Real Estate

Special Report

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

Special Report

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

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

Special Report

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

Special Report

Highlights Even after the COVID-19 pandemic is over, likely within 18 months, many behavioral changes that were forced on society by social distancing will remain. Individuals who have gotten used to working from home, shopping online, and using the internet for socializing and entertainment will continue to do so. Amid any large structural shift, it is easier to spot losers than winners. The biggest losers are likely to be: (1) Parts of the real estate industry, as companies shed expensive city-center office space and office workers move away from big cities; and (2) the travel industry, since business travel will decline. The winners will include: Health care (as governments spend to strengthen medical services); capital-goods producers (with US manufacturers increasingly reshoring production but automating more); and the broadly-defined IT sector which, while expensively valued, is nowhere near its 2000 level and has several years of strong growth ahead.   “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” –  Bill Gates “There are decades where nothing happens, and there are weeks where decades happen.” –  Lenin Introduction The world has been turned upside down since February by the coronavirus pandemic. Households all around the globe have been forced to stay indoors; companies have been forced to drastically change working practices; some industries, such as online shopping or videoconferencing software, have seen a surge in demand. But once the pandemic is over, how many of these changes will stick? What will be the long-term impact on society, the workplace, consumer attitudes, and companies’ strategic planning? How should investors position themselves to take advantage of secular changes in the sectors that will be most affected, ranging from health care and technology, to real estate, retailing, and travel? In this Special Report (which should be read in conjunction with two other recent BCA Research Special Reports on the macro-economic and geopolitical consequences, respectively, of COVID-191), we look at the social and industry implications of the coronavirus pandemic. We assume that, within the next 12-to-18 months, the pandemic will be a thing of the past, either because a vaccine has been developed, or because enough people have caught it for herd immunity to develop. This does not mean that people will be unconcerned about a reoccurrence, or about a new virus triggering another epidemic. Pandemics are not rare, even in modern history (Table 1). And COVID-19 may return as an annual mild seasonal flu (as the 1968 Asian flu did), but which is not serious enough to alter behavior. But the assumption in this report is that, within a couple of years, people will feel comfortable again about being in crowded spaces and traveling, without a need for social distancing or periodic lockdowns. Table 1Estimated Mortality And Infection Rates Of Pandemics During The Past Century But that doesn’t mean that everything will return to the status quo ante. At least some individuals who have gotten used to working from home, video conferencing, and shopping online will continue these practices. Companies will, therefore, need to rethink their employment policies, as well as how they manage their office space, global supply chains, and just-in-time inventories. Government policies towards health care and education will need to be rethought. None of these changes are new. Indeed, the result of an exogenous shock is often simply to accelerate trends that were already in place. E-commerce, telecommuting, and “reshoring” have already been growing steadily for years. COVID-19 is, however, likely to accelerate these shifts. Not every individual or company will change their behavior, but even small changes at the margin can have a significant impact. Ultimately, what these changes amount to is a liberalization of space and time. Employees do not need to be in the same physical space to work together. Students can choose when to listen to a lecture. Music lovers based in a small city can have the same access to a live (streamed) concert as those in London or New York. This Special Report is divided into two sections. In the first section, we examine the meta-changes in consumer and corporate behavior that could result from the pandemic. How widely will the shift from office-based work to “working from home” stick? How much will shopping, entertainment, and education stay online? Will companies really bring back a large chunk of manufacturing from overseas? In the second section, we analyze the impact on specific industries, such as real estate, health care, technology, and retailing, and make some suggestions as to how investors should tilt their portfolios over the longer term to take advantage of these trends. In summary, we identify the winners as health care, technology, and capital-goods producers. The clear losers are in real estate and travel. Retailing and consumer goods will see a significant shakeout, with both winners and losers, but the overall impact on these industries will be neutral. Social Impacts Working From Home Teleworking, or working from home, is hardly new. Craftsmen before the industrial revolution did so as a matter of course. But the development of computers and telecommunications in the 1980s made it feasible for white-collar workers to work from home too. As Peter Drucker wrote as long ago as 1993: "...commuting to office work is obsolete. It is now infinitely easier, cheaper and faster to do what the nineteenth century could not do: move information, and with it office work, to where the people are."2  Until now, however, teleworking has been rare. But the requirements imposed by the pandemic could cause that to change. Technically, it is possible for workers in many job categories to telework effectively. A recent study by Jonathan Dingel and Brent Neiman3 estimated, based on job characteristics, that it is feasible for 37% of all jobs in the US to be done entirely from home (46% if weighted by wages). The vast majority of jobs in sectors such as education, professional services, and company management could be done from home (Table 2). Extending the analysis to other countries, they find that more than 35% of jobs in most developing countries can be done from home, but less than 25% in manufacturing-heavy emerging economies such as Turkey and Mexico (Chart 1). Table 2Share Of Jobs That Can Be Done At Home, By Industry Chart 1Share Of Jobs That Can Be Done At Home, By Country But, in practice, before the coronavirus pandemic, many fewer people than this worked from home. Partly this was simply because many companies did not allow it. A survey by OWL Labs in 2018 found that 44% of companies around the world required employees to work from an office, with no option to work remotely.4 The percentage was even higher, 53%, in both Asia and Latin America. By contrast, OWL did find that 52% of employees globally worked from home at least occasionally, and that as many as 18% of respondents reported working from home always. The pandemic forced many white-collar workers to telework for the first time. The Pew Research Center found that 40% of US adults – and as many as 62% of those with at least a bachelor’s degree – worked from home during the crisis.5  How white-collar workers found the experience, and whether they plan to continue to work from home some of the time even if not required to do so, vary widely. Employers are generally positive about the idea. A survey of hiring managers by Upwork found that 56% believed that remote working functioned better than expected during the crisis (Chart 2). They cited reduced meetings, fewer distractions, increased productivity, and greater autonomy as reasons for this. The major drawbacks were technological issues, reduced team cohesion, and communication difficulties. Another survey, by realtor Redfin, found that 76% of US office workers had worked from home during the crisis (compared to only 36% who worked from home at least some of the time beforehand) and that 33% of respondents who had not worked remotely pre-shutdown expect to work remotely after shutdowns end (with another 39% unsure) (Chart 3). Chart 2Employers Found That Teleworking Worked Well Chart 3Many Employees Expect To Continue Working Remotely After The Pandemic Ends But there are problems too. Research published in the Journal of Applied Psychology found that, while teleworking has some clear advantages, such as improved work-family interface, greater job satisfaction, and enhanced autonomy, it also has drawbacks. Most notably, if workers aren’t in the office at least half the week, relationships with fellow workers suffer, as does collaboration.6 There are also developed countries where backward technology has made the experience of working from home difficult. This is particularly the case in Japan. A survey by the Japan Productivity Center found that 66% of office workers said their productivity fell when working from home; 43% were dissatisfied with the experience. The reasons cited for the dissatisfaction were “lack of access to documents when not in the office” (49%), “a poor telecommunications environment” (44%), and a difficult working environment, such as lack of desk space (44%). Japanese companies remain rather paper-based, and household living space tends to be small. Research carried out on employees at Chinese online travel company Ctrip before the pandemic concluded that home working led to a 13% performance increase but, crucially, there were four requirements for working from home to succeed: Children must be in school or daycare; employees must have a home office that is not a bedroom; complete privacy in that room is essential; and employees must have a choice of whether to work from home.7  After the pandemic, a significant shift in the pattern of office work is likely. Many workers will work remotely part or most of the time. But they will also benefit from coming to an office a certain number of days a month to work together, bond with co-workers, exchange ideas, etc. Online Shopping E-commerce has been growing steadily for years. In the US, it increased by 15% year-on-year in 2019, to reach $602 bn, or 16% of total retail sales (Charts 4 and 5). The share is even higher in some other countries: For example, 25% in China and 22% in the UK. The pandemic caused a big acceleration in e-commerce the first few months of this year, as consumers in most countries around the world were either not allowed to go outside, or felt unsafe doing so. Chart 4The Share Of E-commerce Has Been Steadily Expanding For Years… Data from Mastercard show that, in the worst period of lockdowns in April, e-commerce grew by 63% in the US, and 64% in the UK year-on-year, compared to a decline of 15% and 8%, respectively, in overall retail sales (Chart 6). The growth was particularly apparent in products such as home improvement, footwear, and apparel (Chart 7). Chart 5…With Growth Of Around 15% A Year Chart 6In April, Online Sales Soared…   Chart 7…Especially In Certain Categories Moreover, many consumers in advanced economies bought goods such as clothing, medicine, and books online for the first time, and used services such as online grocery delivery, and apps to order food from restaurants (Chart 8). Note, however, that few consumers bought financial services, magazines, music, and videos online for the first time. Presumably these are products that the vast majority of households had already been consuming online. Chart 8Consumers Shifted Purchases Of Many Items Online It is hard to know how sticky these trends will be. Once shops permanently reopen without restrictions, will consumers simply return to their old habits of going to supermarkets, restaurants, and clothing stores? Perhaps many enjoy the experience of browsing. It seems likely, however, that the newly acquired habit of shopping online will at least accelerate the trend towards e-commerce. Many of those who ordered, for example, supermarket deliveries online for the first time will continue to do so at least occasionally in the future. Other changes are likely too: Many smaller retailers were forced to close their physical stores during the pandemic and so had no choice but to set up an online delivery service. Some struggled with this, but others were aided by companies such as Shopify, which simplify the process of setting up a website, processing payments, and arranging delivery. Shopify now works with over a million merchants. These smaller retailers are now better able to compete with giants such as Amazon. During the lockdown, US consumers notably diversified their online product searches away from Amazon and Google to smaller retailers (Chart 9). Chart 9Search Diversified Away From Amazon And Google We might see a trend towards smaller-scale, local shops benefiting as consumers stick to shopping in smaller stores closer to their homes. Many stores during the pandemic refused to accept cash; this might accelerate the shift towards contactless payments. Consumers may be less focused in future on conspicuous consumption. The trend towards wellness, home-cooking, gardening, crafts, and self-investment might continue. Other Uses Of Technology It is not only work and shopping habits that changed during lockdowns. Individuals also got used to a range of technologies for socializing, entertainment, education, and medical consultation. Consumer surveys by the Pew Research Center show that a third of American adults have socialized online using services such as Zoom, and a quarter have used online systems for work or conferences (Chart 10). But these percentages are much higher for certain demographics. For example, 48% of 18-to-29 year-olds have socialized online, and 30% of this age group have taken online fitness classes. The percentage using video systems for work is as high as 48% for people with a college degree. And, unsurprisingly, with many university courses moving online since the spring, 38% of 18-to-29 year-olds say they have taken an online class. Chart 10Individuals Have Been Socializing And Communicating More Online How sticky these trends will be once the pandemic is over is not easy to forecast. But further research by Pew showed that 27% of US adults believed that online and telephone contacts are “just as good as in-person contact,” and only 8% thought of them as not much help at all, although a rather larger 64% answered that online socializing is “useful but will not be a replacement for in-person contact.” The responses differed little between gender, race, and political views, although fewer people under the age of 30 thought online contacts were as good as in-person ones (Table 3). Table 3How Do Online Interactions Compare To In-Person Ones? Another survey in Japan by Ipsos suggests that people’s values have changed as a result of the pandemic and quarantines, with a greater focus on wellbeing, home-based activities such as cooking, and self-improvement. When questioned, a large percentage of people believe they will persist with these habits even when lockdowns end. For example, 51% of Japanese respondents believe they will continue to enjoy themselves as much as possible at home in their spare time, compared to only 20% who favored entertainment at home before the pandemic (Chart 11).  Chart 11Pandemic Brought A Greater Focus On Wellbeing And Home-Based Activities Other areas that have moved online en masse include education, health care, the judiciary, concerts, and sports (e-sports, and popular sports such as soccer and baseball that are now being played in empty venues). Education at the tertiary level in advanced economies was already partly online before the pandemic. In the US, out of 19.7 million tertiary students in 2017, 2.2 million (13.3%) were enrolled in exclusively online/distance learning courses, and another 3.2 million (19.5%) took at least one course online.8 Of course, everything changed during the pandemic, with 98% of US institutions moving the majority of in-person courses online, and many planning to continue this through the Fall 2020 semester. At the elementary and secondary school level, online education was much more limited pre-pandemic. According to the National Center for Educational Statistics, 21% of US schools offered some courses entirely online in 2016 but, of this 21%, only 6% offered all their courses online and only another 6% the majority of courses. Many of these schools were forced to shift entirely online during lockdowns: According to UNESCO data, at the peak of the pandemic 1.6 billion children (90% of the total in school) in 191 countries attended schools that had closed physically. It seems likely that, while in-person teaching will remain the central method of education, distance and online learning solutions, even at the high school level, will become more prevalent in the future. The health care sector has lagged in technology, in terms of using AI for diagnosis, digitalizing patient records, and offering online doctor-patient consultation. But the use of digital tools had started to increase in recent years, particularly in the number of practices using telemedicine and virtual visits (Chart 12). At the peak of the pandemic in April, the number of telehealth visits in the US rose by 14% year-on-year, compared to a 69% decline in in-person visits to a doctor.9 It seems likely that this trend will continue, as medical practitioners find viritual consultations more efficient and effective for many simple initial diagnoses, and as sick or elderly patients prefer to avoid a physical visit to a surgery.10 Chart 12The Transition To A Digital-Driven Health Care Model Travel Travelers have been very reluctant to get back on airplanes and stay in hotels again, even in countries and regions where the pandemic has eased over the past couple of months (Chart 13). Based on our assumption that the pandemic will be completely over within 18 months, it seems likely that people will eventually resume travelling, at least for leisure and to see family and friends. After previous disruptions to global travel, such as 9/11 and SARS, it took only two-to-three years for air travel to resumed its pre-crisis trend (Chart 14). Chart 13Travelers Remained Reluctant Even When Pandemic Eased Business travel might be very different, however. Salespeople who have become used to making sales calls over Zoom may not feel the need to travel to see clients so much. Conferences, exhibitions, and other events will be increasingly (at least partly) online. Travel budgets are a large expense for many companies. According to estimates by Certify, a travel software provider, spending on business trips in 2019 totalled $1.5 trillion (including $315 billion by US businesses). The availability of a technological alternative to at least some business trips will provide a good excuse for many companies to meaningfully reduce the number of trips and their travel budget. In the future, business travel may become more of a privilege than a necessity. It is easy to imagine a significant decline in overall business travel. Manufacturing Supply Chains Corporate behavior could also change as a result of the disruptions caused by the coronavirus. Companies in the US and Europe realized how vulnerable their complex supply chains are. Popular and political pressure is pushing firms to reshore at least some of their overseas production. Firms will need to build in more “operational resilience,” with higher levels of inventory, less debt, and greater redundancy in their systems. Developed economies such as the US have been deindustrializing for 40 years – since reforms in China in the late 1970s, followed by Mexico and central Europe in the 1990s,  made these countries appealing locations for cheap manufacturing. US manufacturing employment has almost halved since 1980, falling to only 27% of the workforce (Chart 15). Manufacturing output, especially outside of the computer sector, has substantially lagged that of the overall private sector (Chart 16). The US has also fallen behind in automation, with a much lower number of robots per manufacturing worker than in countries such as Germany and Japan (Chart 17). Chart 15US Manufacturing Employment Has Halved Since 1980   Chart 16Manufacturing Output Outside The Computer Sector Has Lagged Chart 17The US Has Relatively Few Robots The pandemic highlighted how vulnerable widely distributed supply chains are. This was clearest in the health care sector. The US is far away the biggest spender on health care research and development (Chart 18). And yet it was unable to provide critical medical equipment such as face masks, testing kits, and ventilators to its population at an adequate rate, mainly because almost 70% of the facilities which manufacture essential medicines are based abroad (Chart 19). During the pandemic, countries such as China and India prioritized their own citizens, forcing the US government to strike emergency deals to avoid drug shortages. Chart 18The US Spends A Lot On R&D In Health Care… Chart 19…But Drug Production Is Mostly Done Overseas Once the crisis subsides, CEOs of American companies (as well as the US government) will have to decide if they are comfortable with the fact that, while they possess a vast store of intellectual capital, the manufacturing of their products happens halfway around the world. What happens if there is another pandemic? What about a global disaster caused by climate change? Finally, and perhaps more worryingly, what happens if tensions between the US and China escalate seriously? This shift will not happen overnight: China still has much cheaper labor, an enormous manufacturing base of factories and parts suppliers, and formidable transportation infrastructure. Many aspects of supply chains are too deep-rooted and the economics too compelling for them to be unwound quickly. Some production will shift from China to other emerging economies. A Biden administration might be less confrontational with China, and could lower some of the Trump tariffs. But, at the margin, companies will choose to build new factories in the US (and in western Europe and Japan), with highly automated systems. Government policy (via both subsidies and tariffs) will encourage these trends. Manufacturers which have lived “on the edge” in recent years, with dispersed supply chains, just-in-time processes, minimal inventories, the fewest possible workers, and the maximum amount of debt compatible with their targeted credit rating (often BBB) now understand the need to build redundancy into their systems. Corporate debt levels are high by historical standards in many countries (Chart 20). Companies may want to build up a buffer of net cash in the future, as Japanese companies did for decades after the bubble there burst in 1990. Inventories have risen a little relative to sales since the Global Financial Crisis but will probably rise further (Chart 21). These trends are likely to be negative for profit margins. Chart 20In The Future, Will Companies Be Happy With This Much Debt... Chart 21...And Such Low Level Of Inventories? Implications For Industries In light of the social changes described above, how will various industries be reshaped over the coming years? Which sectors should investors tilt towards because they are likely to emerge as winners from post-COVID structural shifts? And which are the sectors that investors should avoid since they will suffer from the creative destruction? In the midst of major social and technological change, it is often easier to spot losers than winners. Think of the arrival of the internet in the 1990s. How many investors would have correctly picked Google, Amazon, Apple, and only a handful of others as the winners? It would have been easier to correctly identify industries that were likely to lose out to disruption, such as book retailers, travel agents, newspaper publishers, and TV broadcasters. We start, therefore, with the industries likely to lose out from post-COVID changes. The Losers Real Estate Over the next few years, prime real estate seems the most likely loser. It is not clear how many white-collar workers will choose to work from home in the future, or how many days a month they will want to come into an office to meet with fellow workers. But it seems likely there will be a strong continued trend in the direction of remote working. As a result, demand for prime central-business-district property will fall, given that it is very expensive. In Manhattan, for example, the average workspace for each of the 1.5 million office workers is around 310 square feet. At pre-COVID rental costs, that amounts to an average of $20,000 per employee – and more than $30,000 for A+ grade buildings. And rent is only part of what a company pays: There are also costs for cleaning, utilities, technology, security, coffee machines, and cafeterias on top of that. Employees working at home pay for their own space, utilities, food (and often even computer equipment). The size, location, and layout of offices will need to be rethought. Maybe companies will choose to build a campus in the suburbs, with a range of different working spaces (for meetings, quiet work, or collaboration). They may prefer to rent shared co-working spaces by the day or week. Some real estate developers and builders would be beneficiaries of this. Companies would save money in real estate costs. But they may need to pay a stipend to employees who work at home to cover the extra space they will require, and to upgrade their technology (computer equipment, internet speed, and so on). On the other hand, companies may pay lower salaries for workers who move out of high-cost locations such as Manhattan or London to places where it is cheaper to live. Many office spaces are leased on a long-term basis, so some companies will not be able to move out of big cities immediately. But residential property is more liquid. The trends in work practices might accelerate a shift to the suburbs which has already been emerging over the past few years (Chart 22). Workers will not need to live so close to the company’s office if they will visit it for only a few days a month. Small towns with a lively community and pleasant environment (and decent transportation links to a big city) could grow in popularity. This would be bad news for developers which are specialized in developing residential property in cities such as London, Sydney, Toronto, and Vancouver, and for the owners of those properties. But it might be positive for builders who will develop the new houses and out-of-town office campuses. Chart 22The Shift To The Suburbs Was Already Taking Place This does not mean that cities will wither away. After previous epidemics and crises in history (think the Great Plague of London in the 17th century, or 9/11), they have always bounced back. “Casual collisions” – chance meetings with interesting people which lead to collaborative relationships – are crucial in creative industries, and happen online only with difficulty. Buildings will be repurposed: Retail space will be turned into warehouses or apartments, for example. A fall in rents would allow cities to “degentrify” and attract back young people, making the city more dynamic again. But the period of transition could be painful for some segments of the real estate industry. Travel A permanent decline in business travel would be a significant blow to airlines and hotel chains. Business travelers account for only about 12% of the number of air tickets purchased, but they generate 70%-75% of airlines’ profits. Even discount leisure airlines such as Southwest have in recent years started to target business travelers. And it will not just be airlines that are affected. Data from the US Travel Association show that 26% of the $2.5 trillion in travel-related revenues in the US in 2018 came from business travelers. Of that, 17% goes to air travel, 13% to accommodation, and 5% to car rental. An even larger portion goes to food (21%). Around 40% of hotel rooms are occupied by business travelers. Conference organizers and venues could also suffer: 62% of US business trips are to attend conferences. “Sharing economy” companies would be affected too. In 2018, 700,000 business travelers booked accommodation through AirBnB, and 78% of business travelers use Uber and other ride-sharing services. Furthermore, a slowdown in business travel would have knock-on effects on the leisure travel sector. Surveys suggest that almost 40% of business trips in the US are extended to include leisure activities (“bleisure” in the travel industry parlance). The Winners Health Care A recent report by BCA Research’s Global Asset Allocation service argued in detail that the macro environment for global health care equities will remain very positive in the coming years.11 An aging population in the world, and a growing middle class in emerging countries will steadily raise demand for health care services (Charts 23 and 24). China, in particular, has underinvested in health care: It spends only 5% of GDP, barely higher than it did 20 years ago, and well behind other emerging economies such as Brazil and South Africa (Chart 25). Chart 23Positives For Health Care Include An Aging Population… Chart 24…And A Growing Emerging Market Middle Class As a result of the COVID-19 pandemic, governments everywhere will need to spend more money on health care (or, in the case of the US, perhaps spend it more effectively). In the US, before the pandemic, intensive-care beds were sufficient to cope only with the peak of a normal seasonal influenza breakout. The World Health Organization warns that, while pandemics are rare, highly disruptive regional and local outbreaks of infectious diseases are becoming more common (Chart 26). More money will need to be spent, in particular, on developing health care technology (online consultations, digitalized patient records, track-and-trace systems), on improving senior care homes (80% of COVID-19 deaths in the Canadian province of Quebec were in such facilities), and on biotech (such as gene-related therapies). Chart 25Expenditures On Health Care Will Have To Grow Chart 26Number Of Countries Experiencing Serious Outbreak Of Infectious Disease   The health care equity sector is not expensive, trading in line with its long-run average valuation (Chart 27). Within the sector, biotech and health care technology look more attractive than pharmaceuticals, which are expensive and vulnerable to the price caps proposed by Joe Biden if he is elected US president this November. Chart 27Health Care Stocks Are Not Expensive Technology In a plethora of ways, the pandemic has propelled the use of technology: For working at home, communication, online shopping, entertainment, etc. Companies such as Zoom have moved from niche players to mainstream business providers: Zoom’s peak daily users rose from 10 million in December 2019 to 300 million in April. Chart 28Tech Stocks Are Nowhere Close To Previous Peaks Assuming that at least some of these developments remain in place once the pandemic is over, it is easy to see how technology stocks (broadly defined to include any company that uses information technology as a central part of its business) will continue to prosper. These stocks will not be just in the IT sector, but also in communications and consumer discretionary. Picking the individual winners will be hard: Will Microsoft overtake Amazon in cloud computing? Will Zoom’s much-discussed privacy issues undermine it? Will competitors emerge to Shopify in merchant services? Can Spotify compete with Apple in online music streaming? But the broadly-defined sector seems likely to have improving fundamentals for some years to come. The only question is whether the good news is already priced in, after the huge run-up in stock prices over the past few years. We do not believe it is fully. The valuations of these sectors are still nowhere close to the level they reached at the peak of the TMT Bubble in 1999-2000 (Chart 28), they have strong balance-sheets, and considerable earnings power. For their outperformance to end, it will take one of two things. The first trigger could be a significant shift down in growth. Over the past three years, Amazon has grown EPS at a compound rate of 47%, and Netflix at 76% (Chart 29). Over the next three years (2020-2023), analysts forecast compound EPS growth of 32% for Netflix, 30% for Amazon, 15% for Facebook (compared to 24% in 2016-2019), and 12% for Microsoft (compared to 16%). Those are still impressive growth numbers, and should be achievable as long as these companies can continue to grow market share. Chart 29Can The Big Tech Stocks Keep Growing Earnings At This Rate? The second set of risks would be regulatory: A move to break up companies such as Google and Amazon, the US introducing data privacy legislation similar to that in the European Union, or a move to a digital tax or minimum global taxation. None of these seems likely in the immediate future. Automation/Robotics/Capital Goods The return, at the margin, of some manufacturing to the United States (and other developed economies) will bring about economic changes. Unable to tap into the pool of cheap international labor as easily as before, companies will have to invest significantly in this sector. This will result in the following: A resurgence of manufacturing productivity, thanks to increased investment. An intensification of automation. The US will need to boost the number of robots per capita to compete with Korea, Germany, and Japan. This will further improve productivity. The development of a high-tech manufacturing sector. Analogous to the FAANG stocks during the 2010s, a new group of innovative manufacturing companies could emerge. New infrastructure, roads, factories, and machinery will be needed to replace what is now an outdated capital stock in the US (Chart 30). These trends should all be positive for the capital-goods sector. Such a project would also need large amounts of raw materials. This might push up the prices of commodities such as industrial metals, and benefit materials producers. As mentioned above, it could boost the price of real estate outside of the major cities, where the new manufacturers would be likely to set up. Chart 30The US Capital Stock Is Becoming Outdated Mixed Retailing / Consumer Goods Retailing is likely to see a significant shakeout over the next few years. The cracks have been apparent for some years: Decreasing footfall, and empty units on many high streets and shopping malls, amid the shift to online shopping. A shift to the suburbs and further growth in online shopping will change retailing further. Rents in the highest end Manhattan shopping districts have already fallen noticeably since the start of the year, especially Lower Fifth Avenue (between 42nd and 49th Streets) which is dominated by large chain stores (Chart 31). Shopping malls, particularly undistinguished ones in poorer areas, will continue to suffer. Overall, the US in particular has an excess of retailing space, almost five times as much per capita as the major European economies (Chart 32). Chart 31Manhattan Retail Store Rents Already Falling Sharply Chart 32The US Has Far Too Much Retail Space But it is hard to predict the winners from this shake-out. Overall spending by consumers is unlikely to be significantly affected, so it is a matter of forecasting which companies and formats will emerge victorious. Will Walmart and Target and other large retail chains improve their online offering to fight back against Amazon? Facebook, Shopify, and others have set up new services to compete with Amazon on price – will they be successful? Will small stores start to win back market share? Will supermarkets figure out how to make profits from their order-online-and-deliver services (which are now very costly because most often a human has to run around the store picking out the items ordered), or will new, fully automated competitors emerge? Will new technologies materialize to make it easier to buy clothes online (for example, digitized body measuring systems)? These changes will also affect producers of consumer products. They will have to understand the new channels, and adapt their offerings and positioning strategies accordingly. These changes will make the sector a tricky one. A skilled fund manager might be able to predict which companies’ strategies will be successful. But it could be a problematic area for investors owning individual stocks within the sector who do not have detailed expertise. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "Beyond The Virus," dated May 22, 2020 and Geopolitical Strategy, "Nationalism And Globalization After COVID-19," dated June 26, 2020. 2 Peter E. Drucker, "The Ecological Vision: Reflections on the American Condition," 1993, p.340. 3 Jonathan I. Dingel and Brent Neiman, "How Many Jobs Can Be Done At Home?" NBER Working Paper No. 26948, April 2020. 4 OWL Labs, “The State of Remote Work Report,” available at www.owllabs.com. 5 Pew Research Center survey conducted March 19-24 2020. Please see https://www.pewsocialtrends.org/2020/03/30/most-americans-say-coronavirus-outbreak-has-impacted-their-lives/psdt_03-30-20_covid-impact-00-4/ 6 Gajendran, R.S., & Harrison, D.A., “The Good, the Bad, and the Unknown about Telecommuting”,  Journal of Applied Psychology 92(6), 2007. 7 Nicholas Bloom, James Liang, John Roberts & Zhichun Jenny Ying, “Does Working from Home Work? Evidence From a Chinese Experiment,” The Quarterly Journal of Economics (2015), 165-218. 8 Please see educationdata.org. 9 Ateev Mehrotra, Michael Chernew, David Linetsky, Hilary Hatch, and David Cutler, "The Impact of the COVID-19 Pandemic on Outpatient Visits: A Rebound Emerges," The Commonwealth Fund, dated May 19, 2020.  10For more on the long-term outlook for the health care sector, Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight," dated July 24, 2020, available at gaa.bcaresearch.com. 11Please see Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight,"dated July 24, 2020, available at gaa.bcaresearch.com.

Special Report

Highlights The housing market is tight, but not undersupplied, as the construction of new homes has kept up with the pace of household formation. Demand for homes should remain well supported as household formation has room to increase and the economy recovers from the pandemic-induced crisis. But existing barriers to new home construction persist and the economic recovery will help hold down residential mortgage defaults and prevent a wave of listings by desperate sellers. As such, home prices have scope to remain well-bid. Feature US home prices keep grinding higher despite the most severe recession since the Great Depression. In a May Special Report1 entitled “Housing In The Time Of COVID-19”, we highlighted that the initial uptick in home prices was spurred by housing supply falling faster than housing demand. Lockdowns and strict social distancing measures halted the construction of new homes and prompted sellers of existing homes to de-list their properties, thus immediately curbing the supply of homes for sale. Meanwhile, the mortgage forbearance allowed under the CARES Act prevented a wave of defaults and mass property listings by desperate sellers and low interest rates and generous fiscal transfers supported demand. Since then, economic activity has been recovering at a faster pace than widely anticipated and mortgage applications have eclipsed pre-pandemic highs. Yet, building permits and housing starts still have ample room to catch up. Are we heading towards a dearth of housing supply? Tight Or Undersupplied? Most real estate agents would claim that the biggest challenge they have had to face in the past few years was developing a new listing pipeline given low levels of new construction relative to history. The economic data confirms this observation: the inventory of homes for sale, as well as the share of homes currently sitting vacant, both stand at record lows (Chart 1). A rising pool of potential buyers and record-low interest rates make for lost commission opportunity amid this weak supply backdrop. Chart 1A Tight Housing Market All that one can infer from these observations, however, is that the housing market is currently a sellers’ market. Only the assessment of the underlying driver of long-term housing demand – household formations – can determine whether the overall housing market is over or undersupplied. Chart 2The Pre-GFC Extended Period Of Construction Excesses Was An Exception Rather Than The Norm There have been four2 extended phases of gains in new home prices since the 1970s (Chart 2). The longest one extended for 14 years from 1992 to 2006 but was also the slowest on a compound annual growth rate basis (CAGR). Nine million building permits were issued over the 103-month span of the most recent phase, a permit-per-month pace that was just two-thirds of the average pace of the preceding three phases (Table 1). Although a declining number of permits issued confirms the on-the-ground observations detailed above, the rate of household formation in the past decade was much slower than it was in the 1970s and 1980s. Table 1The Last Four Phases Of New Home Prices Gains Put In Perspective The number of permits adjusted for household formation shows that the housing cycle that culminated in the Global Financial Crisis (GFC) was marked by excessive construction. During that time, 1.4 building permits were issued for every new household formed. Conversely, in the other three new home price appreciation phases over the last 50 years, that ratio nears one-to-one. An alternative analysis using the number of housing starts instead of housing permits would yield similar results. Therefore, construction has been in line with the growth of new households formed in the latest cycle. As such, the market is not undersupplied. Drivers Of Household Formation Household formation is largely demographic-driven over the long term as today’s population growth trends will only be reflected in household growth a couple of decades down the line, when the newborn population reaches adulthood. Over a shorter horizon, household formation is mostly driven by the economic health of population cohorts in their 20s and 30s. Ample research has shown that today's younger generations have pushed marriage and homeownership to their 30s. Widely accepted reasons include lifestyle changes as well as a relatively more precarious financial situation, which is leading younger individuals to require several more years of income and savings to achieve preceding generations’ level of wealth. The positive takeaway for household formation and housing demand is that today’s 20-something cohorts will likely strike out on their own in the coming years as their financial situations improve. They are not a lost generation of household heads and homeowners, just a delayed one. The pool of young individuals still living at home and the economic recovery constitute a pocket of future household formation, which is the underlying driver of housing demand. We have shown in previous research that 25-34 year olds' financial situation has been improving. They have driven the bulk of the uptick in the homeownership rate and in mortgage applications. As a result, growth in the share of young adults living at home has started to decrease (Chart 3). The economic recovery should sustain this trend. Moreover, a growing pool of individuals aged 20-25 constitutes a pocket of future household formation (Chart 4). Overall, the number of households has room to increase at a healthy rate. Chart 3Improving Financial Situation Among Younger Individuals To Support Household Formation Chart 4A Growing Pocket Of Future Near-Term Housing Demand Decreasing Supply Elasticity Conversely, some obstacles are now standing in the way of additional new-home supply. After the decade of over-construction that preceded the 2008 housing crisis, evidence shows that homebuilders have been operating with caution and restraint ever since. Chart 5Banks Are Shifting Away From Relatively Riskier Construction Loans Researchers at the Bank of England, Norges Bank and Oslo Metropolitan University3 have examined how various degrees of supply elasticity explain the dispersion in home prices across the United States. Supply elasticity measures the extent to which changes in home prices drive new construction. The research paper sheds light on a generalized nationwide trend towards declining supply elasticity. Constrained access to credit partly explains homebuilders’ restraint. Bank lending practices have been relatively muted since the GFC. Lending over the past expansion grew at a markedly slower pace than it did in any other postwar expansion.4 The composition of banks’ balance sheets also reflects more conservative lending behaviors. Their loan books have increasingly shifted away from construction5 loans towards relatively safer multi-family mortgages (Chart 5). Rising construction costs are also likely reducing the number of viable construction projects. In March 2018, the Trump administration announced tariffs of 25% on imported steel and 10% on imported aluminum. The construction sector accounts for half of the global demand for steel and the US is the largest net importer. The price of lumber has increased 125% since March. A crackdown on immigration under the current administration is also contributing to rising labor costs, in an environment where homebuilders have reported that skilled labor availability issues persist. Supply has been constrained over the latest cycle…and we do not expect these supply headwinds to abate any time soon. Our colleagues at BCA’s Geopolitical Strategy remark that by highlighting the risks of globalization and border insecurity, the COVID-19 crisis is reinforcing two of Trump’s major policy themes: tighter borders and a renaissance in domestic manufacturing activity. They also note that immigration policy first started tightening under the Obama administration (Chart 6). Although a potential Biden administration might view immigration more favorably, the highly polarized US political climate and the need to address populist grievances will limit immigration even if the Democrats gain control of both the Senate and the White House. Chart 6US Will Tighten Immigration Laws One Way Or Another Chart 7Increasing Market Share Amongst The Largest Homebuilders An increase in land use regulation may also be stifling homebuilders. A recent NBER research paper6 reports that the level of regulation has generally increased between 2006 and 2018. Moreover, the concentration of big players within the homebuilding sector has increased. The share of total single-family completion by the 50 largest US homebuilders has grown from 24% to 35% between 2000 and 2019 (Chart 7). A higher concentration allows homebuilders to better navigate an increasingly regulated housing market, but it also decreases competition. Empirical evidence shows that firms with high market power may be incentivized to reduce output if doing so contributes to product scarcity, high sale prices and increased profits. On the demand side, so called NIMBYism (Not-In-My-BackYard) may also represent a headwind to additional new construction. The Bank of England, Norges Bank and Oslo Metropolitan University research paper notes that supply elasticity has decreased by a wider margin in states where home prices suffered most in the housing crisis. There is sound basis to hypothesize that since 2008, homeowners have become increasingly focused on maintaining the value of their properties by opposing new development projects. Towards A Supply Squeeze? Chart 8Current And Prospective Homeowners Taking Advantage Of Record-Low Mortgage Rates We do not expect the major supply headwinds to abate any time soon. Bank lending standards may ease at the margin as the economy recovers and some of the uncertainty about the credit outlook abates, but stricter bank regulation and more conservative lending standards should prevent a repeat of the subprime era’s construction excesses. Our geopolitical strategists have noted that a Democratic White House and Senate will likely maintain the pressure on China. As such, there is no assurance that tariffs on imported commodities would be reversed in the event of a Democratic sweep. We expect that the apex of globalization and pockets of inflationary pressure from COVID-19 supply disruptions will keep homebuilders’ input costs elevated. Demand has upside, though. It is already holding up well amid the current recession thanks to record-low mortgage rates and fiscal and monetary policy makers’ emergency efforts. The 30-year fixed mortgage rate fell below 3% for the first time in July. Mortgage lenders have reported increased backlogs due to the surging number of mortgage and refinancing applications (Chart 8), and mortgage rates may be headed lower once lenders are convinced that increased demand is sustainable. The extension of the Federal Reserve’s emergency lending facilities through the end of the year, announced last week, should help the economy at the margin. As long as Congress extends fiscal aid, policy makers’ efforts will help sustain the demand for homes and fears of a wave of mortgage defaults and distressed home sales one would expect in a severe recession will not materialize. Putting It All Together If demand remains well supported while the supply of new and existing homes remains muted, home prices do not have much room to decline. In our housing Special Report from May, we had hypothesized that the technical feasibility and increased acceptance of working remotely might lift suburban and satellite city home demand. There is early evidence of this phenomenon taking place in cramped and richly priced housing markets like San Francisco and New York. Moreover, the NAHB not only reported a stellar recovery to pre-pandemic levels in homebuilder sentiment in June and July but also an “increasing demand for families seeking single-family homes in inner and outer suburbs that feature lower density neighborhoods.” It saw improving new home demand “in lower density markets, including small metro areas, rural markets and large metro exurbs, as people seek out larger homes and anticipate more flexibility for telework in the years ahead”. Whether the pandemic will result in a material exodus from large cities is still up in the air. It remains to be seen whether remote working flexibility will recede as the pandemic weakens. Both employers and employees may favor part-time remote working arrangements, as suggested by many surveys, which would still warrant having a pied à terre within commuting distance from one’s workplace. Large metropolitan cities also remain attractive for reasons outside of one’s occupation, such as tourism or access to entertainment and leisure. Downward pressure on rents in large metropolitan areas might be more likely than an outright exodus from the city. Current renters and prospective first-time homeowners might want to take advantage of low mortgage rates and the ability to move further out from one’s workplace (though still within commuting distance) thanks to part-time work-from-home arrangements.   Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Footnotes 1 Please see BCA Research US Investment Strategy Special Report, "Housing In The Time Of COVID-19", dated May 18, 2020, available at usis.bcaresearch.com. 2 The real new home median sale price series goes back to 1963. We have identified four new home prices expansions starting from the first apparent bottom reached in December 1970 (Chart 2, first panel). 3 "The declining elasticity of US housing supply", Knut Aastveit, Bruno Albuquerque, Andre Kallak Anundsen, published 25 February 2020. 4 Please see BCA Research US Investment Strategy Special Report, "How Vulnerable Are US Banks? Part 2: It’s Complicated", dated April 6, 2020, available at usis.bcaresearch.com. 5 Construction loans are typically the most volatile and risky category of commercial real estate loans. Risks stem from frequent delays and sometimes the cancellation of construction projects. Loan delinquencies and defaults are common due to the cycle of booms and busts inherent to the construction industry. 6 Gyourko, J., Hartley, J., & Krimmel, J. (2019). The Local Residential Land Use Regulatory Environment Across U.S. Housing Markets: Evidence from a New Wharton Index. (No. w26573). National Bureau of Economic Research.

Last week we put a 5% rolling stop on the long S&P homebuilding/short S&P REITs pair trade in order to protect profits. Yesterday, our stop got triggered and we crystalized 10.3% gains since the May 26 initiation date. A slew of better-than-expected homebuilder reports caused the recent spike in this market-neutral trade, confirming that all-time low mortgage rates have brought back residential real estate buyers with a vengeance. While most of the key catalysts for this intra-real estate pair trade remain in place that we first outlined in our late-May report, we obey our risk management metric and choose to move to the sidelines for now. Bottom Line: Lock in two-month gains of 10.3% in the long S&P homebuilding/short S&P REITs pair trade and step aside, but stay tuned. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.  

Our intra-real estate pair trade long S&P homebuilders / short S&P REITs vaulted roughly to the 15% return mark intraday yesterday, compelling us to institute a 5% rolling stop in order to protect handsome profits since the late-May inception. Our thesis for putting on this market-neutral trade remains intact. The Fed’s ZIRP policy as far as the eye can see is perhaps the biggest catalyst for US homebuilders, especially as the one-off pandemic effects begin to wear off and people are able to take advantage of all-time low mortgage rates that recently breached 3%. In fact, the chart below suggests that the pair trade is poised for additional gains in the coming months. Bottom Line: We continue to recommend the long S&P homebuilders / short S&P REITs pair trade as more gains are in store, but from a portfolio management perspective we are instituting a 5% rolling stop in order to protect gains.

Dear Client, In lieu of our regular report next week, I will present our view on China’s economic recovery, geopolitical risks, and implications on financial markets in two live webcasts. The webcasts will take place next Wednesday, July 15 at 10:00AM EDT (English) and at 9:00PM EDT (Mandarin). Best regards, Jing Sima, China Strategist Highlights China’s economic recovery continues through June, but the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009. The intensity of the PBoC’s monetary easing may start to taper in H2, but the central bank is likely to stay on the easing course and keep liquidity conditions ample. Bank lending to the corporate sector should increase further in H2. Chinese stocks rallied through last week’s enactment of the new national security law for Hong Kong and the subsequently announced sanctions from the US government. The existing US sanctions should have limited impact on Hong Kong and mainland China’s economies and financial markets. We remain positive on Chinese stocks despite the recent rallies in China’s equity markets. Feature June’s official and Caixin manufacturing PMIs indicate that China’s economic recovery continues at a steady rate, with the production side of the economy picking up slightly faster than the demand side. The drag on China’s economic recovery from lackluster demand growth should be temporary. Unlike in 2015 when policy uncertainties hindered the recovery in both economic activity and stock prices, the Chinese government has been determined to support its economy and job market in the current cycle. The massive stimulus implemented since March has tremendously boosted activities in China’s construction sector. While households and the corporate sector remain reluctant to spend and to invest, their marginal propensity to spend usually catches up with credit growth with about a 6-9-month lag (Chart 1). The sharp pickup in credit growth should meaningfully support China’s economic rebound, while a better global growth outlook in H2 should also provide some modest tailwinds. On June 30, the PBoC announced a 0.25 percentage point cut to its relending rates for small and rural enterprises and to its general rediscount rate. While the scale of rate cuts in H2 will unlikely match that of Q1, China’s monetary and fiscal policy support will remain in place through the rest of the year. Chinese investable and domestic equities were some of the best performers among global asset classes in June, whereas they were the third-worst the month prior (Chart 2). In the first week of July, both Chinese investable and domestic stocks rallied even further. As we noted in our last week’s report,1 China’s stronger economic outlook, less uncertainty related to its domestic COVID-19 containment, and policy support should provide more room for Chinese stocks to trend upwards. Last week’s passing of the new national security law for Hong Kong and the subsequently announced sanctions from the US government, in our view, should have limited impact on investors’ sentiment for now. Chart 1China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months Chart 2Chinese Equities Are Taking Flight   Tables 1 and 2 present key developments in China’s economic and financial market performance in the past month, and we highlight several of these developments below: Table 1China Macro Data Summary Table 2China Financial Market Performance Summary China’s June official manufacturing PMI ticked up to 50.9 from 50.6 in the previous month. The Caixin manufacturing PMI came in at 51.2, beating the expectation of 50.5 and compared to 50.7 in May. Both suggest that China’s manufacturing sector continues to expand, however the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009 (Chart 3). Although the import and export subcomponents have fared better in June from the low levels in April and May, their readings in June were still below the 50 boom-bust line (Chart 4). Headwinds remain strong for global trade as the US and many of emerging economies are still struggling with the pandemic. Even without re-imposing lockdowns, the resurge in the number of new cases in the US may result in a drag on consumption and global trade. The IMF projects a 12% contraction in global trade in 2020. While the external demand may improve in H2, positive contribution to China's GDP growth from the net exports will be limited this year. Chart 3Current Recovery Lies Somewhere Between 2009 And 2015 Chart 4Demand-Side Recovery Remains Muted   The employment situation in the manufacturing sector has worsened since May, and has returned to contraction following a brief improvement in March and April (Chart 5). An estimated 8.7 million new graduates in 2020,2 a historical high number, will hit the job market in July and August. As such, China’s labor market will likely remain under significant pressure. Even though employment usually lags economic recoveries, depressed expectations on the job market will refrain policymakers from prematurely withdrawing stimulus measures. Small and micro enterprises are an important part of China’s private sector, which provides 80% of jobs in China. The manufacturing PMI of small enterprises fell below the 50 boom-bust line in June, reflecting a persistent weakness in this part of China’s economy. The recent relending and rediscount rate cuts suggest that the PBoC is committed to stay on the easing course. The intensity of monetary easing may start to taper in H2, but the central bank is likely to keep liquidity conditions ample and encourage banks to accelerate lending to the corporate sector. The contraction in Chinese producer prices deepened to -3.7% (year-over-year) in May. However, we think PPI deflation is likely to bottom in Q3. Both the purchasing and producer price subcomponents of the manufacturing PMI ticked up sharply in June, while the drawdown in industrial product inventory relative to new orders has accelerated (Chart 6). The ongoing accommodative policy should provide powerful tailwinds to both economic activity and the PPI in H2. The improvement in the PPI will help to boost industrial profits growth, which turned positive in May (year-over-year) for the first time this year. We expect year-to-date industrial profits to end the calendar year with a modest positive growth rate.  Chart 5Labor Market Pressure Intensifies Chart 6PPI Deflation Nears Its Bottom   China’s property market indicators have notably trended up in May, with year-over-year growth in housing demand normalizing to its pre-pandemic level (Chart 7A & Chart 7B). As the demand in housing rebounded faster than the supply, housing prices have correspondingly turned the corner in May after trending down for 6 consecutive months. Chart 7AHousing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Chart 7BStrong Rebound In Property Investments   Chart 7B shows that housing investments and land purchases have also recovered to near their pre-pandemic levels. Financing restrictions for property developers that were put in place since 2018 have been loosened in H1, which helped to boost real estate investments. We expect the property sector financing conditions to remain accommodative through the rest of this year. Moreover, there is a possibility that the PBoC will lower the 5-year MLF (medium lending facility) rate in Q3. As downward pressures on China's labor market and household income growth intensify, the government is likely to lower the mortgage rate to ease payment constraints on households. Chart 8Chinese Stocks Rallied Through Frictions Over Hong Kong Despite the passing of China’s new and controversial national security law for Hong Kong on June 30 and the subsequently announced sanctions from the US government, stock prices in both China’s onshore and offshore markets rallied (Chart 8). While we agree the US may impose further and more concrete sanctions on China during the months leading up to the November US presidential election, our preliminary assessment points to a limited economic cost on China from the existing US sanctions. The removal of Hong Kong’s special trade status will subject Hong Kong’s export goods to the same tariffs the US levies on Chinese exports. But the raised tariffs will barely make a dent in Hong Kong or mainland China’s export status quo. Hong Kong’s economy consists mainly of the financial, logistical and services sectors. The manufacturing sector only accounts for 1% of its overall economy. Chart 9 shows that Hong Kong’s exports to the US only accounted for around 1% of its total exports and 1.3% of its GDP in 2019. More importantly, of the $5 billion goods Hong Kong exports to the US, only 10% is actually produced in Hong Kong. Most of Hong Kong's exports to the US are goods produced in China that are re-exported through Hong Kong, which are already subject to the same tariffs as the goods China exports to the US directly.3 On the other hand, US exports to Hong Kong accounts for 2% of its total exports, with a trade surplus of about $30 billion in the past two years (Chart 9, bottom panel). The US trade surplus with Hong Kong has drastically reduced since the US-China trade war broke out in 2018, suggesting that the US has already imposed restrictions on its export goods to mainland China through Hong Kong. Moreover, the large trade surplus with Hong Kong as well as China’s commitment to the Phase One trade deal may be part of the reason President Trump is unwilling to impose more substantial sanctions on China right now. The US senate and house have also passed a bill which, if signed and implemented by President Trump, will allow the US government to levy any foreign financial institutions for knowingly conducting business with individuals who are involved in jeopardizing Hong Kong’s autonomy. Chinese banks with operations in the US will be mostly exposed to such sanctions. However, Chinese banks are largely domestic-focused with very low reliance on foreign-currency funding (Chart 10). Hence, the direct impact of a deteriorating operating environment in the US will be limited on Chinese banks. Chart 9Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Chart 10Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Weekly Report "Upgrading Chinese Stocks To Overweight," dated July 1, 2020, available at cis.bcaresearch.com 2 iiMediaReport, Analysis report on current situation and development trend of Chinese employment entrepreneurship market in 2020. 3 Please see Nicholas Lardy, “Trump’s latest move on Hong Kong is bluster”. Peterson Institute For International Economies, dated June 1, 2020.   Cyclical Investment Stance Equity Sector Recommendations