Equities

The vaccine announcement this week accelerated the unwinding of the long tech short everything else pandemic trade. While such a rotation is augmenting our portfolio via an explicit long “Back To Work”/short “COVID-19 Winners” trade, as we highlighted in yesterday’s Daily US Sector Insight, our small cap size bias is another prime beneficiary. Specifically, small caps outshined large caps by nearly 4% this week. One of the key drivers behind such a quick move is the delta in sector composition between the small and large cap indexes. The relative gap in deep cyclicals alone is 13% as we highlighted in recent research. The implication is that as manufacturing rebounds, so will the relative performance of small caps (top panel). Moreover, easy fiscal policy is a tonic to the small/large share price ratio. As a flood of money enters the economy with a slight lag, small caps will continue to make up ground lost during the early stages of the pandemic (fiscal balance shown inverted, bottom panel). Bottom Line: We reiterate our recent small cap bias.

Highlights US inflation expectations will moderate, and US real yields will rise. This will support the US dollar. The potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Rising US real yields are a risk to high-multiple global growth stocks. Maintain a neutral allocation to EM in global equity and credit portfolios. Feature In this week’s report we identify market-relevant issues and topics and then present the investment implications of these potential developments. Current key investment-relevant topics and issues are as follows: 1. Implications of the US elections Fiscal Stimulus: In the context of Biden’s victory and the Senate remaining Republican, the odds of a meaningful fiscal package in the next several months are quite low. The Republican Senate did not support a fiscal package going into the elections. Odds are low that it will now agree to a fiscal package larger than $750 billion. Chart 1Rising US Real Yields Are Positive For The US Dollar According to the US Congressional Budget Office’s calculations, without a new fiscal package, the fiscal thrust in 2021 will be -7.5% of GDP or $1.5 trillion. Hence, fiscal stimulus should be more than $1 trillion to avoid a slump in growth. Granted that the recovery in US consumer income and spending that has been underway since April has to a large extent been supported by US fiscal transfers, the lack of current government income support to households poses a risk to the economy.  Of course, if US economic activity tanks again and the stock market plunges, Republicans will support a much larger package. However, as things stand now, the probability of a substantial (more than $1 trillion) fiscal package is low. The lack of fiscal stimulus implies that US growth and inflation expectations will moderate. Chart 1 shows that US inflation expectations have probably reached an apex and will downshift for now. US nominal bond yields are capped on the upside (by the Fed’s purchases and its commitment not to raise interest rates for several years) and on the downside (by the Fed’s reluctance to reach negative interest rates). Consequently, swings in inflation expectations will drive fluctuations in real yields, as has been occurring in recent months. As inflation expectations decline, real yields will rise. Impact of rising US real yields on financial markets: A stronger US dollar and lower prices for Nasdaq stocks. Rising real rates will support the US dollar (Chart 1, bottom panel). Chart 5 on page 5 reveals that the real rates differential between the US and the euro area has recently been moving in favor of the greenback.  Chart 2Rising US Real Yields Are Negative For Growth Stocks Budding investor realization that the US might not pursue an aggressively expansionary fiscal policy, as has been expected since spring, could also support the greenback. Less issuance of Treasury securities might be interpreted as less public debt monetization and less money creation by the Federal Reserve. Such a viewpoint will also be marginally positive for the US dollar. As to the equity market, US real (TIPS) yields have been negatively correlated with the Nasdaq index (Chart 2). As US real yields continue to rise, odds are that global growth stocks will come under selling pressure. Geopolitical ramifications: The impact of the forthcoming change in the White House on US foreign policy has been widely anticipated and has already been priced in by financial markets. A Biden administration will have a positive impact on the euro area, Canada, Mexico and Asia Pacific countries with the exception of China – as was not the case under the Trump administration. On the other end, Russia, Turkey and Saudi Arabia will be under heat from Biden’s White House. In our view, the impact on China will be neutral, not better than during Trump’s administration. It might be mildly positive in the near term but negative in the long run. In the short run, the new US administration will be less likely to use global trade as a weapon. In the long run, however, Biden will likely mobilize Europe to join its geopolitical confrontation with China. This will be negative for the Middle Kingdom.   One country where the impact of Biden’s administration has not been fully priced in is Brazil. The US executive branch will take a tougher stance in its dealings with Brazil’s right-wing government because their social values are not aligned and policy priorities differ. We remain short the BRL and underweight Brazilian equity and fixed-income markets within their respective EM portfolios. 2. Vaccines We have no better expertise than the market’s judgement on the timing of vaccine availability and its effectiveness in containing the pandemic in EM ex-China countries. It is clear, however, that the process of vaccine acquisition and distribution might be slower in EM ex-China than in advanced countries. On all three fronts – the spread of the pandemic, policy stimulus and vaccine distribution – EM excluding China, Korea and Taiwan will continue lagging DM. Therefore, EM ex-China domestic demand will continue to underperform relative to expectations and versus those in DM. This argues for continuous underweight, or at best a neutral allocation, in EM ex-China, Korea and Taiwan equities versus their DM peers. Chart 3Chinese Onshore Equities Have Been In A Trading Range Since Early July 3. China: the business cycle and regulatory clampdown China’s business cycle recovery has further to go. The stimulus injected into the economy has been considerable and will continue to work its way into the economy. Even though we believe that China has reached peak stimulus, the latter works with a time lag of 6-12 months and economic growth will top only around mid-2021. That said, Chinese onshore share prices have been in a consolidation phase since early July and this is likely not over yet (Chart 3).  In turn, Chinese investable stocks have been surging in absolute terms and outperforming the global equity index (Chart 4, top panel). However, the entire Chinese equity outperformance has been due to growth stocks (TMT/new economy). Excluding these, the absolute and relative performance of Chinese investable stocks has been lackluster (Chart 4, top and bottom panels). Chart 4Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks In short, the spectacular performance of Chinese investable stocks this year has been attributed to three new economy stocks: Alibaba, Tencent and Meituan. These three stocks presently account for 40.5% of China’s MSCI Investable Index and 17.5% of the aggregate EM MSCI equity index. Concerns about regulatory clampdowns on new economy stocks have been, and remain, a major risk, not only in China but also in advanced economies. It is impossible to time regulatory actions. Nevertheless, investors should take into account the possibility that regulation may curb the profitability of new economy companies, especially if they are de-facto monopolies or oligopolies. Chinese authorities will not back down from imposing new regulation and scrutiny over the activities of giant new economy companies. Hence, risks of further de-rating remain elevated. In short, even though the mainland business cycle recovery is on a track, Chinese share prices remain at risk of correction due to overbought conditions and re-pricing of regulatory risks for new economy stocks. Will The US Dollar Capture Some Of Its Luster? US real yields are rising not only in absolute terms, but also relative to real yields in the euro area (Chart 5). Rising real yields in the US versus the euro area generally lead to a dollar rally against the euro.  Apart from rising US real bond yields, there are a number of other factors that will likely support the greenback: Investor sentiment on the US dollar is very low (Chart 6). From a contrarian perspective, this is positive. Chart 5The US Versus Euro Area: Real Yield Differentials And Exchange Rate Chart 6Investors Are Downbeat On The US Dollar   Consistently, investors are very short the US dollar, especially versus DM currencies (Charts 7and 8). Positioning is less short in the US dollar versus cyclical DM and high-beta EM currencies (Chart 8). That said, the fundamentals of EM high-beta currencies such as BRL, TRY, ZAR and IDR are poor. Chart 7Investors Are Very Long Safe-Haven Currencies… Chart 8...And Modestly Long Cyclical Currencies   The Republican Senate will block corporate tax increases and limit any regulatory initiatives by Democrats in Congress. Such business-friendly policies are currency bullish. In short, a Republican Senate is broadly positive for the US dollar, and markets have not priced it in. The fact that broad US equity averages – such as small caps and equal-weighted equity indexes – continue outperforming the rest of the world in local currency terms is also dollar bullish (Chart 9). The reasoning is that US equity outperformance versus the rest of the world suggests better profitability and return on capital in the US versus its peers. That favors a firmer US dollar. Finally, the broad-trade weighted US dollar is oversold and is sitting on a long-term technical resistance level (Chart 10). Chart 9US Relative Equity Outperformance Heralds A Stronger US Dollar Chart 10The US Dollar Is Very Oversold   Bottom Line: We have been highlighting downside risks to the US dollar since July 9. However, the conclusion of the US election raises the odds of a playable US dollar rebound. EM Strategy EM Equities We have been advocating for a neutral allocation toward EM in a global equity portfolio since July 30. If the US dollar rebounds, as we expect, EM stocks will not outperform the global equity index (Chart 11). Notably, excluding Chinese investable stocks, EM share prices have not outperformed the global benchmark (Chart 12). Besides, as shown in the top panel of Chart 4 on page 4, China’s outperformance against the global equity benchmark has been driven exclusively by new economy stocks. Chart 11EM Stocks Do Not Outperform When The Dollar Rallies Chart 12EM Versus Global Equity Performance: With And Without China   All in all, Charts 4 and 12 reveal that excluding three large Chinese new economy stocks – Alibaba, Tencent and Meituan – EM share prices have underperformed the global equity benchmark. Going forward, the potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Meanwhile, the correction in the NASDAQ and the increased scrutiny on the part of Chinese authorities over new economy stocks poses a risk to Chinese mega-cap TMT share prices. In absolute terms, we have been waiting for a pullback to buy EM equities, but they have surged following the US elections and the news on Pfizer’s vaccine. Chart 13EM Equity Index: No Breakout Yet The EM equity index could still advance and reach its 2011 or 2018 highs before rolling over (Chart 13). However, given our view on the US currency and risks to EM stemming from a rising US dollar, we refrain from playing such limited upside. EM currencies EM currencies will be at a risk if the US dollar stages a rebound. Since July 9, we have been shorting a basket of BRL, CLP, TRY, KRW, ZAR and IDR versus an equally-weighted basket of the euro, CHF and JPY. We are sticking with this strategy. Even if the US dollar rebounds, downsides in the euro, CHF and JPY against the greenback will be relatively limited. However, investors might consider adding the US dollar to the long side of this strategy. EM local bonds and EM credit markets We continue recommending long duration in EM local rates. However, we remain reluctant to take on currency risk. We maintain our recommendations from April 23 about receiving 10-year swap rates in Mexico, Colombia, Russia, India, China and Korea. We are also receiving 2-year rates in Malaysia and South Africa as a bet on rate cuts in these economies. In the EM credit space, we are also neutral. Our sovereign credit overweights are Mexico, Colombia, Peru, Russia, Thailand, Malaysia and the Philippines. Our underweights are South Africa, Turkey, Indonesia, Argentina and Brazil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Yesterday’s vaccine news reawakened investors to the reality that the world might be going back to normality much sooner than previously anticipated unleashing a violent equity rotation. Perhaps one of the most illustrative examples is the one-day percentage change in our “Back To Work” and “COVID-19 Winners” baskets. The top and middle panels of the chart on the right highlight the point: 7/14 stocks in the “Back To Work” basket experienced more than a 10% increase with AXP leading the pack with a mighty 21% rise. On the other side, pandemic beneficiaries got clobbered with ZM losing 17% of its value.  As a reminder, we have been recommending being long our “Back To Work” basket at the expense of the “COVID-19 Winners” basket since early September, and this trade is currently up 15% since inception. Importantly, the economic normalization process has just begun and according to the ISM manufacturing PMI new orders sub-category there is likely a long runway ahead for this pair trade (bottom panel). Bottom Line: Stick with the long “Back To Work” basket / short “COVID-19 Winners” basket, but recent market action is enticing us to put a trailing stop at the 10% return mark in order to protect profits. ​​​​​​​

In this Monday’s Special Report we introduced our 2021 SPX target of approximately 4,000 and also updated our EPS forecast from $162 to $168. We arrived at these targets by applying our three-scenario approach that we first implemented in our research methodology early in the year. Specifically, our worst-case scenario (with the lowest probability of occurrence) is a recessionary relapse (double-dip recession) in 2021. Our base- and best-case scenarios incorporate bullish recovery dynamics that we forecasted in our Special Report and that Table 1 below also summarizes. Bottom Line: We remain cyclically and structurally bullish on the US equity market with the current end-2021 SPX target of 4,000 and EPS of $168. Table 1

Special Report

Feature In April we first published our view that S&P 500 EPS would return to trend level of $162 in calendar 2021. At the time, it seemed unrealistic as heightened uncertainty was cloaking over 2020 let alone 2021. But fast-forward to today, and analysts have already eclipsed our stale $162 estimate according to I/B/E/S data. In this Special Report, we update our very well-received three SPX EPS scenario analysis that we highlighted in January, validate whether the $162 estimate is still reasonable, and finally introduce our 2021 SPX target. Importantly, our four-factor macro S&P 500 earnings model ticked up recently following a better-than-expected ISM manufacturing release. The profit model’s current projection calls for roughly 20% year-over-year (yoy) growth for the first quarter of 2021 (Chart 1). Understandably, such a bullish outlook might raise some eyebrows. However keep in mind that 20% yoy growth from a recessionary trough is by no means an overly bullish estimate as we have shown in recent research owing largely to base effects. The next step is to put some science behind our forecast and arrive at a robust and quantifiable EPS forecast. Thus, we deconstruct our SPX profit growth model into its components and trace their likely paths over the next 8 months. Our model has four inputs: ISM manufacturing PMI, the greenback, interest rates and house prices. The first three components are responsible for the lion’s share of explanatory power; hence this is where we focus most of our attention. Chart 1One-Way Road To 2021   Extending The Model: ISM Manufacturing PMI To plot the likely path of PMI data, we introduce US Equity Strategy's FutureCast Indicator, which is based on Michael Howell’s of CrossBoarder Capital D-star (duration*) measure.1 As a brief explanation, D-star measures duration at which curvature of the US Treasury curve is maximized. The interpretation of D-star is that it is a duration boundary after which, economic conditions become uncertain. Consequently, the further away that boundary is, the longer the sanguine macro environment is expected to last. Similarly, as D-star takes smaller values, it signifies that the boundary is getting closer to the present, meaning that the length of the sanguine macro window is contracting. For more details on the D-star measure, please refer to Michael Howell’s original publication.2 While our FutureCast indicator is a slightly modified version of the original D-star measure, it still preserves all of the properties including a lead on the ISM manufacturing PMI data by 15 months (Chart 2). The current message is also enticing: over the course of 2021 the ISM manufacturing PMI will stay perched in the mid-to-high 50s on a three-month moving average basis while dipping into the low-to-mid 50s in 2022. Chart 2Introducing FutureCast Indicator The next series that will help us gauge the ISM’s future path is the BCA US Liquidity Indicator (USLI), which is a blend of six variables including credit conditions and “excess money” calculations that quantify how much extra money is available to the financial economy after the real economy takes its share adjusted for inflation. Similar to our FutureCast Indicator, the USLI used to lead the PMI by approximately 18 months prior to the dot-com bubble, but since then the lead has changed to 30 months (Chart 3). This extension likely reflects the growing dependence of the US economy on the financial sector. Chart 3Everyone Gets Liquidity! We have entered a brand-new liquidity cycle as the USLI is printing nearly all-time high readings. The reason behind such an aggressive rise is a number of exogenous shocks that were hounding the market over the past several years. Not only was liquidity already contracting in 2018, but the trade war with China exacerbated the manufacturing downturn capping new inflows. As a result, by the time the virus hit, US liquidity canisters were running dry, and policy makers had to open the liquidity spigots in order to belatedly cushion the blow from the trade war and combat this year’s COVID-19 related lockdown. The net result is that today abundant liquidity is sustaining the budding recovery, which will be reflected in upbeat PMI prints going forward. Extending The Model: The US Dollar The US dollar is the second major input in our earnings model as the S&P 500 derives 43% of its sales outside US boarders. Table 1 also highlights that deep cyclical sectors source most of their revenues internationally, further underscoring greenback’s importance. Currently, the US dollar remains range bound likely taking a breather before resuming its downtrend as ours and BCA’s working view remains for a cyclical depreciation in the currency. The bearish USD thesis is multifaceted. Starting from a structural (5-10 years) time horizon, swelling twin deficits as far as the eye can see emit a bearish US dollar signal; in more detail, prior to the pandemic, the US twin deficits were estimated to gradually rise toward the 7.5% mark, but COVID-19 related fiscal largess has pushed the twin deficits into the stratosphere (top panel, Chart 4). Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* Switching gears from a structural to a medium-term horizon (2-3 years), BCA’s four-factor macro model, is also sending an unambiguous bearish message for the greenback (middle panel, Chart 4). Finally, on a short-term time frame, the USD is lagging the money multiplier by approximately 3 months, and the nosedive in the latter cements the US dollar bearish thesis (bottom panel, Chart 4). Chart 4Bearish Across All Timeframes Since S&P 500 sales and the greenback are inversely correlated, and as the dollar bearish view unfolds, it will serve as a tonic to top- and bottom-line growth. Extending The Model: US 10-Year Treasury Yield Now onto the final piece of the puzzle – the 10-year US Treasury yield. Up until recently, the bond market was dormant refusing to price in the recovery. While the selloff in bonds that commenced in early August took a breather on the back of the GOP retaining the Senate, i.e. implying a smaller than previously expected fiscal stimulus package, the path of least resistance remains higher for yields. As the economy continues to reopen in 2021, a new bear market in bonds is likely. US yields are tightly correlated with the ebbs and flows of global growth, especially G7 industrial production (IP) growth. Global IP is set to recover from the depths of the COVID-19 recession paving the way for higher 10-year US Treasury yields. In fact, our excess demand for goods indicator, which gauges the difference between the total number of goods produced versus consumed, leads industrial production data by 12 months and currently predicts a long overdue V-shaped recovery in global IP (Chart 5). In summary, it is only a question of time until the ten-year catches up with “soft” data and the bullish economic signal from the equity market, both of which have already discounted a V-shaped recovery. The US 10-year Treasury yield has a positive coefficient in our SPX EPS growth regression model, implying that rising yields that reflect an economic rebound boost EPS and vice versa. Chart 5Yields Will Rise Tying It All Together Adding all the pieces of the puzzle reveals that our previous $162 estimate is slightly pessimistic for calendar 2021. We arrived to this conclusion by applying our three-scenario approach that we first implemented in our research methodology early in the year. Specifically, our worst-case scenario (with the lowest probability of occurrence) is a recessionary relapse (double-dip recession) in 2021. Our base- and best-case scenarios incorporate bullish dynamics that we outlined earlier in the report and we quantify below to arrive at our new probability-weighted $168 EPS estimate. We then deduce our 2021 SPX target through a five-step process outlined in Table 2. Table 2Three Scenarios Step 1: We plug into the model our base, worse and best case estimates of the four macro variables into mid-2021, and we get as output the model’s estimate of EPS growth for end-2021 with a range of -3.6% to 36.2% (one important assumption is that the historical correlation of the movement of these variables holds steady). Step 2: Then, we apply these growth rates to the expected IBES 2020 EPS forecast of $136/share and arrive at our end-2021 three scenarios EPS level estimates with a range of $131/share to $185/share. Step 3: We then assign probabilities to those three outcomes resulting in our new 2021 EPS forecast of $168/share. Step 4: In order to get an SPX expected value we need to apply a forward P/E multiple to our EPS estimate. Thus, we introduce our base-, worse- and best- case forward P/Es and multiply them with our $168/share weighted EPS forecast in order to arrive at the SPX 3,940 expected value for end-2021. Concluding Thoughts So what does it all mean? At the onset of the report we mentioned an eyebrow-raising 20% EPS growth estimate. However as it turns out, if we take into account the long overdue economic recovery that started in early-2020, but got short-circuited due to the COVID-19 outbreak, there are reasonable scenarios that can overwhelm our previous $162 2021 EPS target. Moreover, if the looming stimulus lands sometime in early Q1/2021, our best-case scenario may come to fruition. Under such a backdrop the SPX is likely to gallop even higher than our roughly SPX 4,000 target by the end of 2021. Finally, last week Wall Street analysts upgraded their calendar 2021 EPS estimate to $168 following news that the GOP would retain the Senate, which will prevent Biden’s tax increase should he be the winner of the 2020 election. If everything goes according to plan, then there are high odds that sell-side analysts will eventually catch up to our best-case scenario. But by then the market will have likely already discounted such a rosy backdrop, calling for a brand-new earnings analysis. Stay tuned.   Arseniy Urazov Research Associate Arseniyu@bcaresearch.com     Footnotes 1     Howell, Michael J. 2017. Further Investigations into the Term Structure of Interest Rates. London: University of London. 2     Ibid.