Market Returns
In lieu of the next strategy report, I will be presenting the quarterly webcast titled ‘Five Contrarian Predictions For 2021-22’ on Thursday February 11 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join. Highlights Many of the ‘short squeezed’ investments that day traders have bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side. The biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. The happy corollary is that the structural bull market in equities will only end when the 10-year T-bond yield reaches zero. Until then, stay structurally overweight equities. Structurally overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal trade: short AUD/JPY. Feature Chart of the WeekShort-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) There is no divine law that decrees the ‘correct’ time-horizon for any investment. Depending on your objectives and skills, a correct investment horizon could be anything spanning a few milliseconds to a hundred years. Once you absorb this fundamental point, it leads to a profound conclusion: The ‘correct’ price for any investment depends on your investment horizon. The Most Important Investment Question Is, Who Is Setting The Price? A long-term investor and a day trader will go through completely different thought processes to determine a stock’s ‘correct’ price. The long-term investor, intending to buy and hold the stock for ten years, will receive 40 quarterly dividend payments plus the stock price as it stands in 2031. Hence, the correct price is the discounted value of those expected cashflows. But for the day trader, intending to buy today to sell tomorrow, only one cashflow matters – tomorrow’s price. Hence, the correct price is simply the expected price at which he can sell tomorrow. The longer-term cashflows are irrelevant, unless they set the selling price tomorrow. Yet this is unlikely, because as Benjamin Graham put it: In the long run the market is a weighing machine, but in the short run it is a voting machine. Therefore, a long-term investor and a day trader are completely different animals, whose price-setting behaviour must be seen through different lenses. This matters because the price is always set by the last marginal transaction. The important question then is, who is setting the price? All of which brings us to the battle raging between a cabal of day traders and a group of hedge funds. The day trader is buying today because he expects that the hedge fund, desperate to cover its short positions, must buy at an even higher price tomorrow. The day trader’s behaviour is rational, so long as it is within the law, and so long as the hedge fund short-covering is the marginal price taker. Eventually though, the desperate hedge fund will not take the price, because there are no more short positions left to cover. At this point, if the day trader wants to exit his position, the marginal buyer will be a longer-term investor who will only buy at a much lower fundamentally-determined price. The day trader will have won the battle, but lost the war. The crucial takeaway is that we should always monitor which time-horizon of investors is setting the marginal price of an investment. We can do this by continually measuring the fractal structure of the investment’s price. We should always monitor which time-horizon of investors is setting the marginal price of an investment. When the fractal structure of an investment has collapsed, it means that the time-horizon of investors setting the price has compressed to a near-term limit. Thereby it signals that the price-setting baton will return to long-term investors who will reset the price to valuation anchors, such as discounted long-term cashflows. The implication is that the preceding trend, fuelled by short-term price setters, is likely to reverse. Today, we observe that many of the investments that day traders have recently bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side (Chart of the Week, Chart I-2 and Chart I-3). Chart I-2Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Chart I-3Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) The Major Misunderstanding About Real Bond Yields A common question we get is, should we compare the prospective returns on equities and bonds in nominal terms or in real terms? In an apples-for-apples comparison it shouldn’t really matter. The problem is that while we know the prospective nominal return from bonds (it is just the bond yield), it is extremely difficult to know the prospective real return from bonds. As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield. A trustworthy ex-ante real bond yield requires a trustworthy prediction of inflation. But both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds are lousy at predicting inflation.1 As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield (Chart I-4 and Chart I-5). Chart I-4The Markets Are Lousy At Predicting Inflation In Europe... Chart I-5...And In The ##br##US A second point is that the required excess return on equities versus bonds is a nominal concept. This is because the bond yield’s lower limit is set in nominal terms, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. As the riskiness of equities and bonds converges, the required nominal return on equities collapses towards the ultra-low nominal bond yield. There are two important takeaways. First, we should always compare the valuation of equities and their prospective nominal return with the nominal bond yield. Second, the valuation of equities is exponentially sensitive to an ultra-low nominal bond yield (Chart I-6). Chart I-6The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential We conclude that the biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. Yet the happy corollary is that the structural bull market in equities will only end when bond yields can go no lower. In practice, this means when the 10-year T-bond yield reaches zero. Until then, long-term investors should stay in the stock market. The Major Misunderstanding About Valuation Another common question we get is, is it always meaningful to compare an investment’s valuation versus its own history? The answer is no. The comparison with a historical average is meaningful only if the valuation is mathematically stationary, which is to say it has not undergone a ‘phase-shift’. If the valuation has undergone a phase-shift, then the comparison with its own history is meaningless. As an analogy, nobody would compare their bodyweight with its lifetime average, because we understand that our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our bodyweight with its lifetime average, it would give the false signal that we were permanently overweight! Likewise, to avoid getting a false signal from a valuation, we should always ask, has it undergone a phase-shift? If a valuation has undergone a phase-shift, then a comparison with its own history is meaningless. Unfortunately, the structural prospects for financials, oil and gas, and basic resources – sectors that dominate ‘value’ indexes and stock markets – did suffer a major downward phase-shift at the start of the 2000s (Chart I-7). It follows that we cannot compare the valuations of ‘value heavy’ indexes with their long-term history, and draw any meaningful conclusions. Chart I-7Value' Sector Profits Are In A Major Structural Downturn Proving this point, the relationship between value-heavy European valuations and subsequent 10-year return is much worse for periods ending after the global financial crisis compared with periods ending before it. Whereas the relationship between growth-heavy US valuations and subsequent return has barely changed, because the structural prospects for growth sectors have not suffered downward phase-shifts (Chart I-8 and Chart I-9). Chart I-8The Relationship Between Valuation And Future Return Has Changed In Europe... Chart I-9...But Not So Much ##br##In The US Given the ongoing trends in value versus growth profits, it is much safer to overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal Trading System* The rally in AUD/JPY is at a potential a near-term top based on its collapsed 65-day fractal structure. Accordingly, this week’s recommended trade is short AUD/JPY, setting the profit target and symmetrical stop-loss at 2.8 percent. Chart I-10AUD/JPY In other trades, short European basic resources versus the market achieved its 4 percent profit target and is now closed. The rolling 12-month win ratio now stands at 57 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Long-term investors should seek companies and sectors that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised… …and a way of life in which we live, work, and interact more online, remotely, and digitally. The long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives. The long-term losers will be banks, oil and gas, and resources: the value cyclicals. The European stock market’s substantial underweighting to the growth defensives will weigh on its relative performance, both in the short term and in the long term. Fractal trade: Overweight the US 30-year T-bond versus the French 30-year OAT. Also, we have closed our tactical underweight to equities versus bonds. Feature Chart of the WeekYield Chasers Get A Rude Awakening As Dividends Collapse For the world’s yield chasers, 2020 has been a rude awakening. What seemed to be safe and attractive dividend yields have vanished into smoke, as blue-chip company after blue-chip company has slashed its dividend. To name just a few, HSBC has cut its dividend to zero for the first time ever; Barclays has cut its dividend to zero for the first time since 2009; and Royal Dutch Shell has slashed its dividend by 34 percent, taking it back to where it was in 2009. More generally, the high-yielding sectors have slashed their dividends: the world oil and gas sector by 60 percent (Chart of the Week) and the world bank sector by 33 percent (Chart I-2). The basic resources sector has cut its dividend by a more modest 15 percent, but the dividend now stands at the same level as it was in 2009 (Chart I-3). Chart I-2Dividend Cuts From High-Yielding Banks... Chart I-3...And High-Yielding Resource Companies In contrast, the low-yielding technology and healthcare sectors have managed to grow their dividends consistently over the past decades, and then maintain the dividends during the current crisis (Chart I-4 and Chart I-5). Chart I-4Dividend Growth And Continuity From ##br##Low-Yielding Healthcare... Chart I-5…And Low-Yielding ##br##Tech The world’s yield chasers have had a rude awakening because they often confuse yield with return. One reason for this confusion is that for cash and for high-quality government bonds held to redemption, yield and return are broadly the same.1 But for an equity, yield and return are not the same. As we have seen with the oil and gas sector and banks, an equity could start with a seemingly safe and attractive dividend yield yet end up generating a deeply negative return.2 The lesson is that long-term investors should never search for yield, they should always search for return. Mental Accounting Bias, And The Irrational Search For Yield The confusion between yield and return is not just an issue of semantics. It is a well-known phenomenon in behavioural finance known as mental accounting bias.3 This psychological bias describes the tendency to group financial gains and losses into separate mental accounts or buckets. This causes people to treat money differently according to the bucket that the money occupies. One version of this bias is a distinction between the return that an investment provides from yield and that which it provides from capital appreciation. The distinction between yield and capital appreciation is irrational. Assuming an equal tax treatment, the money that comes from yield and the money that comes from capital appreciation is perfectly fungible. Yet psychologically, the distinction is very stark. Behavioural finance postulates that because of fears about self-control, some people tend to categorize an investment’s yield as spending money, and its capital as saving money. Long-term investors should never search for yield, they should always search for return. Hence, those people who want their assets to generate spending money – say, retirees – have an irrational bias towards investments that generate yield. Whereas those people that are saving for the long term have a bias towards investments that generate capital growth. To reiterate, these biases are completely irrational. Under normal circumstances, the irrational biases are not a problem because there are enough investments available for both buckets. But in today’s world of zero and negative interest rates, the assets that would normally generate the safe income for the spending bucket – cash and government bonds – are no longer doing so (Chart I-6). In the ensuing ‘search for yield’, income focussed investors have flocked to the dwindling number of investments that appear to generate the required income, such as high-yielding equities. But in irrationally focussing on yield rather than on expected return, the world’s yield chasers have lost a lot of money. Chart I-6Equities Are The Only Yield-Generating Mainstream Asset-Class The Halo Effect, And The Shattered Halo The matter is made worse by a second phenomenon in behavioural finance known as the halo effect. This is the tendency to worship – place a halo – on someone or something based on some narrow criteria. For a company, the narrow criteria can mean its dividend history. The dividend is one of the few financial metrics over which the company has substantial control, giving it totemic significance with the company’s investors. Investors place a halo on companies with dividend continuity, a lengthy absence of a dividend cut. The distinction between yield and capital appreciation is irrational. However, if the company cuts its dividend, even slightly, then the halo shatters. Given this stigma, companies try very hard not to cut the dividend until it is unavoidable. But when they do cut, they usually cut big, and for an extended period – because the halo is shattered anyway (Chart I-7 and Chart I-8). Chart I-7When Firms Cut Their Dividends, They Usually Cut Big... Chart I-8...And For An Extended ##br##Period Realising this, investors flip the company from saint to sinner, meaning that they demand a higher cost of capital. The upshot is that even after the dividend cut, the stock can suffer a prolonged period of underperformance. Low Yield To Deliver High Return To repeat, long-term investors should never search for yield, they should always search for return. Today, this search for return boils down to two questions: Which companies will be able to grow or, at the very least, maintain their dividends in the post-pandemic world? What is the likely direction of bond yields, and specifically the long-duration T-bond yield, given its pivotal role in setting the discount rate on all investments? To the first question, the winning companies will be the ones that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised. And one in which the way we live, work, and interact – both socially and economically – is more remote, online, and digital. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Crucially, this means that when a credible treatment for Covid-19 eventually arrives, it will not reverse the major changes that our way of life is now undergoing. To the second question, the Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric, especially to the labour market. The central bank has told us that it will be thick-skinned to reflationary shocks or lower unemployment, but trigger-happy to the slightest further deflationary shock or higher unemployment. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Hence, when the slightest further deflationary shock comes – and sooner or later it will – the Fed will either follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or more likely, the Fed will follow the Bank of Japan in formally implementing yield curve control. Either way, US long-duration bond yields will eventually converge with those in the UK and Japan at zero. The result of our two answers is that long-term investors should seek companies that can thrive off the major changes in the way we live, work, and interact; and investors should seek companies with long-duration cashflows that benefit most from a further compression in the long-duration T-bond yield. In combination, the long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives (Chart I-9). And the long-term losers will be banks, oil and gas, and resources: the value cyclicals (Chart I-10). Chart I-9Growth Defensives Are The Long-Term Winners Chart I-10Value Cyclicals Are The Long-Term##br## Losers For the European stock market, the unfortunate consequence is that its substantial underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* This week’s recommended trade is to go long the US 30-year T-bond versus the French 30-year OAT. Set the profit target and symmetrical stop-loss at 3.2 percent. The tactical underweight to equities versus bonds (short DAX versus 10-year T-bond) reached the end of its holding period. Although it closed in slight loss, the fractal signal correctly identified that the majority of the strong rally in the DAX was over by mid-July after which the DAX has traded broadly sideways. The countertrend move in the Italian BTP’s rally versus the German bund did not materialise, so this trade was closed at its stop-loss. The rolling 1-year win ratio now stands at 57 percent. Chart I-1130-Year Govt. Bonds: US Vs. France When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no reinvestment risk on the bond’s income. 2 This is because unlike the government bond, the equity does not generate a predetermined stream of cash flows. 3 See Rational Choice and the Framing of Decisions by Amos Tversky and Daniel Kahneman. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Chart 1Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 2nd, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 63 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 63 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 2nd, 2020) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Highlights Portfolio Strategy We recommend investors participate in the equity market rotation during the ongoing correction and position portfolios for next year’s bull market resumption by preferring unloved and undervalued deep cyclical laggards. Ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs. Vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities. Recent Changes Our trailing stop got triggered and we downgraded the S&P internet retail index to neutral for a gain of 20% since the mid-April inception. This move also pushed our S&P consumer discretionary sector weighting to a benchmark allocation for a gain of 15% since inception. Table 1 Feature The S&P 500 broke below the important 50-day moving average last week, but managed to bounce off the early-June 3233 level – also a level where the SPX started the year – that could serve as temporary support (Chart 1). We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Chart 1Critical Support Levels The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated last week. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow. Figure 1The Fiscal Policy Loop It is no surprise that the Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry (Chart 2). Chart 2In Dire Need Of Fiscal Stimulus If Congress fails to pass a new fiscal package by October 16, the latest now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse despite households drawing down their replenished savings (middle panel, Chart 3). This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. With regard to equity market specifics during the current FPL iteration, banks are most at risk as they are levered to the economic recovery, and commercial real estate ails remain a big headache. Absent a fiscal package bank executives will have to further provision for loan losses when they kick off Q3 earnings season in late-October as CEOs will err on the side of caution. Tack on the recent news on laundering money – including by US banks – and the Fed’s new stringent stress tests, and the risk/reward tradeoff remains poor for the banking sector (bottom panel, Chart 3). Odds are high that volatility will remain elevated heading into the election, therefore this phase represents an opportunity for investors to reshuffle portfolios and prepare for an eventual resumption of the bull market in early-2021. We continue to recommend investors avoid our “COVID-19 winners” basket and prefer our “back-to work” equity basket that we initiated on September 8. Similarly, this pullback is serving as a catalyst to shift some capital out of the fully valued tech titans and into other beaten down parts of the deep cyclical universe. Chart 3Show Me The Money We doubt this correction is over as positioning in the NASDAQ 100 derivative markets is still lopsided; stale bulls are caught net long as NQ futures are deflating, thus a flush out looms (Chart 4). Chart 4Flush Out The easy money has likely been made in the tech titans that near the peak on September 2, AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out. Using a concrete rebalancing example to illustrate such a rotation is instructive.2 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift (Chart 5). As a reminder our portfolio has an above benchmark allocation in all three deep cyclical sectors, and this week we reiterate our overweight stance on both the industrials sector and on a key subgroup. Chart 5Rotation Rotation Rotation Buy The Machinery Breakout Were we not already overweight the S&P machinery index, would we upgrade today? The short answer is yes. Aggressive loosening in Chinese financial conditions have underpinned the economic recovery (second & third panels, Chart 6). Infrastructure projects are making a comeback and absorbing the slack in machinery demand caused by COVID-19. As a result, Chinese excavator sales have soared in the past quarter which bodes well for US machinery profit prospects (bottom panel, Chart 6). Beyond China, emerging markets demand for machinery equipment is robust as the commodity complex is recovering smartly (second panel Chart 7). The US dollar bear market is also bolstering global trade growth, despite the greenback’s recent technical bounce, and should continue to underpin machinery net export growth and therefore profit growth for US machinery manufacturers (third & bottom panels, Chart 7). Chart 6Enticing Chinese Backdrop Chart 7Dollar The Great Reflator The domestic machinery demand backdrop is also conducive to a renormalization of top line growth to a higher run-rate. The ISM manufacturing new orders sub-component is shooting the lights out, heralding a jump in machinery orders in the coming months (second panel, Chart 8). Simultaneously, a quick inventory check is revealing: both in the manufacturing and wholesale channels cupboards are bare which means that the risk of a liquidation phase in non-existent (third panel, Chart 8). Encouragingly, an inventory buildup phase is looming in order to satisfy firming demand. The tick up in machinery industrial production growth, the V-shaped recovery in the utilization rate and newly expanding backlog orders, all suggest that domestic demand conditions are on the mend (Chart 9). Tack on still prudent payrolls management that is keeping the machinery industry’s wage bill at bay (bottom panel, Chart 8), and a profit margin expansion phase is a high probability outcome. Chart 8What’s Not… Chart 9…To Like Our resurgent S&P machinery revenue growth model and climbing profit growth model do an excellent job in encapsulating all the industry’s moving parts and suggest that the path of least resistance is higher for relative share prices in the New Year (Chart 10). Finally, relative valuations have also recovered from the depth of the recession, but are only back to the neutral zone leaving enough room for a multiple expansion phase (Chart 11). Chart 10Models Say Buy Chart 11Compelling Entry Point In sum, ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs. Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Industrials Are Jumpstarting Their Engines We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Industrials equities have been on the selling block and suffered a wholesale liquidation during the dark days of the COVID-19 pandemic, and have yet to regain their footing (top panel, Chart 12). The GE and Boeing sagas have dealt a big blow to this deep cyclical sector, but now this market cap weighted sector has filtered these stocks out as neither of these “fallen angels” is occupying a spot in the top 5 weight ranks. Relative valuations are washed out, and relative technicals are still deep in oversold territory (second & third panels Chart 12). Sell-side analysts are the most pessimistic they have been on record with regard to the long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 12)! All this bearishness is contrarily positive as a little bit of good news can go a long way. Already, relative EPS breadth is stealthily coming back, and net earnings revisions are rocketing higher (Chart 13). Chart 12Liquidation Phase… Chart 13…Is Over One reason behind this optimism rests with the domestic recovery. Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (Chart 14). Emerging markets (EM) and China represent another source of industrials sector buoyancy. The EM manufacturing PMI clocking in at 52.5 hit an all-time high. China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 300 points from -240 to above +60 over the past six months. The upshot is that US industrials stocks should outperform when China and the EM are vibrant (Chart 15). Chart 14Domestic And … Chart 15… EM Green Shoots Are Bullish Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve (third panel, Chart 16). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel, Chart 16). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel, Chart 16). The US Equity Strategy’s macro based EPS growth model captures all the different earnings drivers and signals that an earnings-led recovery is in the offing (Chart 17). Chart 16The Greenback Holds The Key Chart 17Models Flashing Green Adding it all up, vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities. Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. 2 Our example assumes benchmark allocation in all sectors for illustrative purposes. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth
Highlights While we are bearish on the US dollar in the long run, the greenback is primed for a rebound in the near term. Consistently, commodities prices will relapse and EM currencies will depreciate versus the US dollar. Global growth stocks will correct further because they are overbought/over-owned and expensive. The rest of the equity market will relapse because its fundamentals are poor, especially given the renewed rise in new infection cases across Europe and the US. Feature Global financial markets are in the process of a reset. Several segments have been through very sharp and considerable movements in recent months, and these movements are starting to partially unwind. The US dollar will rebound, commodities prices will correct and global equities will continue selling off. In brief, EM risk assets and currencies are entering a period of weakness, which will eventually lead to buying opportunities. Inter-Linkages Between Fixed-Income, Currencies And Commodities Chart I-1A Reset In US Inflation Expectations And Real Rates Is Overdue US inflation expectations have risen meaningfully, and US TIPS (real) yields have plummeted since April (Chart I-1). Consistent with plunging US real rates, the US dollar has sold off sharply (Chart I-1, bottom panel). Although our bias is that US inflation will rise in the coming years, for now, the rise in inflation expectations seems excessive. Given the tight correlation between oil prices and US breakeven inflation, as illustrated in the top panel of Chart I-1, lower crude prices will cause a drop in inflation expectations. Moreover, the absence of another large US fiscal stimulus will also lead to a downgrade in growth and inflation expectations. US nominal bond yields will likely remain largely range bound, and a drop in breakeven inflation will lead to higher real yields. The latter will help the US dollar to rebound from oversold levels, and EM currencies will depreciate against the dollar. In turn, a rebound in the greenback will be associated with lower commodities prices. Notably, investors’ net long positions in copper have become very elevated (Chart I-2). Investor sentiment on commodities in general is quite positive. Hence, from a contrarian perspective, commodities prices are primed for a pullback. In addition, Chinese imports of commodities will slow in the near term, reinforcing the correction in resources prices. China has evidently been stockpiling commodities, as its commodities imports have been considerably stronger than its underlying final demand. In particular, Chart I-3 demonstrates that mainland imports of copper, crude oil, steel and iron ore have been surging. Chinese imports of crude and industrial metals are likely to drop temporarily. Chart I-2Long Copper Is A Crowded Trade Chart I-3China Has Been Stockpiling Commodities China’s booming intake of commodities in recent months was stipulated by the country’s previously depleted commodity inventories, low prices and the availability of cheap bank financing. Granted commodity inventories have been replenished and resource prices are no longer low, Chinese imports of crude and industrial metals are likely to drop temporarily. That said, from a cyclical perspective, China’s economic recovery will continue, and final demand for resources will expand. Thus, we will see a material correction, not a crash, in commodities prices. EM credit spreads inversely correlate with commodities prices and currencies – EM sovereign and corporate credit spreads are shown as inverted on both panels of Chart I-4. As commodities prices retreat and the US dollar rebounds, EM credit markets will sell off. Chart I-4EM Credit Markets Will Weaken As EM Currencies And Commodities Sell Off EM local currency bond yields might slightly back up as EM currencies depreciate and US real yields rebound. However, economic conditions in many EM countries outside China remain extremely weak, and inflation is very subdued. Hence, any back up in EM domestic bond yields will be limited. Bottom Line: While we are bearish on the US dollar in the long run, the greenback is primed for a rebound in the near term. Consistently, commodities prices will relapse and EM currencies will sell off versus the US dollar. Notably, oil prices, as well as several EM and DM currencies, have rolled over at technical levels which typically herald a major reversal (Chart I-5A and I-5B). Chart I-5AFacing A Major Resistance Chart I-5BFacing A Major Resistance Finally, EM fixed-income markets will experience a correction that will provide a buying opportunity. The Equity Correction: More To Go The correction in global share prices has further to run. Market leaders – growth stocks – remain overbought, and it is reasonable to expect that they will at least retest their 200-day moving averages. Meanwhile, the parts of the global equity universe hardest-hit during March have failed to break above their 200-day moving average. This can be interpreted as an indication that they have not yet entered a bull market. These include: EM ex-TMT1 and global value stocks as well as the US Value Line Geometric Composite Index (Chart I-6). In short, growth stocks will correct further because they are overbought/over-owned and expensive; the rest of the equity market will relapse because its fundamentals are poor, especially given the renewed rise in new infection cases across Europe and the US. Chart I-6These Stocks Have Not Entered A Bull Market Yet Chart I-7Downside Risks To EM Equities In addition, the following indicators also point to further selloff in EM and DM share prices. Our Risk-On / Safe-Haven currency ratio2 has been falling since June and continues pointing to lower EM share prices (Chart I-7). The EM and DM advance-decline lines have relapsed below zero indicating a deteriorating equity market breadth (Chart I-8). This heralds lower stock prices. As EM corporate bond yields rise due to either weaker EM currencies or lower commodities prices, as we argued above, EM share prices will tumble (Chart I-9). Chart I-8Deteriorating Breadth Points To Lower Share Prices Chart I-9Rising EM Corporate Bond Yields Will Reinforce EM Equity Selloff Bottom Line: Global and EM share prices are in a correction that has not run its course. Investment Strategy A meaningful setback in their EM currencies will lead us to recommend switching from receiving long-term rates to buying their cash local currency bonds (taking currency risks as well). EM Domestic Bonds: We continue recommending receiving 10-year swap rates in Mexico, Colombia, Russia, India, China, Korea and Malaysia. A meaningful setback in their EM currencies will lead us to recommend switching from receiving long-term rates to buying their cash local currency bonds (taking currency risks as well). EM Equities: Absolute-return investors should be cautious at the moment as EM share prices are set to deflate further. Within a global equity portfolio, we continue recommending a neutral allocation to EM. Better equity valuations in EM than in the US will be offset by a rebound in the US dollar, warranting a trading range in EM versus DM relative equity performance. Our country equity allocation within the EM universe is always presented at the end of our report (please refer to page 10). EM Exchange Rates: Even though we expect a meaningful rebound in the nominal broad trade-weighted US dollar, we believe the safe-haven currencies – such as the JPY, CHF and the euro – will outperform EM currencies. As such, we reiterate our strategy of shorting a basket of EM currencies versus an equally-weighted basket of JPY, CHF and the euro. Our short EM currency basket consists of BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Finally, we recommend a neutral allocation to EM credit markets (US dollar bonds) versus US corporate credit. Absolute-return investors should accumulate this asset class on a weakness. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1Technology, media and telecom stocks excluding information technology (IT) sector before December 2018 and excluding IT, media & entertainment and internet & direct marketing retail as of December 2018 2Average of CAD, AUD, NZD, BRL, IDR, MXN, RUB, CLP & ZAR total return indices relative to average of JPY & CHF; rebased to 100 at January 2000 Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Portfolio Strategy We opt to stay patient and refrain from deploying fresh capital especially in the tech sector in the near-term; a better entry point will likely materialize between now and the end of the year. The softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and the risk of a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. A balanced outlook keeps us on the sidelines in the S&P home improvement retail (HIR) index. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities tried to regain their footing last week, but risks still lingering on the (geo)political front should sustain the tug of war between bulls and bears and rekindle volatility. While monetary and fiscal policies will remain loose, the intensity of easing is waning as both the Fed’s impulse (i.e. second derivative) of asset purchases has ground to a halt and Congress has hit a stalemate over the next round of stimulus. Crudely put, the thrust of monetary and fiscal policies is at heightened risk of shifting from stimulative to contractive (Chart 1). As a result, we remain patient with fresh capital and will wait to deploy it when the dust settles hopefully by the end of the year. Turning to equity market internals and other high frequency financial market data is instructive in order to get a clearer picture of the direction of the broad equity market. The value line arithmetic and geometric indexes and small cap stocks that led the March 23 SPX trough are emitting a distress signal (Chart 2). Chart 1Running Out Of Thrust Chart 2Market Internals... Drilling deeper on a sector basis, hypersensitive chip stocks, energy shares, and discretionary versus staples equities will likely weigh on the prospects of the broad equity market (Chart 3). The VIX index, the vol curve and the yield curve, all excellent leading indicators of the S&P 500, have crested and warn that the shakeout phase has yet to run its course (VIX shown inverted ,Chart 4). Chart 3...Say It Is Prudent... Chart 4...To Remain On The Sidelines Trying to quantify the SPX drawdown, we turn to CBOE’s equity put/call (EPC) ratio. The EPC ratio is nowhere near recent extreme readings. SPX pullbacks since the early-2018 “Volmageddon” have corresponded to significantly higher EPC ratio readings. In the past 10 such iterations, the median EPC ratio has been 0.86, the mean 0.93, with a range of 0.77 to 1.28 (Table 2). Currently, the EPC ratio is hovering near 0.58 suggesting that downside risks persist (EPC ratio shown inverted, Chart 5). Chart 5Downside Risks Persist Table 2Equity Put/Call (EPC) Ratio During Pullbacks Since 2018 Finally, the commodity complex is also firing warnings shots. Lumber has collapsed nearly $300/tbf from the recent peak, oil is trailing gold bullion and silver is also cresting versus the yellow metal, iron ore is petering out and the Baltic dry index is wobbling. True, copper and materials stocks are holding their own, but overwhelmingly commodity market internals are waving a yellow flag (Chart 6). Chart 6Commodity Yellow Flags Netting it all out, we opt to stay patient and refrain from deploying fresh capital especially in the tech space in the near-term; a better entry point will likely materialize between now and the end of the year. This week we reiterate our underweight stance in a niche technology index and shed more light on our recent downgrade to neutral of a key consumer discretionary subgroup. Chip Equipment Update: Tangled Up In The Trade War We remain committed to our intra-tech strategy of preferring defensive software and services tech names to aggressive hardware and equipment tech stocks. In that light, we reiterate our underweight stance in the niche S&P semi equipment index. Recent news of the Trump administration’s potential tightening of the noose on Chinese chip company SMIC (the country’s largest foundry) was a net negative for US semi cap names, similar to export restrictions of American technology to Huawei was a net negative for US semi cap names. As a reminder, these manufacturers count China as one of their largest export market alongside Taiwan and South Korea. Thus, this flare up in the US/Sino trade war bodes ill for semi cap companies’ future sales and profit growth projections (Chart 7). There are high odds that relative share prices have plateaued earlier this month and a fresh down cycle has commenced. Under such a backdrop, this hyper-sensitive manufacturing group will likely overshoot to the down side as is evident in the historical tight correlation with the ISM manufacturing survey: these violent oscillations are warning that a cooling off in the ISM will be severely felt in this niche manufacturing intense index (Chart 8). Chart 7Lofty Expectations Chart 8Violent Oscillations On the global demand front, there is an element that COVID-19 is stealing sales from the future and bringing demand forward. Already global semi sales are rolling over, and a couple of industry pricing power proxies are deflating at an accelerating pace: Asian DRAM prices are topping out in the contraction zone and Taiwanese export prices are sinking like a stone, warning that a deficient demand down cycle will squeeze semi cap profit margins (Chart 9). Importantly, Taiwanese tech capex, which TSMC dominates, has crested, warning that all the euphoria behind 5G deployment and uptake is likely baked in the relative share price ratio. The implication is that semi cap names remain vulnerable to any global 5G-related hiccups (top panel, Chart 10). Chart 9Waning Selling Price Backdrop Chart 10Cresting Finally, the tight positive correlation between Bitcoin prices and the relative share price ratio remains intact. Were a knee-jerk rebound in the US dollar to knock down Bitcoin, at least temporarily, it would serve as a catalyst to shed chip equipment stocks (bottom panel, Chart 10). Moreover, 90% of the industry’s sales originate abroad, thus a rise in the greenback would eat into their P&L via FX translation losses. Adding it all up, a softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. Bottom Line: Stay underweight the S&P semiconductor equipment index. The ticker symbols for the stocks in this index are: BLBG S5SEEQ – AMAT, KLAC, LRCX. Home Improvement Retailers: Stay On The Sidelines Two weeks ago our trailing stop was triggered in the S&P home improvement retail index (HIR) and we monetized gains of 15% since the mid-April inception and moved to the sidelines. Today we reiterate our benchmark allocation in this consumer discretionary sub group. Clearly, HIR was a major beneficiary of the lockdown as the US and Canadian governments deemed these retailers “essential” and allowed them to stay open during the peak of the pandemic. These Big Box retailers saw their sales soar as the fiscal easing package replenished consumers’ wallets, and coupled with the lockdown, caused a surge in DIY remodeling activity. Our portfolio also greatly benefited from the stellar performance of the S&P HIR index, as existing home sales staged a significant comeback and inventories of homes for sale receded substantially thus further tightening the residential real estate market (top & middle panels, Chart 11). As reminder, historically a vibrant housing market is synonymous with handsome returns in relative share prices and vice versa. But now a number of stiff headwinds, which our HIR model encapsulates, signal that a lateral digestive move is in store in the coming months (Chart 12). Chart 11Unsustainable Front Running Chart 12Stiff Headwinds First, a repeat of the spike in demand for home improvement projects is highly unlikely, especially given that demand was brought forward. Also during the autumn and winter months there is a natural slowdown in the take-up of remodeling projects until the spring home selling season arrives. Second, the industry’s sales-to-inventories (S/I) ratio is literally off the charts (bottom panel, Chart 11). An inventory build-up and easing in demand will bring back the S/I ratio back to a more reasonable level. Lastly, lumber prices have taken a beating of late collapsing from over $900/tbf to below $600/tbf. This drubbing of this economically hypersensitive commodity directly cuts into HIR earnings. These Big Box retailers make a set margin on lumber sales so as prices fall they take a big bite out of profits (bottom panel, Chart 13). Nevertheless, a few offsets prevent us from turning outright bearish in this early cyclical retailers. Namely, the industry’s profit growth bar is on a par with the broad market and thus does not pose a large hurdle to overcome. Importantly, given that HIR earnings have kept pace with the massive run-up in stock prices (second panel, Chart 14), they have kept relative valuations at bay. While, the S&P HIR 12-month forward P/E trades at a market multiple, the relative forward P/E changes hands at a 20% discount to the historical mean. Thus, HIR enjoy a significant valuation cushion (bottom panel, Chart 14). Chart 13Timber! Chart 14But There Are Powerful Offsets Finally, the Fed just explicitly committed to stay on the zero interest rate line until 2023! This easy monetary policy as far as the eye can see is a powerful tonic to early cyclical and interest rate-sensitive home improvement retailers (fed funds rate shown inverted, top panel, Chart 14). Netting it all out, a balanced outlook keeps us on the sidelines in the S&P HIR index. Bottom Line: Stick with a benchmark allocation in the S&P home improvement retail index. The ticker symbols for the stocks in this index are: BLBG S5HOMI – HD, LOW. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth
Dear Client, We will be working on our Fourth Quarter Strategy Outlook next week, which will be published on Tuesday, September 29th. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors should favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term and vulnerable to a further correction. Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. While we ultimately expect a deal to be reached, it may take a stock market sell-off to force Republican leaders to accede to Democratic demands for more spending. US monetary policy will stay accommodative for at least the next two years, a view that this week’s FOMC meeting further validated. Investors should pivot into cheaper areas of the stock market – in particular, deep cyclicals and financials, non-US stocks, and value stocks. Value stocks are especially appealing, as they are now trading at the biggest discount on record relative to growth stocks. The “pandemic trade” will give way to the “reopening trade.” The latter will benefit value stocks. In addition, stronger global growth, ongoing Chinese stimulus, a weaker US dollar, and modestly steeper yield curves all favor value indices. Value investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Market Commentary Chart 1Drastic Drop In Weekly Unemployment Insurance Payments We continue to favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term despite correcting modestly over the past few weeks. Tech stocks rallied hard into September. Aggressive buying of out-of-the-money call options helped fuel the rally. While some big institutional players such as Softbank have reportedly scaled back their positions, many retail investors remain unfazed. The triple leveraged long Nasdaq 100 ETF, TQQQ, experienced the largest weekly inflow on record in September. In addition to being technically stretched, equities face near-term risks from the impasse in the US Congress over a new stimulus bill. Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. Chart 1 shows that weekly unemployment payments have fallen by $15 billon since the end of July, representing a drop of more than 50%. At an annualized rate, this amounts to 3.7% of GDP in fiscal tightening. On top of that, the funds in the small business Paycheck Protection Program have run out, while many state and local governments face a severe cash crunch. BCA’s geopolitical strategists expect a fiscal deal to be reached over the next few weeks. The fact that Speaker Nancy Pelosi has said that Congress will stay in session until both sides agree on an aid package is good news in that regard. Nevertheless, given all the acrimony in Washington in the run up to the November election, there is still a non-negligible chance that a deal falls through. Why, then, are we still bullish on stocks on a 12-month horizon? Partly it is because voters want more stimulus, which means that fiscal policy is likely to be loosened again, even if this does come after the election. It is also because the pandemic seems to be receding. While the number of new cases is rising again in the EU and some other regions, fatality rates remain much lower than during the first wave. Progress also continues to be made on developing a viable vaccine. According to The Good Judgment Project, about 60% of “superforecasters” expect a mass-distributed vaccine to be available by Q1 of 2021, up from 45% just four weeks ago. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 2). Chart 2High Odds Of A Vaccine Within 6-To-12 Months Lastly, monetary policy remains exceptionally accommodative. The Fed this week formally incorporated its new flexible average inflation targeting strategy into its post-meeting statement. The FOMC promised to keep rates at rock-bottom levels until the economy has reached “maximum employment” and inflation “is on track to moderately exceed two percent for some time.” The dot plot indicated that the vast majority of FOMC members did not expect rates to rise until at least the end of 2023. As Chart 3 shows, the global equity risk premium remains quite elevated. This favors stocks over bonds. Not all stocks are equally attractive, however. Four weeks ago, in a report titled “The Return of Nasdog,” we made the case that investors should pivot away from growth stocks towards value stocks. The report generated quite a bit of interest from readers. Below, we review and elaborate on some of the issues raised in a Q&A format. Q: Being long value stocks relative to growth stocks has been a widowmaker trade for more than a decade. Why do you think we have reached an inflection point? A: Value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 4). Chart 3Global Equity Risk Premium Remains Quite Elevated Chart 4Value Stocks Are Extremely Cheap Relative To Growth Stocks Admittedly, valuations are not a good timing tool. One needs a catalyst to unlock those valuations. Good news on the virus front may end up being such a catalyst. The “pandemic trade” benefited tech stocks, which are overrepresented in growth indices. It also favored health care stocks, which are similarly overrepresented in growth indices, at least globally (Table 1). The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. Table 1Breaking Down Growth And Value By Sector Chart 5 shows that retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels. Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 6). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. Chart 5Are Brick-And-Mortar Retailers Coming Back To Life? Chart 6The Pandemic Has Caused Global Server And PC Shipments To Surge Q: How are investors positioned towards value versus growth? A: According to the September BofA Global Fund Manager Survey, tech and pharma were the two sectors with the largest reported overweights. Thus, there is significant scope for money to shift out of these sectors. Q: What about the overall macro environment underpinning growth and value? A: While the relationship is far from perfect, value stocks tend to outperform growth stocks when the US dollar is weakening (Chart 7). Recall that growth stocks did very well during the late 1990s, a period of dollar strength. In contrast, value stocks outperformed between 2001 and 2007, a period during which the dollar was generally on the back foot. As we have spelled out in past reports, we expect the dollar to weaken over the next 12 months, which should benefit value stocks. Value stocks also tend to do best when global growth is accelerating (Chart 8). Provided that governments maintain adequate levels of fiscal support and a vaccine becomes available by early next year, global GDP should bounce back swiftly. Chart 7Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Chart 8Value Stocks Also Tend To Do Best When Global Growth Is Accelerating Q: Won’t lower real bond yields favor growth stocks? A: By definition, growth companies generate more of their earnings further in the future than value companies. As such, a decline in real yields will tend to increase the present value of cash flows more for growth companies than for value companies. We do not expect real yields to rise significantly over the next two years. However, given that real yields are already deeply negative in almost all countries, they probably will not fall either. Q: You seem to be making the cyclical case for the outperformance of value stocks. But what about the secular case? It appears to me that the stronger earnings growth displayed by growth stocks will ultimately translate into higher long-term returns. A: Historically, that has not been the case. As Chart 9 and Table 2 illustrate, value stocks have outperformed growth stocks by a wide margin over the past century. In particular, small cap value has clobbered small cap growth. Chart 9Value Stocks Have Outperformed Growth Stocks By A Wide Margin Over The Past Century Table 2Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns How did value stocks manage to triumph over growth stocks if, as you say, growth stocks usually experience faster earnings growth? The answer has to do with what is priced in and what is not. If everyone expects a company’s earnings to grow next year, this will already be reflected in its share price. It is only unanticipated earnings growth that should move share prices. For the most part, both analysts and investors have tended to overextrapolate near-term earnings growth. As we discussed in a special report titled “Quant-Based Approaches To Stock Selection And Market Timing,” while analysts are generally able to predict which companies will display superior earnings growth over the next one-to-two years, they systemically overestimate earnings growth on longer-term horizons (Chart 10). As a result, investors tend to overpay for growth, causing growth stocks to lag value stocks. Chart 10A Mug’s Game Q: That may have been true historically, but it seems that more recently, investors have been guilty of underpaying for growth. A: Yes and no. If one looks at the period between 2007 and 2017, the superior performance of growth stocks was broadly matched by their superior earnings growth. As a result, relative P/E ratios did not change much. Since 2017, however, the P/E ratio for growth indices has soared relative to value indices (Chart 11). Chart 11AThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion Chart 11BThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion Q: What has happened since 2017 that has caused growth stocks to become so much more expensive? A: FANG, FAANG, FANGMAN, whatever acronym you want to use, it was mainly a story about investors becoming infatuated with mega cap tech stocks. After seeing these companies beat earnings estimates quarter after quarter, investors decided that they deserve to trade at much higher valuation multiples. Q: What about other tech companies? A: For the most part, they were left in the dust. Our proprietary Equity Analyzer system allows us to sort companies based on all types of fundamental and technical factors. Chart 12 shows that “value tech” companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales have gotten completely clobbered by “growth tech” companies trading in the top quartile of these valuation metrics. Chart 12Value Tech Versus Growth Tech Interestingly, the opposite pattern was true among financials: “Value financials” – financials that trade cheaply based on the valuation measures listed above – have outperformed “growth financials.” The net result is a bit surprising: Since “value tech” underperformed the average tech stock, while “value financials” outperformed the average financial stock, the average “value tech” stock has delivered a return over the past decade that was almost identical to the average “value financial” stock. Chart 13There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years Q: This seems to suggest that value managers would not have made any money by shifting exposure from financials to tech? A: Correct. Consider the iShares MSCI USA Value Factor ETF (ticker: VLUE). It is structured to have the same sector weights as the overall US market. It currently has 27% of its assets in technology and 10% in financials. Compare that to the Vanguard Value Index Fund ETF Shares (ticker: VTV). It has 10% of its assets in technology and 19% in financials. As Chart 13shows, VTV has actually outperformed VLUE over the past five years. Year to date, VTV is down 10%, while VLUE is down 15%. Q: While value managers would not have made money by shifting capital from financials to tech, I presume the same thing could not be said for growth managers. A: You can say that again. “Growth tech” outperformed the average tech stock, while “growth financials” underperformed the average financial stock. Thus, shifting money from “growth financials” to “growth tech” would have supercharged returns. Q: This still leaves open the question of why mega cap stocks were able to grow earnings so rapidly? A: Two explanations come to mind. First, tech companies often gain from so-called network effects: The more people there are who use a particular tech platform, the more attractive it is for others to use it. Second, tech companies benefit from scale economies. Once a piece of software has been written, creating additional copies costs nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner-take-all environment where success begets further success. Q: It seems this process could go on indefinitely? A: Not indefinitely. No company can control more than 100% of its market. There is also a limit to how big the overall market can get. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. Q: These companies have plenty of cash. Can’t they try to enter new types of businesses if they want to keep growing? A: They can try, but there is no guarantee they will succeed. Kodak was one of the pioneers in digital photography. However, it could never really reinvent itself and ended up fading into oblivion. Moreover, while first-mover advantage is a powerful force, it is not invincible. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Q: And I suppose government policy could also turn less friendly towards tech? A: That is a definite risk. Republicans have been cheap dates for tech companies. Republican politicians have showered tech companies with tax cuts and allowed them to exploit a variety of loopholes in the tax code. They also kept tech regulation to a minimum. All this happened despite the fact that many tech leaders have publicly panned conservative viewpoints, while tech company employees have rewarded Democratic politicians with the lion’s share of campaign donations (Chart 14). Chart 14Tech Company Employees Donate Heavily Towards Democrats Going forward, Republicans are likely to sour on big tech. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). Tucker Carlson, a leading indicator for where the Republican party is heading, has frequently lambasted tech companies on his highly popular television show. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies For their part, the Democrats are moving to the left. Alexandria Ocasio-Cortez, a leading indicator for the Democratic party, has voiced her support for Senator Elizabeth Warren’s calls to break up big tech. She has also accused Amazon of paying starvation wages, adding that "If Jeff Bezos wants to be a good person, he'd turn Amazon into a worker cooperative." Q: The political climate for tech companies may be souring. But couldn’t one say the same thing about banks and energy companies, which are overrepresented in value indices? A: One difference is that tech companies trade at premium valuations, while banks and energy companies trade near book value (Chart 16). Another difference is that banks have already felt the wrath of regulators. Thanks to Dodd-Frank and pending Basel III regulations, banks today function more like utilities than like the casinos of yesteryear. While private credit growth is unlikely to return to its pre-GFC pace, banks will still profit from a revival in global growth and increasing consolidation within their industry. Stronger global growth should also allow for modestly higher nominal bond yields and somewhat steeper yield curves. This will benefit bank shares (Chart 17). Chart 16Tech Firms Trade At Premium Valuations Chart 17Modestly Higher Bond Yields Will Benefit Bank Shares As far as energy stocks are concerned, again, we need to benchmark our views to what the market expects. Oil is not going back above $100 per barrel anytime soon, but it does not need to for energy stocks to go up. Bob Ryan, BCA’s chief commodity strategist, sees Brent averaging $65/bbl in 2021, $19 above what is currently priced in forward markets. Q: What about materials and industrial stocks? They are also overrepresented in value indices. A: Both materials and industrials tend to outperform the broader market when global growth accelerates (Chart 18). To the extent we expect global growth to rise, this is good news for these two sectors. They also trade at attractive valuations. Q: How does China figure into this value/growth debate? A: As we saw during the 2001-2007 period, strong Chinese demand for commodities and industrial goods benefits value indices. Even though trend Chinese GDP growth has decelerated over the past decade, the Chinese economy is five-times as large as it was back then. In absolute terms, Chinese consumption of most metals continues to increase (Chart 19). Chart 18Materials And Industrials Usually Outperform When Growth Accelerates Chart 19Chinese Consumption Of Most Metals Continues To Rise Chart 20 shows that Chinese GDP would need to grow by about 6% per year over the next decade to keep output-per-worker on track to converge with, say, South Korea by the middle of the century. Thus, Chinese demand for natural resources and machinery is unlikely to weaken anytime soon. Chart 20China Still Has Some Catching Up To Do Q: Let’s wrap up. What final tips would you give investors who want to pivot towards value? A: There are a number of ETFs that track value indices. We expect them to outperform the broad indices over the coming years. For investors who want even higher returns, a selective approach would help. Distinguishing between value stocks and value traps is not easy. True value stocks have often congregated in the shadows of the market, where there is limited analyst coverage and thin institutional ownership. The small-cap sector offers more opportunities for finding such mispriced stocks. Hence, it is not surprising that historically, the value premium has been greater in the small cap realm. The same is true for emerging markets and smaller developed economies (Chart 21).1 Thus, investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Chart 21AHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Chart 21BHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Asset Allocation Special Report, “Value? Growth? It Really Depends!” dated September 19, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights The great political surprises of 2016 are approaching key deadlines on November 3 and December 31. Investors should not let Brexit take their eye off the US election. Globalization will retreat faster under Trump regardless of what happens in the United Kingdom. The market is starting to price several clear risks: a failure to extend fiscal relief in the US (25% chance); a surprise Trump tariff move (40%); a contested election (20%); or a failure of the UK and EU to seal a deal (35%). Trump is unlikely to pull off a landslide like Boris Johnson in December 2019. The backdrop has darkened and Biden is an acceptable alternative for voters, unlike Jeremy Corbyn. Go long GBP-USD at the 1.25 mark; go long GBP-EUR volatility. Feature The end game is approaching for the two great political shocks of 2016 – Brexit and Trump. November 3 is the US election and December 31 is the deadline for an UK-EU trade deal. Investor sentiment is starting to show some cracks for various reasons, some technical (Chart 1). But we do not believe near-term volatility and risk-off sentiment have fully run their course yet. Either the US election cycle or the UK’s brinkmanship with the EU, or both, will agitate markets as the deadlines approach. The former is a much weightier factor. Chart 1Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive The risks in play are a failure to extend fiscal relief in the US (25% chance); a conflict between Trump and one of America’s foreign rivals such as China, whether due to Trump’s reelection or lame duck status (40%); a contested election (20%); or a failure of the UK and EU to seal a deal, setting back their economic recovery (35%). Maybe all of these risks will dissipate by mid-November, but maybe not. The market has not discounted any of them fully. So investors should buy insurance now. Vox Populi Is The Biggest Constraint For global investors Brexit is far less consequential than President Trump’s “America First” policy but the UK does punch above its economic weight in financial markets (Chart 2). Chart 2Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Geopolitical analysis teaches that limitations on policymakers should be the starting point of analysis. For democracies, the biggest constraint of all is the vox populi – the voice of the people, or popular will. The Brexit movement faced a vociferous “Resistance” that won over the media and financial market consensus until reality struck in the general election of December 12, in which the Conservative Party won a historic victory. Chart 3Joe Biden Is Not Jeremy Corbyn The election vindicated Prime Minister Boris Johnson’s brinkmanship and “hard Brexit” terms, while once again chastening the elites and experts – including an innovative Supreme Court. Johnson’s single-party majority, combined with COVID-19 and the surge in domestic economic stimulus, have increased the odds that the UK will choose sovereignty over the economy and walk away from trade talks. Trump’s supporters show the same enthusiasm as Brexiteers and the same scorn for conventional wisdom and opinion polls. Will they be similarly vindicated? Beyond any knee-jerk equity rally, that would entail a “Phase Two” trade war with China – and possibly a new trade war with Europe or a global trade war. However, Trump faces much worse odds than Boris Johnson did. First, Johnson’s snap election took place at the top of the business cycle, back when a novel coronavirus was just starting to be discovered in Wuhan, China. This is how Harry Truman won his surprise victory in 1948, in defiance of all the opinion polls. Had Truman run in 1949, after a deep recession, the story would have gone differently – which is a problem for both Trump and the near-term equity market. Second, the political alternative was not acceptable in the United Kingdom but it is in the United States. Johnson led Jeremy Corbyn, a far-left rival for the premiership, by around 15%-20% in the polls. The Conservative Party itself led the Labour Party by 10%. By contrast, former Vice President Joe Biden is a center-left Democrat who has many flaws but is not out of the mainstream. He leads President Trump in the polling, as do Democrats over Republicans, though only by single digits. There is no contest between Biden and Corbyn (Chart 3). Trump might still win, but an American version of the UK landslide in 2019 is unlikely. Trump will lose the popular vote even if he wins the Electoral College, and Republicans have a very slim chance of winning the House of Representatives. The implication for financial markets is doubly negative, at least in the near term: there is about a 35% chance that the UK will leave without a deal and about a 35% chance that Trump will win. He could also kick China in the interim period if he loses. Won’t stocks cheer a Trump comeback and victory? Perhaps, but a data-dependent approach suggests that a “blue sweep” is still the base case, and that would be a good trigger for a full equity correction. Nor would a Trump win be positive for long-term equity returns in the final analysis. Trump is reflationary, but a larger trade war would hamper the global economic recovery and thus keep earnings suppressed. There is a 35% chance that Trump will win re-election. Trump is unlikely to win the national vox populi, like Brexit did, but he obviously can win the popular vote in the critical regions – the Sun Belt and the Rust Belt. If he does, the revolution in the global system will be confirmed: the retreat of globalization will accelerate. If he does not, then Brexit alone cannot confirm de-globalization; rather the UK will face even more pressure to make concessions and get a trade deal. Trump’s Path To Victory Chart 4Sitting Presidents Win Half The Time If Recession Ends In H1 We may well be forced to upgrade Trump’s odds of winning if his comeback gains momentum. Our subjective odds of a Trump win come from the historical record – incumbent parties only retain the White House amid recessions five out of 13 times in American history – but there are some important exceptions. First, the longest-serving American president, Franklin Delano Roosevelt, served during the Great Depression. So obviously a bad economy does not always disqualify a president. Nevertheless FDR got lucky with the timing of the fluctuations and he was personally popular, unlike President Trump. Second, an incumbent president wins 50% of the time if the recession ends before the election – namely in 1900, 1904, and 1924 (contrasted with defeats in 1888, 1912, and 1980). Today’s market performance looks similar to these cases, though premature fiscal tightening is now jeopardizing Trump’s bid (Chart 4). Assuming new stimulus passes, it is extremely beneficial for President Trump that COVID-19 cases are subsiding (Chart 5). Chart 5COVID-19 Subsides In Nick Of Time For Trump? Chart 6Even Approval Of Trump’s Pandemic Response Improving His approval rating on handling COVID-19 is somewhat recovering at the moment (Chart 6). Trump’s “law and order” message is also benefiting him amid the rise in vandalism, rioting, and homicide, judging by his improvement in national approval rating across almost all demographic groups, including many that are otherwise averse to Trump. Finally, Trump’s Abraham Accords – a potentially major peace deal between Israel and an expanding list of Arab states – could give his image another boost (Table 1). Foreign policy will not decide the election but these peace deals should not be underrated because they underscore a more important argument for voters: that the US should withdraw from its endless foreign wars and pursue peace and prosperity instead. If Trump’s typically weak approval rating on foreign policy starts to rise then his comeback gains breadth. Table 1The Abraham Accords Give Boost To Trump Image As Peacemaker We will upgrade our 35% odds of Trump’s re-election if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Our quantitative model is now giving Trump a 45% chance, which is in line with the consensus view but well above our subjective odds (Chart 7). We will upgrade our view if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Chart 7Quantitative US Election Model Puts Trump Win At 45% Odds Chart 8Stimulus Hiccups Cause Market To Sell The stock market does not perform well during periods in which fiscal cliff negotiations are prolonged – the failure of the Emergency Economic Stabilization Act in 2008 is one thing, but today’s impasse is more reminiscent of the debt ceiling crises of 2011 and 2013. Trump is now directly pressuring Senate Republicans to capitulate to House Democratic spending demands. If Republican senators abandon him, market turmoil will undercut his argument that he is the best man to revive the economy and he will lose the election (Chart 8). We do not think they will – and House Speaker Nancy Pelosi’s pledge to keep the House in session until a deal is passed is very positive news – but until the deal is sealed the market is vulnerable. As mentioned above we give a 25% chance of a failure to pass any stimulus bill in September or October. The next chance for stimulus will be in late January or February. Trump stands for growth at all costs, which will be received well by equity markets, other things being equal. But a Trump victory implies more trade war and that the GOP will retain the Senate, creating a steeper fiscal cliff next year – so any relief rally will be short-lived. Meanwhile a Trump defeat raises the risk he will take aggressive actions on the way out to cement his legacy as the Man Who Confronted China, and bind the Biden administration to decoupling policy. This is not a favorable outlook for investor sentiment or the economic recovery over the next few months. Brexit: The Three Kingdoms Will Force A Trade Deal Chart 9Sterling Will Fall Before It Bounces Back On A Deal In December 2016 we pointed to the three kingdoms – England, Ireland, and Scotland – as the origin of the geopolitical and constitutional crisis that would arise from the Brexit referendum and act as a powerful bar against a no-deal Brexit. That framework remains salient today as the risk of no-deal escalates due to quarrels over Northern Ireland Protocol, which was agreed in October 2019 as part of the formal Withdrawal Agreement that made Brexit happen on January 31, 2020. The implication is that the pound has not bottomed yet, though we see a buying opportunity around the corner (Chart 9). No one should doubt that the UK could walk away from the EU without a deal this December: The Tories’ single-party majority gives them the raw capability to push through plans they decide on – and raises the risk that they will overreach. The tariff shock of a no-deal exit is frequently exaggerated. The UK would suffer a tariff shock of about 1.38% of GDP, larger than what the US suffered in its tariff-war with China but hardly a death knell (Table 2). (The costs of losing single-market access would grow over time, however.) Table 2A No-Trade-Deal Brexit Would Create A Minimum Tariff Shock Of 1.4% Of GDP COVID-19 has supplanted the worst-case outcome of a no-deal exit by producing a much worse recession than anyone feared. The US is using the disruption to decouple from China and the UK could do the same with the EU. The result of COVID-19 is massive domestic stimulus that raises the UK’s and Europe’s threshold for pain. Any failure of trade talks would spur more stimulus. The Bank of England still has some bond-buying ammunition left and parliament, again, is undivided. Given that Boris Johnson has until 2024 before the next election, there is theoretically time for his personal and party approval ratings to improve as the economy recovers from the pandemic and any messy Brexit (Chart 10). Chart 10Bojo Has Until 2024 To Recover From Crises Chart 11UK Would Face WTO-Level Tariffs If No Deal The UK’s position in the quarrel over Ireland is rational – but so is the EU’s. If the trade talks collapse, the UK will need to remove any regulatory or customs divisions with Northern Ireland. Yet in preparing to do so it vitiates trust with the EU and makes a trade deal less likely. However, weighing all these points up, an UK-EU trade deal is still the most likely outcome (65% chance), as the economic and political costs are crystal clear while the benefits of a hard break are not so clear. Allow us to explain. Northern Ireland is the latest cause of tensions, although it was inevitable that tensions would arise ahead of the end-of-year deadline for a trade deal. Westminster has proposed an Internal Market Bill, which has passed with solid majorities in two readings in parliament, to reclaim aspects of sovereignty over Northern Ireland that were traded away to clinch the Withdrawal Agreement last year. The Johnson government’s position should be seen as a negotiating tactic to build leverage in the talks but also as a real fallback position if the talks fail. The House of Lords could delay the bill by a year, meaning that it may not take effect until end of 2021 – but a trade deal would make it moot. The Northern Ireland Protocol solved the riddle of how to preserve the integrity of the EU’s single market after Brexit yet avoid a return to a hard customs border with the Republic of Ireland. Customs checks were removed with the Good Friday (or Belfast) Agreement in 1998, which ended the Troubles between the two Irelands. The Protocol introduces a pseudo-customs border on the Irish Sea, requiring declarations on exports to Great Britain and EU oversight of UK state aid for Northern Irish firms, so that Northern Ireland can stay in the EU customs area while the UK can leave and still preserve a semblance of its own customs area in Northern Ireland. If the UK and EU get a trade deal, then all trade is tariff-free and the Protocol becomes redundant. Also, the Protocol enables a Joint Committee to review disputes over exports to Northern Ireland that are “at risk” of making their way into the EU without duties. The Protocol is supposed to operate even if the UK and EU fail to get a trade deal. Yet it is politically untenable for the UK to subject trade within its own country to EU rules or duties, or allow the EU to supervise state corporate subsidies across the UK, if no deal is agreed. The UK is more likely to violate the treaty to preserve its internal integrity. As Northern Ireland Secretary Brandon Lewis admitted, “Yes, this [Internal Market Bill] does break international law in a very specific and limited way.” While the EU’s threat to slap tariffs on British food exports to Northern Ireland is the proximate trigger of the Internal Market Bill, another key reason for the UK’s aggressive shift is the issue of state aid. All governments are extending emergency aid to major corporations to keep them from insolvency amid the recession. This will be the case for some time and it is even more true of the EU than of the United Kingdom. However, under the Protocol, the EU would be able to penalize companies in Great Britain that receive subsidies if goods or firms in Northern Ireland can be shown to benefit. Northern Ireland is supposed to operate within the EU’s standards on state aid. London obviously bristles at this backdoor for letting in EU regulation, not least because, in the event that a trade deal is not reached, it will need to pump the country full of state aid to compensate for the shock of seeing exports to the EU rise by 3% across the board according to Most Favored Nation status under the World Trade Organization (Chart 11). An UK-EU trade deal is the most likely outcome. As Dhaval Joshi of BCA’s European Investment Strategy points out, Boris needs to keep his own Tories under his heel (Chart 12). The Internal Market Bill provoked a backlash among 30 moderates. If that number rises to 40 Johnson loses his majority. This is a problem that he is seeking to address by giving parliament a veto over any future uses of the bill that would violate international law (this is an acceptable compromise because he has a majority). But a failure to drive a hard bargain with the EU would cause a much bigger rebellion among hard Brexit Conservative MPs and threaten his job. Chart 12Bojo Must Balance Hard Brexit Tories Geopolitics is about might, not right – the UK can assert its sovereignty and violate these international agreements, while the EU can then apply punitive tariffs, non-tariff barriers, and sanctions under the Withdrawal Agreement. Brexit is a power-political struggle that could devolve into a trade war. Obviously that would be a very bad outcome for the market, particularly for the UK, which is overmatched (Chart 13). But this risk is also a key limitation on the UK that will prevent this worst-case outcome. Indeed, despite all of the above, our base case is still that the UK and EU will get a deal. First, the economy will clearly suffer without a deal. After all, the US-China tariffs produced a negative effect for these two economies in 2019 and the impact on the UK would be bigger than that on the US (Chart 14). Chart 13The Brick Wall The UK Cannot Avoid Chart 14UK Faces Trade Shock If No Deal Second, the public doesn’t support a no-deal exit (Chart 15). Northern Ireland itself voted against Brexit in the referendum and as such would rather see an agreement that groups the UK and the EU under a single zero-tariff free trade agreement. Third, Boris faces a rebellion in Scotland if he pursues a hard break. The Scottish National Party would revive ahead of Scottish elections in May 2021 and demand a second independence referendum (Chart 16). The Irish Sea is a natural division that makes a more intrusive customs presence more supportable than otherwise. A little more paperwork is an acceptable cost to keep the United Kingdom from falling apart. Scotland is much more likely to go independent than Ireland is to unite. Chart 15Only 25% Think 'No Deal' A Good Outcome Boris is now prime minister, not just party leader, and he will ultimately have to decide whether he wants to be the last prime minister of a United Kingdom. Assuming Boris is at least focused on the next election, he will have to decide if he wants the rest of his premiership to be consumed with a self-inflicted double-dip recession and democratic revolt in Scotland, or a recovery on the back of a functional if uninspiring trade deal enabling him to head off the Scottish threat and save the union. Chart 16No Deal' Would Boost Scottish Independence Movement Obviously the final deal may not be clinched until the eleventh hour. The October 15 deadline can be delayed but talks must conclude in November or December in time to be ratified by the EU member states by December 31. US Election Drives Geopolitics, But Not The Brexit Outcome One factor that will not play much of a role in the UK’s decision-making is the US election. It is true that the Johnson government would benefit from President Trump’s reelection. But the EU is a much bigger market for the UK and the UK’s best strategy is to focus on its national interest regardless of what the US does. The US election may not be decided in mid-December in time for the UK to agree to a deal that can be ratified by year’s end anyway. Moreover the UK’s best strategy is to conclude a deal with the EU first, and then pursue a deal with the United States. This is because President Trump will be inclined to sign at least an executive deal, while a congressional deal requires support from the Democrats, which is only possible if Northern Ireland is resolved without hard border checks. Because the EU makes up such a larger share of British trade, an American deal does not give the UK much leverage in negotiating with the EU, but an EU deal does give the UK greater leverage in negotiating with the US. As Diagrams 1 and 2 show, this strategic logic holds even if the UK knows the outcome of the US election ahead of time: the scenarios with the least benefit and the greatest cost would still be scenarios involving no deal with the European Union. Diagrams 1 & 2United Kingdom Wants An EU Trade Deal (Regardless Of Trump/Biden) Diagram 3 boils all of this down to a single decision tree. First, the diagram shows that the economic costs are not prohibitive and therefore the risk of a no-deal exit is substantial – we would say 35%. Second, it shows that the risks of the negotiation are skewed to the downside. Third, it highlights that the UK will settle its affairs directly with the EU and not hinge its actions on the US election cycle. Diagram 3No-Deal Brexit Cost Not Prohibitive, But Best Strategy Is To Get A Deal Clearly the best strategy and best outcome involve seeking a trade deal with the EU, and hence it is our base case. This means an opportunity to buy the pound and domestic-oriented British equities, and turn neutral on gilts, is just around the corner. Investment Takeaways The GBP-EUR is the best measure of the market’s sensitivity to Brexit risks, so it should fall in the near term and rally sharply after resolution. However, the US election complicates things. The euro’s response is fairly binary: it is one of the biggest winners if Biden wins and one of the biggest losers if Trump wins. Hence GBP-EUR volatility will rise in the coming months (Chart 17). We recommend going long 1-month implied volatility contracts for October and November. The pound sterling, by contrast, will ultimately rise regardless of US election result, since the UK will pursue a trade deal out of its own national interest. Trump is less negative for the US dollar than Biden and a comeback and victory will drive a counter-trend dollar bounce. However, in the medium term we expect the dollar to fall regardless due to debt monetization and global growth recovery. Thus we recommend going long GBP-USD on a strategic basis when political risks peak over the next two-to-three months and GBP-USD falls to around 1.25, as recommended by our Foreign Exchange Strategist Chester Ntonifor (Chart 18). Chart 17EUR-GBP Volatility Will Rise Sterling bears are forgetting that the sound defeat of Corbyn ruled out a sharp left-wing turn in domestic economic policy (higher taxes), while the Tories have made a clear turn against fiscal austerity. Therefore the worst-case scenario is a failure to agree to a trade deal by the end of this year. But that is not the base case and the risk will be priced within a month or two. Chart 18Pound Will Rally After Deal Concluded In November Or December Chart 19Yes, China Is Opening The Taps We remain tactically cautious and defensive even though the US fiscal negotiations are improving. The market is underrating too many clear and concrete risks to sentiment and the corporate earnings outlook, so the current bout of volatility can continue until there is greater clarity on US fiscal spending, the US election cycle, associated geopolitical risks, and the Brexit showdown. Book gains on long Brent trade for a return of 69.7%. We initiated this trade on March 27 in our “No Depression” report, which marked our shift to a strategic risk-on positioning. We remain bullish on oil prices and commodities on the back of global stimulus and our assessment that the OPEC 3.0 cartel will maintain discipline overall, but the next three-to-six months are crowded with downside risk. Cyclically, we see a global economic recovery deepening and broadening. China’s stimulus is surprising to the upside, as we have long written and the latest credit numbers bear this view out (Chart 19), which is critical for global reflation. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com