. One would expect that a meaningful downward move in the efficiency ratio might be in store, based on what the banks have learned from the pandemic about optimizing human inputs, virtual applications and their costly branch footprints. The data do not support the claim that the industry is in the midst of a structural decline and an efficiency tailwind is likely in the offing once the acute phase of the pandemic passes. Chart 9Banks' Non-Interest Expenses Relative To Revenue Are Structurally Declining Concluding Thoughts Stocks that are oversold can become even more oversold and cheap does not necessarily mean valuable. It is entirely possible that the SIFI banks are a value trap; our call has underperformed since the late May/early June backup in long yields was summarily unwound (Chart 10). Something seems off, however, when the SIFIs are performing nearly as badly year-to-date as office and retail REITs. The latter face a structural shrinking of their businesses while banks are looking at nothing more than a cyclical ebb. Chart 10A Marathon, Not A Sprint Fiscal policymakers demonstrated their ability to counter the cyclical drag over the spring and summer; if they recover their willingness to do so, the SIFIs' outlook is far less grim than markets are currently discounting. Given our view that both the administration’s re-election prospects and Republican control of the Senate depend on staving off severe adverse economic consequences from the pandemic, we think that Congress will rediscover its resolve. If it doesn’t, we will have to close our position and potentially seek a better entry point after the new session of Congress convenes in January. It won't be all hearts and rainbows for the SIFIs over the next year, but concerns about the yield curve and the banking industry's trend earnings and revenue growth are misplaced. They are positioned to climb a wall of worry as soon as the pandemic begins to loosen its grip. Under our base-case policy scenario, the selling in the SIFIs has gone way too far. With policymakers squarely in the SIFIs’ corner, we’re thrilled to have a chance to take a shot at them from the long side below book value. The market is right to recognize that the banks will not have smooth sailing even if Congress eventually comes through, but we think it has failed to consider how much more protected the SIFIs are than their smaller brethren. If it’s holding them down because of yield curve concerns, or the idea that the banking industry is in the midst of a long-run decline, it simply has its facts wrong and we’re confident that they will rise over the next six to nine months. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com     Footnotes 1     JPM, BAC, C and WFC are the commercial/universal banks that regulators have deemed systemically important. 2     Please see the February 28, 2011 US Investment Strategy Special Report, “Banks And The Yield Curve,” available at usis.bcaresearch.com.

Neutral - Downgrade Alert Bank stocks fail to catch a break. Following the recent Fed stress results and the resulting dividend cuts, banks have continued to trail both the broad equity market and their early cyclical peers: consumer discretionary stocks. Worryingly, on all three income generation fronts, dark clouds are gathering for banks, the nervous system of the US economy. While the initial knee jerk reaction of corporates was to tap their existing credit lines in order to fight the pandemic that caused an exponential rise in C&I loan growth, going forward a steep reversal is looming (middle & bottom panels). Bankers are tightening lending standards at the fastest pace in a decade despite ZIRP, weighing heavily on relative share prices (top panel). On the price of credit front, the Fed’s recent perching of the fed funds rate on the zero line for as far as the eye can see all but guarantees a tough pricing power environment for banks. The latest FDIC Quarterly Banking Profile revealed that the banking industry broke the 3 handle on net interest margins coming in at 2.81%, the lowest level since the history of the data dating back to 1984. Finally, with regard to credit quality, a double digit unemployment rate, along with commercial real estate ails will propel non-performing loans, which are extremely lagging by nature. While credit quality deterioration is late to show up, it wreaks immediate havoc on bank income statements as loan loss provisions. Aggressive provisioning will likely continue at least until the end of the year. Bottom Line: Stay neutral the S&P banks index, but it is now on downgrade alert.  

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. 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