Bubbles/Crises/Manias

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising US Goods Prices Are Rising US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection US Markets Are Priced To Perfection US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising US Goods Prices Are Rising US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection US Markets Are Priced To Perfection US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The post-2008 boom in stocks, corporate bonds, and real estate is a ‘rational bubble’, because the relationship between risk-asset valuations and falling bond yields is exponential. But the ‘rational bubble’ is turning into an ‘irrational bubble’. Stay tactically neutral to stocks for the next few weeks to see whether valuation can revert to rationality. This means keep existing investments in the market, but hold fire on new deployments of cash. If valuation reverts to rationality, then investors can safely deploy new cash into the market. But if valuation moves into irrationality, then it will require a completely different investment mindset, in which fractal analysis will become crucial in identifying the bursting of the bubble, just as it did in 2000. Fractal trade: the Chinese stock market is vulnerable to correction. Feature Chart of the WeekA 'Rational Bubble' And An 'Irrational Bubble' A 'Rational Bubble' And An 'Irrational Bubble' A 'Rational Bubble' And An 'Irrational Bubble' Regular readers will know that we have characterised the post-2008 boom in stocks, corporate bonds, and real estate as a ‘rational bubble’. Rational, because the nosebleed valuations are justified by a fundamental driver. And not just any fundamental driver, but the most fundamental driver of all – the bond yield. However, the ‘rational bubble’ is turning into an ‘irrational bubble’, akin to the dot com mania in which valuations became totally disconnected from fundamentals (Chart of the Week). What should investors do? The Relationship Between Bond Yields And Risk-Asset Valuation Is Exponential Everyone realises that a lower bond yield justifies a lower prospective return from competing investments, such as stocks, corporate bonds, and real estate. As valuation is just the inverse of prospective return, a lower bond yield justifies a higher valuation for all risk-assets. (Chart I-2). Chart I-2House Prices have Decoupled From Rents Again (And It Didn't End Happily Last Time) House Prices have Decoupled From Rents Again (And It Didn't End Happily Last Time) House Prices have Decoupled From Rents Again (And It Didn't End Happily Last Time) But few people realise that a lower bond yield justifies an exponentially higher valuation for risk-assets. To visualise this exponential relationship, look again at the Chart of the Week. The bond yield is plotted on a logarithmic (and inverted) left scale, while the stock market forward price-to-earnings is plotted on a linear right scale. The inverted log versus linear scales demonstrate that, in the ‘rational bubble’, the lower the bond yield, the greater the impact of a given decline in the bond yield on stock market valuation. Few people realise that a lower bond yield justifies an exponentially higher valuation for risk-assets. Chart I-3 and Chart I-4 also demonstrate the exponential relationship using the earnings yield as a proxy for the prospective return on stocks. A 1.5 percent decline in the bond yield had a smaller impact on the earnings yield when the bond yield started at 4 percent in 2014 than when the bond yield started at 3 percent in 2019. At the higher bond yield, the prospective return on stocks fell by 1 percent, but at the lower bond yield, the prospective return on stocks plunged by 2.5 percent. Chart I-3A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 Percent... A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 percent... A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 percent... Chart I-4…Than When The Bond Yield Started ##br##At 3 Percent ...Than When The Bond Yield Started At 3 Percent ...Than When The Bond Yield Started At 3 Percent To repeat, the lower the bond yield, the greater the impact of a given move in the bond yield on the prospective return from stocks. The intriguing question is, why? To answer this question, we must venture into a branch of behavioural psychology developed by Nobel Laureate Daniel Kahneman and Amos Tversky, called Prospect Theory. Prospect Theory Explains The ‘Rational Bubble’ Prospect Theory’s key finding is that we consistently overvalue the prospect of a tail-event, both positive and negative. For example, if there is a one in a million chance of winning a million pounds, then the expected value of this prospect is one pound. Yet we will consistently pay more than one pound for this positive tail-event. This willingness to overpay for a positive tail-event is the foundation of the multi-billion pound gambling and lottery industry. Now consider an ‘inverse lottery’, in which there is a one in a million chance of losing a million pounds. In theory, we should take on the risky prospect for one pound. Yet in practice, we will consistently demand more than one pound to take on this negative tail-event. In other words, we will demand a substantial ‘risk premium’. Prospect Theory explains that we overvalue tail-events because we are bad at comprehending small probabilities. Hence, the prospect of winning a million pounds, while in practice a negligible possibility, generates excessive optimism which results in overpayment for the bet. Likewise, the possibility of losing a million pounds, while in practice a negligible possibility, generates excessive pessimism, for which we demand payment of a ‘risk premium’. In the financial markets, stock markets tend to ‘gap down’ much more than they ‘gap up’. Hence, the risk of owning stocks is like the discomfort of the inverse lottery. This explains why investors normally demand a risk premium – an excess prospective return – to own stocks versus bonds. However, the risk relationship between stocks and bonds changes when bond yields approach their lower bound. Now, as bond yields have less scope to move down versus up, bond prices can gap down much more than they can gap up. The upshot is that the risk of owning bonds becomes no different to the risk of owning stocks, and the risk premium to own stocks versus bonds disappears. At ultra-low bond yields, the bond yield and the equity risk premium move up and down in tandem. Given that the prospective return on stocks equals the bond yield plus the risk premium, we can now answer our intriguing question. At ultra-low bond yields, the prospective return on stocks moves by more than the move in the bond yield, because the bond yield and the risk premium are moving up and down in tandem. The result is an exponential relationship between the bond yield and risk-asset valuations. And this explains how the post-2008 collapse in bond yields to unprecedented lows has generated a ‘rational bubble’ in stocks, corporate bonds, and real estate (Chart I-5 and Chart I-6). Chart I-5A Rational Bubble In Risk-Assets... A Rational Bubble In Risk-Assets... A Rational Bubble In Risk-Assets... Chart I-6...Everywhere ...Everywhere ...Everywhere   The Rational Bubble Is Turning Irrational The post-2008 boom in risk-asset valuations is rational given the exponential relationship with a collapsed bond yield. But the rational valuation is turning irrational. Over the past few months, the stock market’s forward price-to-earnings multiple has continued to increase despite a backup in the bond yield. Note that this multiple is calculated on the next 12 months of earnings, so it already incorporates a strong post-pandemic earnings rebound (Chart I-7). Chart I-7The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational Furthermore, since 2009, the bond yield (plus a fixed constant) has defined a reliable lower limit for the technology sector earnings yield, meaning a well-defined upper limit for the technology sector’s valuation. Since 2009, this valuation limit has effectively defined the limit of the rational bubble and hasn’t been breached. That is, until now. The recent breach of the post-2008 valuation limit means that the rational bubble is turning irrational (Chart I-8). Chart I-8The Post-2008 Rational Valuation Limit Has Been Breached The Post-2008 Rational Valuation Limit Has Been Breached The Post-2008 Rational Valuation Limit Has Been Breached There are three ways that an irrational valuation can revert to rationality: Stock prices decline. Bond yields decline. Stock prices and bond yields drift sideways while (forward) earnings gradually rise to improve stock valuations. The Investment Decision The decision to be invested in the stock market is probably the most important decision for all investors, including those in Europe. Furthermore, the direction of the stock market is a global rather than a local phenomenon. Our current recommendation is to stay tactically neutral for the next few weeks to see whether risk-asset valuations can revert to rationality. This means keep existing investments in the market, but hold fire on new deployments of cash. Hold fire on new deployments of cash. If valuation reverts to rationality in any of the three ways listed above, then investors can safely deploy new cash into the market. But if valuation turns into irrationality, then it will require a completely different investment mindset. After all, you cannot analyse an irrational market using rational tools! In this case, technical analysis becomes much more important, and front and centre of these techniques is fractal analysis. Specifically, as investors with longer and longer time horizons join the irrational bubble, there will be well-defined moments of heightened fragility, at which correction risk increases. This is what burst the irrational bubble in 2000 (Chart I-9), and will burst any new irrational bubble. Stay tuned. Chart I-9The Dotcom Bubble Burst When All Investment Time Horizons Had Joined It The Dotcom Bubble Burst When All Investment Time Horizons Had Joined It The Dotcom Bubble Burst When All Investment Time Horizons Had Joined It Fractal Trading System* The recent strong rally and outperformance of the Chinese stock market is fragile on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to underweight China versus New Zealand (MSCI indexes), setting a profit target and symmetrical stop-loss at 9 percent. In other trades, the continued momentum of reflation plays has weighed on some recent positions as well as stopping out short MSCI World versus the 30-year T-bond. Nevertheless, the rolling 12-month win ratio stands at 54 percent. Chart I-10MSCI: China Vs. New Zealand MSCI: China Vs. New Zealand MSCI: China Vs. New Zealand 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 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights There is too much euphoria and complacency in global markets. The main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. Yet, it does not mean that the bull market will continue uninterrupted. This rally might be short circuited by gravitational forces as happened with the S&P 500 in 1987 and Chinese onshore stocks in 2015. Investors should consider going long EM equity or EM currency volatility to hedge their exposure. Feature There is growing evidence that the global equity rally has turned into a frenzy. Signs of investor euphoria include: The number of traded call options in the US equity market has surged to an all-time high (Chart 1). The number of put options has spiked only in the past couple of weeks and remains well below the number of call options. Chart 1A Call Buying Frenzy Is A Symptom Of Investor Exuberance A Call Buying Frenzy Is A Symptom Of Investor Exuberance A Call Buying Frenzy Is A Symptom Of Investor Exuberance Critically, there is currently too much complacency: the US put-call ratio is as low as it was in 2000 (Chart 2). The volume of stocks traded on and off all US stock exchanges has exploded since late October, reaching an all-time high (Chart 3). Chart 2A Sign Of Equity Market Complacency A Sign Of Equity Market Complacency A Sign Of Equity Market Complacency Chart 3US Equity Trading Volumes Are At All-Time Highs bca.ems_wr_2021_02_04_c3 bca.ems_wr_2021_02_04_c3 Chart 4Retail Investors Haven Been A Powerful Force In Korea And Taiwan Retail Investors Haven Been A Powerful Force In Korea And Taiwan Retail Investors Haven Been A Powerful Force In Korea And Taiwan Equity fervor is prevalent not only among American individual investors but also in many parts of the world. For instance, the breathtaking rallies in the KOSPI and Taiwanese stocks has been primarily driven by local retail investors, as shown in Chart 4. The surge in Taiwanese share prices is stunning because it completely ignores the escalating geopolitical tensions over Taiwan. BCA Research’s Chief Geopolitical Strategist, Matt Gertken, recently argued that while China is unlikely to invade Taiwan immediately, a military stand-off cannot be ruled out. China and the US have yet to arrive at a mutual understanding regarding China’s access to computer chips made in Taiwan. Overall, since the lockdowns in March last year, individual investors have rushed into equities in many countries such as the US, Korea, Taiwan, Japan, India and Brazil, to name a few. Finally, US institutional investors are fully invested, as shown in Chart 5. Besides, Chart 6 reveals that US-domiciled EM equity mutual funds’ liquidity ratio (cash as a percentage of assets) is very low. Chart 5US Institutional Investors Are Long Stocks US Institutional Investors Are Long Stocks US Institutional Investors Are Long Stocks Chart 6US-Domiciled EM Mutual Funds' Cash Is Low US-Domiciled EM Mutual Funds' Cash Is Low US-Domiciled EM Mutual Funds' Cash Is Low   There have been doubts within the global investment community about the potential for small individual investors to move the needle in the overall market. We believe that their impact has been substantial: First, there is plenty of anecdotal evidence to suggest that individual traders have been involved in options trading since the pandemic erupted. By purchasing call options, retail investors exert substantial upward pressure on share prices: dealers – who sell/write call options – typically hedge their risks by acquiring and holding the underlying stock for the duration of respective options. In short, by putting even small amounts of money at work to purchase call options, individual traders meaningfully affect share prices. Second, price formation in financial markets is influenced by the marginal investor. Everything else being equal, the entry of a new buyer into the marketplace leads to higher prices. Further, retail investors’ impact on financial markets has not been limited solely to stocks they purchase. Rather, there has been a ripple effect on the broader market. For instance, there is evidence that individual investors flocked to the market in March and April and bought en masse shares of companies most negatively affected by the pandemic, such as cruise operations, hotels, airlines and energy producers. As individual investors provided substantial bids for these stocks, institutional investors were able to offload these stocks and buy others. For instance, in Q2 last year Warren Buffett offloaded his airline stocks and allocated that capital to natural gas storage and pipelines, banks, pharma and auto stocks. If retail investors had not provided support to stocks of companies hit hard by the lockdowns and social distancing, Warren Buffett and other professional investors would not have had the opportunity to exit their positions in these stocks at acceptable prices and acquire other securities. This is the mechanism whereby the impact of new market entrants extends beyond the specific equities they purchase. Chart 7A Mini Call Option Mania Among Retail Investors A Mini Call Option Mania Among Retail Investors A Mini Call Option Mania Among Retail Investors Finally, Charts 1 and 3 above clearly illustrate the surge in both the number of call options and trading volumes since last March. Among call options, transactions with a small number of options have ballooned (Chart 7). This reflects individual investors activity. Consistently, the number of brokerage accounts for retail investors has mushroomed in the US and elsewhere. Bottom Line: It is obvious that the ongoing equity market euphoria is considerable. Individual investors have been playing a vital role in fostering it. The GameStop stock saga, among others, reinforces this point. When And How Will It End? This bull market shares some similarities with previous market cycles, but it also has its distinct features. Similarities: Retail investors typically rush into financial markets toward the end of a bull market. The current US equity market rally began in 2009. After the S&P 500 showed its resilience by rebounding quickly and making new highs following the selloffs in 2015, 2018 and 2019, retail investors were reassured to jump on the bull market train when the 2020 crash occurred.  In short, it took about 11 years of a US equity bull run for individual investors to feel comfortable enough to play the stock market. This is a characteristic of a late cycle/mature bull market. Speculative instruments and schemes are designed and launched. The IPO boom in SPACs1 will probably go down in history as a key feature of the speculative excesses in this cycle. Valuations overshoot during stock market euphoria but investors find reasons to justify lofty equity multiples. FAANGM stocks and other parts of the US equity market are expensive, but investors are using extremely low US bond yields – artificially suppressed by the Federal Reserve – to justify the current multiples. In such a case, the bond market will likely hold equities hostage. As bond yields rise going forward, equity valuations will be threatened. In fact, we believe rising bond yields, not the outlook for economic growth, to be the primary risk to US share prices akin to the late 1960s (Chart 8). Differences: Typically, retail investors feel comfortable investing in the stock market when the economy is strong. In this cycle, they jumped on the stock market train when the economy crashed due to the pandemic. This is a departure from previous cycles. Massive stimulus and ongoing vaccination deployment suggest the economic outlook for the US and many emerging economies is positive. In particular, EM corporate profits are set to recover (Chart 9). Chart 8The US In The 1960s: Share Prices And Treasury Yields The US In The 1960s: Share Prices And Treasury Yields The US In The 1960s: Share Prices And Treasury Yields Chart 9EM EPS Is To Recover EM EPS Is To Recover EM EPS Is To Recover   Hence, it is hard to be bearish on stocks based on the cyclical outlook for growth, assuming vaccination campaigns will allow many major economies to fully reopen in H2 2021. Yet, a lot of this good news seem to be already priced in. Retail investors arrive to the stock market party usually in the late stage of a business cycle – when unemployment is low, inflation is rising, and policymakers are tightening policies. That combination proves lethal for the equity market and a major top in share prices ensues. Presently, due to the pandemic-induced lockdowns, we have the opposite occurring in the US and in many EM economies. Unemployment is high, inflation remains contained, and policymakers are committed to providing unlimited stimulus. In short, the main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. History doesn't repeat itself, but it does rhyme. Does it mean that the bull market will continue uninterrupted? Not necessarily. This rally might be short circuited for reasons that may differ from those that terminated previous stock market frenzies. First, speculative bubbles could burst without policy tightening. An example of this is China’s equity bubble in 2015, which crashed without policy tightening due to gravitational forces reasserting themselves. Another example is the 1987 US stock market crash that occurred without an economic or fundamental financial cause. Chart 10 illustrates the cyclical trajectories of US GDP and the Fed funds rate did not change materially before and after the equity market crash. In short, the 1987 equity crash was a case when excessive speculation/overbought conditions rather than policy tightening or a recession caused an abrupt equity sell-off. Second, in the EM equity universe, leadership has been extremely narrow. Only a handful of companies have outperformed the aggregate benchmark, propelling the index to 2007 highs. These include a few Chinese new economy stocks, and Korean and Taiwanese technology stocks (Chart 11). Outside North Asian markets (China, Korea and Taiwan), every single EM bourse has underperformed both the EM and global equity benchmarks in the past year. Chart 10The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy Chart 11Euphoria In Asian TMT Stocks Euphoria in Asian TMT Stocks Euphoria in Asian TMT Stocks Chart 12Global ex-TMT Stocks Have Not Broken Out Yet bca.ems_wr_2021_02_04_c12 bca.ems_wr_2021_02_04_c12 If these global and EM TMT stocks relapse, they will inflict major damage on the EM and global indexes. The EM index has become extremely concentrated with the top five stocks accounting for 24% of the MSCI EM equity index’s market cap. Interestingly, global ex-TMT stocks have not yet broken out to new highs (Chart 12). Finally, US overall equity and global TMT valuations are vulnerable to rising US bond yields. The latter could rise without the Fed hinting at policy tightening if fixed-income investors decide that the Fed is behind the inflation curve. This could trigger a major selloff even if policymakers do not tighten policy. Investment Conclusions Chart 13Go Long EM Equity And Currency Volatility Go Long EM Equity And Currency Volatility Go Long EM Equity And Currency Volatility We are in a euphoria phase where fundamentals are less pertinent. The market can either rally a lot or sell off hard regardless of the profit outlook. Navigating through such markets is challenging. Going long EM equity or EM currency volatility offers a good risk-reward profile (Chart 13). Volatility will likely rise in the coming months in both scenarios: either risk assets continue rallying or they sell off. For global equity and credit portfolios, we continue recommending a neutral allocation to EM. The long-term US dollar outlook is negative, but it is oversold and odds of a near-term rebound are still high. Our currency strategy remains to short a basket of EM currencies versus an equal-weighted average of the euro, CHF and JPY. This basket of EM currencies includes the BRL, CLP, ZAR, KRW and TRY. We continue receiving 10-year swap rates in Mexico, Colombia, Russia, China, India, Indonesia and Korea. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Special Purpose Acquisition Companies (SPAC), also known as “blank check companies”, are organizations with no commercial operations that raise capital through an IPO, which is then deployed to purchase an existing company. This process is done to bypass the lengthy process of launching a traditional IPO for a young company.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights An uninterrupted advance in reflation trades will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. EM equity valuations are neither cheap in absolute terms nor relative to Europe and Japan. EM is cheap only versus the S&P 500. US relative equity outperformance in common currency terms is breaking down. Go long EM stocks / short the S&P 500. The Blue Wave in the US is very bearish for the greenback and has reduced our expectations of the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Feature Financial markets are at a crossroad. On the one hand, the reflation trades have already rallied a great deal and might be at a point of exhaustion. On the other hand, gigantic monetary and fiscal support from authorities worldwide, and the US in particular, could push global share prices into a no gravity zone where major overshoots and manias are possible. The bullish view is well-known: DM central banks’ easy monetary and fiscal policies will endure. Moreover, the global economy will continue its recovery as vaccines are made accessible by mid-year to a large share of the population in advanced economies. Markets will ignore any growth disappointment stemming from the expansion and/or extension of lockdowns as they are forward-looking and expect widespread vaccine deployment to eventually allow for a reopening of the economies. We agree with these points. The negative view is also well-recognized: investor sentiment on global equities in general and EM in particular is very elevated and reflation trades have become overbought. These are valid and correct points as well. Chart I-1 illustrates that the Sentix investor sentiment1 on EM equities is at an all-time high. In the past, when sentiment reached these levels EM share prices experienced either a correction or a bear market. Chart I-1Investor Sentiment On EM Equities Is At A Record High Investor Sentiment On EM Equities Is At A Record High Investor Sentiment On EM Equities Is At A Record High Further, the December issue of the Bank of America/Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. These proved to be the major (structural) tops in EM equities and commodities. Certainly, positioning in EM is even more crowded now than it was four weeks ago. Are EM equities at a point of exhaustion – where the rally runs out – or at a point of no gravity – where nothing will stop them from marching higher? In the near term, either is possible. It truly depends on investor behavior which is impossible to forecast with any high degree of certainty. Chart I-2Korean Stocks Have Benefited From Local Retail Mania Korean Stocks Have Benefited From Local Retail Mania Korean Stocks Have Benefited From Local Retail Mania For instance, retail mania has been happening not only in the US but also in many developing countries. In particular, the astonishing rally in Korean stocks has been propelled not by foreign investors but by local retail investors (Chart I-2). That is why traditional yardsticks of investment analysis have not been useful. In the medium and long term, the trend in global share prices, and thereby EM, will likely be shaped by issues where there is no consensus among investors. In our opinion, there are two subjects upon which investors disagree: (1) whether global and EM equity valuations are too expensive, and (2) whether US inflation will rise sufficiently so that the Federal Reserve abandons its super-easy monetary policy stance, and when markets will begin to price this in. EM equity valuations are not at all cheap. An uninterrupted advance will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. Concerning US inflation, the odds are that it will rise sooner and faster than is expected by the market and the Fed. Although the Fed is unlikely to singlehandedly spoil the party, fixed-income markets could start pricing in rate hikes sooner rather than later with ramifications for share prices. We will discuss equity valuations in this report and devote a separate report in the coming weeks to the inflation outlook in the US and China. Market Implications Of The Blue Wave Chart I-3US Consumption Of Industrial Metals Is Too Small Reflation Trades: Exhaustion Or No Gravity? Reflation Trades: Exhaustion Or No Gravity? We expected US Republicans to maintain their majority in the Senate after Georgia’s Senate elections, thus dimming the likelihood of more large-scale fiscal stimulus. If realized, that would have triggered a rebound in the US dollar from very oversold levels. US Democrats effectively gaining control of the Senate has major implications for financial markets: America’s fiscal policy will be looser than otherwise. Swelling government spending will boost domestic demand and will produce a wider trade deficit and higher inflation. Yet, the Fed is unlikely to tighten policy anytime soon and real interest rates will remain negative. This is very bearish for the US dollar. Any rebound in the greenback, which is possible given its oversold conditions, should be faded. According to our Chief Geopolitical Strategist Matt Gertken, odds are that Democrats will partially repeal the corporate tax cuts enacted during Trump’s administration. This is negative for both the US dollar and for Wall Street. One of the main campaign promises of Democrats has been to address income inequality. Actions on this front are good for Main Street but these policies will weigh on corporate profitability. Big Tech faces a greater threat of taxes from a united Congress as opposed to a divided Congress, but Biden’s executive decrees will not be too harsh given that these companies are a major source of support for Democrats. US nominal interest rates will rise but so will nominal GDP growth. The negative impact of higher US bond yields on EM will be more than offset by two forces: a weaker US dollar and stronger exports to the US. Finally, the shift in US fiscal policy is clearly inflationary. However, the impact on commodities prices will be modest. The US accounts for only 8% of global industrial metals consumption compared to China’s 57% share (Chart I-3). So, a slowdown in China commencing in H2 2021 will more than offset the rise in US metals consumption. Concerning oil, the US is the world’s largest crude consumer. Hence, higher household income and spending are positive for oil prices. However, a forceful Democrat push toward green energy is structurally negative for US oil consumption. These two forces might offset each other leaving oil prices to be determined by other factors. Bottom Line: Democrat control of both houses of Congress is positive for US nominal GDP and, hence, for corporate revenues but is bearish for the US dollar and corporate profit margins. Net-net, this reinforces our view that US relative equity outperformance in common currency terms has already passed its secular top and is breaking down (Chart I-4, top panel). By contrast, this US policy shift is positive for EM financial markets (Chart I-4, bottom panel). We recommend a new trade/strategy: go long EM stocks / short the S&P 500. EM Equity Valuations In our opinion, global stocks, especially US ones, are expensive and EM equities are far from being cheap. Let’s begin with EM equity valuations: Chart I-5 shows our Composite Valuation Indicator (CVI) for the MSCI EM equity benchmark. It is an average of four individual valuation indicators: market cap-weighted, equal-weighted, trimmed mean, and median. Chart I-4US Equity Outperformance Is Over US Equity Outperformance Is Over US Equity Outperformance Is Over Chart I-5EM Equities: Good News Are Fully Priced In EM Equities: Good News Are Fully Priced In EM Equities: Good News Are Fully Priced In   In turn, each of these four indicators incorporates five multiples: forward P/E, trailing P/E, price-to-cash EPS, price-to-book value and price-to-dividend ratios. According to Chart I-5, EM equities are expensive. Not only are trailing P/E and price-to-cash EPS ratios extremely elevated but also the forward P/E ratio is the highest and the dividend yield is the lowest it has been in 18 years (Chart I-6). Even though EM stocks do not appear to be expensive based on a price-to-book value (PBV) ratio, a structural decline in EM return on equity (RoE) entails that the fair value range for the PBV ratio has downshifted over the past decade and the current reading should be taken with a grain of salt. Chart I-7 demonstrates that the RoEs for the entire MSCI EM universe, equal-weighted MSCI EM equity index and MSCI non-financial EM companies have deteriorated structurally. Hence, a decline in return on equity is widespread among EM-listed companies, i.e. it is not a feature unique to only large caps. Chart I-6EM Equity Multiples EM Equity Multiples EM Equity Multiples Chart I-7A Structural Drop In EM RoE Heralds Lower Multiples A Structural Drop In EM RoE Heralds Lower Multiples A Structural Drop In EM RoE Heralds Lower Multiples   In brief, the structural decline in EM RoE justifies a lower PBV ratio for EM equities (Chart I-7, bottom panel). Relative to DM, EM equities are not cheap. They are cheap versus their US peers but expensive versus European and Japanese stocks. Chart I-8 exhibits the relative Composite Valuation Indicator for EM relative to DM. For EM, it is the same as in Chart I-5 and for DM we use an identical measure. When discussing equity valuations, one should now distinguish between growth and value stocks. EM growth stocks are grossly overvalued as shown in the top panel of Chart I-9. EM value stocks are close to their fair value, i.e., they are not cheap (Chart I-9, bottom panel). Chart I-8EM Versus DM: Relative Equity Multiples EM Versus DM: Relative Equity Multiples EM Versus DM: Relative Equity Multiples Chart I-9Multiples For EM Growth And Value Stocks Multiples For EM Growth And Value Stocks Multiples For EM Growth And Value Stocks   A caveat is in order: all of these CVIs do not incorporate interest rates into valuation models. We look at equity multiples in the context of low interest rates in the sections that follow. Incorporating Interest Rates Into Equity Valuations Chart I-10EM Earnings Yields Adjusted For Local Bond Yields EM Earnings Yields Adjusted For Local Bond Yields EM Earnings Yields Adjusted For Local Bond Yields There are various ways to incorporate interest rates/the discount factor into equity valuations. One way is to calculate the difference between forward earnings yield (EY) and long-term bond yields. We use forward EY because trailing EPS is still depressed by the pandemic-induced economic crash, i.e., trailing P/Es do not provide a true valuation picture. Chart I-10 demonstrates the gap between EM forward EY and 10-year US bond yields (on the top panel) and the same forward EY and EM local bond yields (Chart I-10, bottom panel). Both measures are not far from their historical means. Hence, adjusted for bond yields, EM stocks are fairly valued. That said, there are two pertinent questions that follow from this: (1) how do EM equities compare to their DM peers; and (2) how well have these interest rate-adjusted valuation measures worked in markets where interest rates had dropped to zero. In other words, do near-zero interest rates warrant a secular bull market? We address this last topic in the section below. As to the first question, Chart I-11 presents the forward EY-local interest rate differential for major equity markets. A higher differential presage cheaper equity valuation relative to lower numbers. Chart I-11US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones According to this measure, Japanese and Euro Area equities have been and remain cheaper than US and EM equities. Chart I-12 ranks all individual EM equity benchmarks as well as major DM bourses based on the differential between forward EY and local nominal bond yields. Stocks in India, Indonesia, South Africa, Turkey, Mexico and Colombia are expensive, adjusted for local bond yields. Chart I-12Cross Country Valuation Ranking: Forward Earnings Yield Minus Local Bond Yields Reflation Trades: Exhaustion Or No Gravity? Reflation Trades: Exhaustion Or No Gravity? By contrast, equity markets in Central Europe, core Europe and Russia offer better value, relative to domestic bonds. The EM aggregate index, the Chinese investable benchmark and the S&P 500 fall in the middle of this valuation ranking. Bottom Line: Based on equity multiples, EM equities are expensive. However, when adjusted for interest rates, absolute valuation of EM equities is neutral. Relative to DM, the EM equity benchmark is not cheap. In fact, they are more expensive compared to European and Japanese stocks. Equity Valuation When Rates Are At Zero No doubt, equity prices should be re-rated as interest rates drop. However, what should the equilibrium P/E multiple be when interest rates are close to zero? Japan, the euro area and Switzerland offer a roadmap. Chart I-13Japanese And European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates Japanese and European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates Japanese and European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates For some time now, these markets have had to process many of the same features that US and global markets are currently facing. Specifically: They have had negative policy rates and 10-year government bond yields for many years. Their central banks have been conducting some sort of QE programs. The Bank of Japan and the Swiss National Bank have been purchasing equities and the ECB has been buying corporate bonds. Finally, onward from 2012 until the eruption of the pandemic, economic growth in Japan, the euro area and Switzerland was decent. Despite negative interest rates, their broad equity markets have failed to break out into a structural bull market. Their stocks have re-rated, but the upside was capped (Chart I-13). Critically, the forward EY differential with their local government bond yields have stayed wide (Chart I-14). Chart I-14Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields In sum, the experiences of Japanese, Swiss and other European markets show that zero or negative interest rates alone did not compel a secular bull market in share prices. Rather, equity re-rating in these bourses has been relatively moderate. Investment Considerations The Blue Wave is very bearish for the greenback as we argued above. This development has reduced our conviction regarding the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Potential EM currencies that investors should consider buying on a dip versus the US dollar are MXN, SGD, KRW, TWD, CNY, INR and CZK. For now, we continue to recommend a neutral allocation to EM equities and credit within global equity and credit portfolios, respectively. However, we note that odds of EM outperformance have risen with the Blue Wave in the US and ensuing US dollar depreciation. Yet, Europe and Japan presently offer a better risk/reward profile than EM. However, to reflect our strong conviction of a breakdown in US relative performance and a more upbeat view on EM versus US stocks, we recommend the following trade/strategy: long EM stocks / short the S&P 500, currency unhedged. Concerning the absolute performance of EM and DM stocks, they are very overbought, reasonably expensive and sentiment is very bullish. In normal times, this would argue for a pullback. For example, Chart I-15 shows that a rollover in the inverted US equity put-call ratio typically heralds a setback in the S&P500. Chart I-15A Red Flag? Do Indicators No Longer Work? A Red Flag? Do Indicators No Longer Work? A Red Flag? Do Indicators No Longer Work? However, if global stocks are moving from a FOMO stage to a mania phase, many traditional relationships and indicators might not work. This and the fact the EM equity index is at a critical juncture entails its outlook is currently highly uncertain – odds of a breakout (FOMO evolving into a mania) and a potential setback are equal. Finally, some housekeeping, we are closing the long Chinese Investable stocks / short Korean stocks recommendation. This trade has generated a massive loss of 33.5% as the KOSPI has taken off in recent weeks. We continue to overweight both Chinese and Korean equities within an EM equity portfolio. We will likely make changes to our recommended country allocations within equity and fixed-income portfolios in the coming weeks. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  The Sentix Asset Classes Sentiment Emerging Markets Equities Index is polled among 5,000 European individual and institutional investors. In the survey, investors are asked about their medium-term price expectations for the asset class. Source: SENTIX.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Recommended Allocation Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Chart 1Only Internet Stocks Have Kept On Rising Only Internet Stocks Have Kept On Rising Only Internet Stocks Have Kept On Rising It has been a very strange bull market. Although global equities are up 52% since their bottom on March 23rd, the rally has been limited largely to internet-related stocks. Excluding the three sectors (IT, Consumer Discretionary, and Communications) which house the internet names, equities have moved only sideways since May (Chart 1). Moreover, the rally comes amid sporadic serious new outbreaks of COVID-19 cases, most recently in Europe (Chart 2). Fears of the pandemic and much-reduced business activity in leisure-related industries have caused consumer confidence to diverge from the stock market in an unprecedented way (Chart 3).  Chart 2New Outbreaks Of COVID-19 In Europe New Outbreaks Of COVID-19 In Europe New Outbreaks Of COVID-19 In Europe Chart 3Why Are Stocks Rising When Consumers Are So Wary? Why Are Stocks Rising When Consumers Are So Wary? Why Are Stocks Rising When Consumers Are So Wary? The only explanation for these phenomena is the unprecedented amount of monetary stimulus, which is causing excess liquidity to flow into risk assets. Since March, the balance-sheets of major central banks have increased by $7 trillion (Chart 4), and M2 money supply growth has soared (Chart 5). Chart 4Central Banks Have Grown Their Balance-Sheets... Central Banks Have Grown Their Balance-Sheets... Central Banks Have Grown Their Balance-Sheets... Chart 5...Leading To A Big Rise in Money Growth ...Leading To A Big Rise in Money Growth ...Leading To A Big Rise in Money Growth Moreover, the Fed’s new strategic framework announced in late August represents a commitment to keep monetary policy loose even when the economy begins to overheat. The Fed will (1) target 2% inflation on average over time which means that, after a period of low inflation, it will “aim to achieve inflation moderately above 2 percent for some time”; and (2) treat its employment mandate as asymmetrical, so that when employment is below potential the Fed will be accommodative, but that a rise in employment above its “maximum level” will not necessarily trigger tightening. Historically the Fed has raised rates when unemployment approached its natural rate (Chart 6). The new policy implies it will no longer do so. The aim of the policy is to raise inflation expectations which have become unanchored, with headline PCE inflation above the Fed’s 2% target for only 14 out of 102 months since the target was introduced in February 2012 (Chart 6, panel 3).  Chart 6The Fed's Behavior Will Be Different In Future The Fed's Behavior Will Be Different In Future The Fed's Behavior Will Be Different In Future Chart 7More Permanent Job Losses To Come More Permanent Job Losses To Come More Permanent Job Losses To Come This commitment to easier monetary policy for longer will certainly help risk assets. But will it be enough? The global economic environment remains weak. Permanent job losses continue to increase, as workers initially put on furlough or dismissed temporarily, are fired (Chart 7). A second wave of COVID-19 cases in the Northern Hemisphere winter would worsen the situation. While central banks everywhere remain committed to aggressive policy, fiscal policy decision-makers are getting cold feet, with the UK’s wage-replacement scheme due to end in October, and government support in the US set to decline absent a big new fiscal package agreed by Congress (Chart 8). Credit risks are beginning to emerge, with bankruptcies surging (Chart 9), and mortgage delinquencies starting to rise (Chart 10). As a result, banks are becoming significantly more reluctant to lend (Chart 11). Chart 8Fiscal Support Is Starting To Slide Fiscal Support Is Starting To Slide Fiscal Support Is Starting To Slide   Chart 9Bankruptcies Are Surging… Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market?   Chart 10...Along With Mortgage Delinquencies ...Along With Mortgage Delinquencies ...Along With Mortgage Delinquencies Chart 11Banks Turning Increasingly Cautious Banks Turning Increasingly Cautious Banks Turning Increasingly Cautious To those concerns, we should add political risk ahead of the US presidential election. President Trump is probably not as far behind as the 7-percentage point gap in opinion polls suggests: After the Republican National Convention, online betting sites give him a 46% probability of being reelected (Chart 12). Over the next two months, he could be aggressive in foreign policy, particularly towards China. A disputed election is not unlikely. Investors might be wise to hedge against that possibility: BCA Research’s Geopolitical service recommends buying December VIX futures, which are still cheaply priced, and selling January VIX futures (Chart 13). 1 Chart 12Trump Could Still Pull It Off Trump Could Still Pull It Off Trump Could Still Pull It Off   Chart 13Hedge Against A Disputed Election Result Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Given the power of monetary stimulus, we are reluctant to bet against equities – not least since the yield on fixed-incomes assets is so low. Nonetheless, we see the risk of a sharp correction over the coming six months, driven by a second pandemic wave, a renewed downturn in the global economy, or political events. We continue to recommend, therefore, only a neutral position on global equities. We would hold a large overweight in cash, to keep powder dry for when a better buying opportunity for risk assets arises. But a warning: The long-run return from all asset classes will be poor. The global bond index is unlikely to produce a nominal return much above zero over the coming decade. While equities look more attractive, our valuation indicator points to a nominal annual return of only around 3% (Chart 14). For the US, valuation suggests a return of zero. Investors will need to become more realistic about their return assumptions. The 7% annual return still assumed by the average US pension fund might have made sense when the yield on BBB-rated corporate bonds was 8%, but it no longer does when it has fallen to 2.3% (Chart 15). Chart 14Long-Term Equity Returns Will Be Poor Long-Term Equity Returns Will Be Poor Long-Term Equity Returns Will Be Poor Chart 15Investors' Return Assumptions Are Unrealistic Investors' Return Assumptions Are Unrealistic Investors' Return Assumptions Are Unrealistic   Chart 16Value Sectors' Profits Have Been Terrible Value Sectors' Profits Have Been Terrible Value Sectors' Profits Have Been Terrible Equities: The most vigorous debate among BCA Research strategists currently is over whether growth stocks will continue to outperform, or whether value will take over leadership. The Global Asset Allocation service is on the side of growth. The poor performance of value stocks (concentrated in Financials, Energy, and Materials) is explained by the structural decline in their profits for the past 12 years (Chart 16). With the yield curve unlikely to steepen and non-performing loans set to rise, we do not see Financials’ earnings recovering. China’s economic shifts represent a long-term headwind for Materials. Internet stocks are expensively valued, but we do not see them underperforming until (1) their earnings’ growth slows sharply, (2) regulation on them is significantly tightened, or (3) long-term bond yields rise, lowering the NPV of their future earnings. This view drives our Overweight on US equities versus Europe and Japan. US stocks have continued to outperform even in the risk-on rally since March (Chart 17). We are a little more enthusiastic (with a Neutral recommendation) about Emerging Market stocks, which are very cheaply valued (Chart 18). Chart 17US Stocks Have Outperformed Even In A Risk-On Market US Stocks Have Outperformed Even In A Risk-On Market US Stocks Have Outperformed Even In A Risk-On Market   Chart 18EM Stocks Are Cheap EM Stocks Are Cheap EM Stocks Are Cheap   Chart 19Short USD Is Now A Consensus Trade Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Currencies: The US dollar has depreciated by 10% since mid-March. Over the next 12 months, the trend for the USD is likely to continue to be down. The new Fed policy emphasizes that real rates will stay low, and US inflation will probably be higher than in other developed economies. Nonetheless, short-USD/long-euro positions have become consensus (Chart 19) and, given the safe-haven nature of the dollar, a period of risk-off could push the dollar back up temporarily. Chart 20IG Spreads Are No Longer Attractive Investment Grade Breakeven Spreads IG Spreads Are No Longer Attractive Investment Grade Breakeven Spreads IG Spreads Are No Longer Attractive Fixed Income: We don’t expect to see a sustained rise in nominal US Treasury yields, despite the Fed’s new monetary policy framework. The Fed has an implicit yield curve control policy, and would react if yields showed signs of rising significantly. TIPS breakevens should eventually rise further to reflect the likelihood of higher inflation in the longer term, though the recent sharp rise in inflation (core CPI rose by 0.6% month-on-month in July, the largest increase since 1991) will likely subside and so the upside for breakeven yields might be limited over the next six months. We are becoming a little more cautious on credit. Investment-grade spreads are now close to historic lows and so returns are likely to be limited (Chart 20). We lower our recommendation to Neutral. Ba-rated bonds still offer attractive yields and are supported by Fed purchases. But we would not go further down the credit curve, and so stay Neutral on high yield. This by definition means that we must also be Neutral within fixed income on government bonds, which is compatible with our view that rates will not rise much. Note, though, that we remain Underweight the fixed-income asset class overall, but no longer have a preference for spread product within it. One exception is EM dollar-denominated debt, both sovereign and corporate, which offers spreads that are attractive in a world of low returns from fixed income. Chart 21Crude Prices Can Rise Further As Demand Recovers Crude Prices Can Rise Further As Demand Recovers Crude Prices Can Rise Further As Demand Recovers Commodities: Industrial metals prices have further to run up, as China continues its credit stimulus, which should lead to a rise in infrastructure investment and increased imports of commodities. The outlook for crude oil will be dominated by the demand side: OPEC forecasts demand destruction this year of 9 million barrels per day (compared to consensus expectations of 8 million) and so will be cautious about loosening its supply constraints. Demand should be boosted by increased driving, as people avoid using public transport for commuting and airlines for vacations. Based on a robust demand forecast (Chart 21), BCA Research’s energy strategists see Brent crude stable at around current levels through to the end of 2020 but averaging $65 a barrel next year. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1  Please see Geopolitical Strategy Special Report, “What Is The Risk Of A Contested US Election?” dated July 27, 2020. GAA Asset Allocation  

Highlights President Trump is making a comeback in our quantitative election model. An upgrade from our 35% odds of a Trump win is on the horizon, pending a fiscal relief bill.  The Fed’s pursuit of “maximum employment,” the necessities of the pandemic response, fiscal largesse, a US shift toward protectionism, and the strategic need to counter China will pervade either candidate’s presidency. A Democratic “clean sweep” would add insult to injury for value stocks, but these stocks don’t have much more downside relative to growth stocks. Trump’s tariffs, or Biden’s taxes, will hit the outperformance of Big Tech, as will the recovery of inflation expectations. Feature More than at any time in recent US history, voters believe that the 2020 election is definitive in charting two distinct courses for the country (Chart 1). No doubt 2020 is an epic election with far-reaching implications. However, from an investment point of view, a Trump and a Biden administration have more in common than consensus holds. Chart 1An Epic Choice About The US’s Future Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The US political parties have finalized their policy platforms, giving investors greater clarity about what policies the parties will try to implement over the next four years.1 While the presidential pick is critical for American foreign and trade policy, the Senate is just as important as the president for US equity sectors. The only dramatic changes would come if the Democrats achieved a clean sweep of government – yet this result is likely as things stand today (Chart 2). Investors should prepare. It would prolong the suffering of value stocks relative to growth stocks by hitting the US health care and energy sectors hard. Chart 2“Blue Wave” Still The Likeliest Scenario Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The State Of Play A “Blue Wave” is still the likeliest outcome – and that’s where the stark policy differences emerge. The race is tightening. Our quantitative election model looks at state leading indicators, margins of victory in 2016, the range of the president’s approval rating, and a “time for change” variable that gives the incumbent party an advantage if it has not been in the White House for eight years. The model now shows Florida as a toss-up state with a 50% chance of flipping back into the Republican fold (Chart 3). Chart 3Florida Now 50/50 In Our Election Quant Model – 45% Chance Of Trump Win Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes As long as the economy continues recovering between now and November 3, Florida should flip and Trump should go from 230 Electoral College votes to 259. One other state – plus one of the stray electoral votes from either Nebraska or Maine, which Trump is like to get – would deliver him the Oval Office again. The model says that Trump has a 45% chance of victory, up from 42% last month. Subjectively, we are more pessimistic than the model. Pandemic, recession, and social unrest have taken a toll on voters and unemployment is nearly three times as high as when Trump’s approval rating peaked in March. Consumer confidence is weak, albeit making an effort to trough. Voters take their cue from the jobs market more than the stock market, although the stock rally is certainly helpful for the incumbent. We await the completion of a new fiscal relief bill in Congress before upgrading Trump to closer to our model’s odds and the market consensus of 45%. Another Social Lockdown? COVID-19 subsiding in the US a boon for Trump in final two months of campaign. The first concern for the next president is COVID-19. On the surface Trump and Biden are diametrically opposed. President Trump is obviously disinclined to impose a new round of lockdowns and the Republican platform calls for normalizing the economy in 2021. By contrast, the Democrats claim they will contain the virus even at a high economic cost. Biden says he will be willing to shut down the entire US economy again if scientists deem it necessary.2 There is apparently political will for new draconian lockdowns – but it is not likely to be sustained after the election unless the next wave of the virus is overwhelming (Chart 4). Biden will need to be cognizant of the economy if he is to succeed. Chart 4Biden Has Some Support For Another Lockdown Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes However, it is doubtful that Trump would refuse to lock down the economy in his second term if his advisers told him it was necessary. After all, it is Trump, not Biden, who implemented the lockdowns this year. Arguably he reopened the economy too soon with the election in mind. But if that is true, then it isn’t an issue for his second term, since he can’t run for president a third time. This is a theme we often come back to: reelection removes a critical impediment to Trump’s policies in a second term as opposed to his first. Bottom Line: The coronavirus outbreak and the country’s top experts will decide if new lockdowns are warranted, regardless of president, but the bar for a complete shutdown is high. COVID-19 is subsiding in both the US and in countries like Sweden that never imposed draconian lockdowns (Chart 5). Still, given that the equity market has recovered to pre-COVID highs, investors would be wise to hedge against a bad outcome this winter. Chart 5Pandemic Subsiding In US And ‘Laissez-Faire’ Sweden Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Maximum Employment The monetary policy backdrop will be ultra-dovish regardless of the presidency. The Fed is now pursuing average inflation targeting and “maximum employment,” according to Fed Chairman Jay Powell, speaking virtually on August 27 at the Kansas City Fed’s annual Jackson Hole summit. This means that if Trump wins, he will not have to fight running battles with Powell over rate hikes. The monetary backdrop for either president will be more reminiscent of that faced by President Obama from 2009-12 – extremely accommodative. It is possible that Trump’s “growth at all costs” attitude could lead to speculative bubbles that the Fed would need to prick. Already the NASDAQ 100 is off the charts. Elements of froth reminiscent of the dotcom bubble era are mushrooming (Chart 6). Nobody has any idea yet how the Fed will square its maximum employment mission with the need to prevent financial instability, but it will err on the side of low rates. Chart 6Frothy NDX Frothy NDX Frothy NDX Chart 7The Mother Of All V-Shapes The Mother Of All V-Shapes The Mother Of All V-Shapes Biden will be more likely to tamp down financial excesses through executive orders – or to deter excesses through taxes if he controls the Senate. But there is no reason the executive branch would be more vigilant than the Fed itself. Higher inflation will push real rates down and weaken the dollar almost regardless of who wins the presidency. Trump’s trade wars – and any major conflict with China – would tend to prop up the greenback relative to Biden’s less hawkish, more multilateral, approach. But either way the combination of debt monetization, twin deficits, and global economic recovery spells downside for the dollar. This in turn spells upside for the S&P500 and inflation-friendly (or deflation-unfriendly) equity sectors in the longer run (Chart 7). Fiscal Largesse The next president will struggle with a massive fiscal hangover resembling late 1940s. The Fed’s new strategy ensures that fiscal policy will prove the driving factor in the US macro outlook. Regardless of who wins the election, the budget deficit will fall from its extreme heights amid the COVID-19 crisis over the next four years (Chart 8). If government spending falls faster than private activity recovers, overall demand will shrink and the economy will be foisted back into recession. Chart 8Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes The deep 1948-49 recession occurred because of the government’s climbing down from wartime levels of spending (Chart 9). Premature fiscal tightening would jeopardize the 2021 recovery. Yet neither candidate is a fiscal hawk. Trump is a big spender; Biden is a Democrat. The House Democrats will control the purse strings. Republican senators, the only hawkish actors left, are not all that hawkish in practice. They agreed with Trump and the Democrats in passing bipartisan spending blowouts from 2017-20. They will likely conclude another such deal just before the election. Chart 9Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery So Trump would maintain high levels of spending without raising taxes; Biden would spend even more, albeit with higher taxes. Table 1Biden Would Raise $4 Trillion In Revenue Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes On paper, Biden would add a net ~$2 trillion to the US budget deficit over ten years, as shown in Tables 1 and 2. But these are loose costings. Nobody knows anything until actual legislation is produced. The risk to spending levels lies to the upside until the employment-to-population ratio improves (Chart 10). Trump’s net effect on the deficit is even harder to estimate because the Republican Party platform is so vague. What we know is that Trump couldn’t care less about deficits. Back of the envelope, if Congress permanently cut the employee side of the payroll tax for workers who earn less than $8,000 per month, as Trump has suggested, the deficit would increase by roughly $4.8 trillion over ten years.3 Table 2Biden Would Spend $6 Trillion In Programs Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes   Chart 10Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending House Democrats will hardly agree to any major new tax cuts – and certainly not gigantic ones that would “raid Social Security.” This accusation will be popular and Trump will want to avoid it during the campaign as well – his 2020 platform does not explicitly mention the payroll tax. Many of Trump’s other proposals would focus on extending the Tax Cut and Jobs Act. For example, it is possible that Trump could extend the full expensing of companies’ depreciation costs for capital purchases, set to expire in 2022 and 2026, to the tune of $419 billion over ten years.4 Thus the overall contribution of government spending to GDP growth will be higher than in the recent past. This trend was established prior to COVID (Chart 11). The rise of populism supports this prediction, as Trump has always insisted he will never cut mandatory (entitlement) spending – a major change to Republican orthodoxy now enshrined in its policy platform. Chart 11Government Role To Increase In America Government Role To Increase In America Government Role To Increase In America Chart 12No Cuts To Defense Likely Either No Cuts To Defense Likely Either No Cuts To Defense Likely Either Meanwhile Biden is not only rejecting spending cuts but also coopting the profligate spending agenda of the left wing of his party. Practically speaking, social spending cannot be cut by Trump – and yet Biden cannot cut defense spending much either, since competition with Russia and China is growing (Chart 12). The common thread in both party platforms is fiscal largesse at a time of monetary dovishness, i.e. reflation. Other Common Denominators Market is overrating Biden’s China friendliness. Both Trump and Biden promise to build infrastructure, energize domestic manufacturing, and lower pharmaceutical prices. The two candidates are competing vociferously over who will bring more American manufacturing jobs home. President Trump won the Republican nomination in 2016 partly because he stole the Democrats’ thunder on “fair trade” over “free trade.” Biden’s agenda is effusive on these Trump (and Bernie Sanders) themes – his party sees an existential risk in the Rust Belt if it cannot steal that thunder back. The manufacturing agenda centers on China-bashing. China runs the largest trade surplus with the US, it has a negative image in the public eye, and it has alarmed the military-industrial complex by rising to the status of a peer strategic competitor over the technologies of tomorrow. Where Trump once spoke of a “border adjustment tax,” or a Reciprocal Trade Act, Biden speaks openly of a carbon border tax: “the Biden Administration will impose carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”5 China’s coal-guzzling economy would obviously be the prime target. It is true that Biden will seek to engage China and reset the relationship. He will probably maintain Trump’s tariff levels or even slap a token new tariff, but he will then settle down for a two-track policy of dialogue with China and coalition-building with the democracies. The result may be a reprieve from strategic tensions for a year or so. Investors are exaggerating Biden’s positive impact on China relations, judging by the correlation of China-exposed US equities with the Democrats’ odds of winning. The truth is that Biden will maintain the Obama administration’s “Pivot to Asia,” which was about countering China. The secular power struggle will persist and China-exposed stocks, especially tech, will be the victims (Chart 13). Chart 13Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Senate election will likely tip with White House – but checks and balances are best for equities. Control of the Senate will determine whether the big differences between the two candidates materialize. Biden can’t raise taxes without the Senate; Trump can’t wage trade wars of choice as Congress is supreme over commerce and could take his magic tariff wand away from him. Trump can use executive orders to pare back immigration, but he cannot force the House Democrats to approve a southern border wall. In fact, he dropped “the Wall” from his agenda this time around. (It didn’t help that former Trump adviser Steve Bannon has been arrested for allegedly scamming people out of their money to pay for a wall.) Biden will be far looser on immigration than Trump and the reviving economy will attract foreign workers. But the Obama administration showed that during times of high unemployment, even Democrats have a limit to the influx they will allow (Chart 14). Meanwhile Biden can use executive orders to impose aspects of his version of the Green New Deal, but he cannot pass carbon pricing laws or other sweeping climate policy if Republican Senators are there to stop him. For this reason, a divided government is likely to produce three cheers from the markets. The single most market-positive scenario is Biden plus a Republican Senate, which suggests a moderation of the trade war and yet no new taxes. Second best would be Trump with a Democratic Congress that would clip his wings on tariffs, but enable him to veto any anti-market laws. The stock market’s performance to date is more reminiscent of a “gridlock” election outcome, in which the two parties split the executive and legislative branches of government in some way, as opposed to a unified single-party government (Chart 15). Chart 14Immigration Faces Limits Even Under Democrats Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Chart 15Stock Market Expects Gridlock? Stock Market Expects Gridlock? Stock Market Expects Gridlock? Investors should not be complacent, however, because the political polling so far suggests that the Senate race is on a knife’s edge. The balance of power will tilt whichever way the heavily nationalized, heavily polarized White House race tilts (Chart 16). A “blue sweep” is still a fairly high probability. Indeed a Biden win will most likely produce a Democratic sweep while a Trump win will produce the status quo. Chart 16Tight Senate Races Will Turn On White House Race Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Biden’s Agenda After A Blue Sweep Democrats would remove the filibuster – another big difference in outcomes. Biden is more likely to benefit from Democratic control of Congress if he wins. He is also more likely to rely on his top advisers and the party apparatus. Hence the Democratic platform matters more than the Republican platform in this cycle. Investors should set as their base case that a new president will largely succeed in passing his top one or two priorities. Less conviction is warranted after the initial rush of policymaking, as political capital will fall and the economic context will change. But in the honeymoon period, a president can get a lot done, especially if his party controls Congress. Investors would have been wrong to bet against George W. Bush’s Economic Growth and Tax Relief Act (2001), Barack Obama’s Affordable Care Act (2009), or Trump’s Tax Cut and Jobs Act (2017). Yet they could never have known that COVID-19 would strike in Trump’s fourth year and overturn the very best macroeconomic forecasts. Critically, if Democrats take the Senate, our base case is that they will remove the filibuster, i.e. the use of debate to block legislation. Biden has suggested that he would look at doing so. President Obama recently linked it to racist Jim Crow laws of the late nineteenth and early twentieth centuries, making it hard for party members to defend keeping the filibuster. Senate minority leader Charles Schumer (D, NY) has signaled a willingness to change the Senate rules if he becomes majority leader. Removing the filibuster would change the game of US lawmaking, enabling the Senate to pass laws with a simple majority of 51 votes – i.e. 50 plus a Democratic vice president. This is entirely within reach. While a handful of moderate Democratic senators may oppose such a dramatic move at first, the Democratic Party leadership will corral its members once it faces the reality of the 60-vote requirement blocking its agenda. The party will remember the last time it took power after a national crisis, in 2009, and the frustrations that the filibuster caused despite having at that time a much stronger Senate majority than it can possibly have in 2021. Populism is rife in the US and it is all about shattering norms. Moreover, the filibuster has already been eroding over the past two administrations (vide judicial appointments). Revoking it would enable Democrats to pass a lot more ambitious legislation, and many more laws, than in previous administrations. This is important because Biden’s agenda is more left-wing than some investors realize given his history as a traditional Democrat. In order to solidify the increasingly powerful progressive faction of his party, symbolized by Vermont Senator Bernie Sanders, Biden created task forces to merge his agenda with that of Sanders. Sanders and his fellow progressive Senator Elizabeth Warren of Massachusetts have much more influence in the party than their 35% share of the Democratic primary vote implies. The youth wing of the party shares their enthusiasm for Big Government. Here are the key structural changes that matter to investors: Offering public health insurance – A public health option will benefit from government subsidies and thus outcompete private options, reducing their pricing power. The lowest income earners will be enrolled in the program automatically, rapidly boosting its size (Chart 17). Enabling Medicare to negotiate drug prices – Medicare’s drug spending is equivalent to almost 45% of Big Pharma’s total sales. Enabling this government program to bargain with companies over prices will push down prices substantially. However, the sector’s performance is not really tied to election dynamics because President Trump is also pledging to cap drug prices – it is an effect of populism (Chart 18). Doubling the federal minimum wage – The wage will rise from $7.25 to $15 per hour, hitting low margin franchises and small businesses alike. Chart 17Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Chart 18Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Eliminating carbon emissions from power generation by 2035 – Countries are already rapidly shifting from coal to natural gas, but the Biden agenda would attempt to move rapidly away from fossil fuels completely (Chart 19). If legislation passes it will revolutionize the energy sector. Prohibiting “right to work” laws – This is only one example of a sweeping pro-labor agenda that would involve an extensive regulatory push and possibly new laws. New laws would prevent states from passing “right to work” laws that give workers more freedoms to eschew labor unions. The removal of the filibuster makes this possible. Moreover Biden will be aggressive in using executive orders to implement a pro-labor agenda, going further than Bill Clinton or Barack Obama attempted to do in recognition of the party’s shift to the left of the political spectrum. Chart 19Blue Sweep Would Bring Climate Policy Onslaught Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Subsidizing college tuition and low-income housing. US housing subsidies currently make up 25% of domestic private investment in housing and Biden’s government would roll out a significant expansion of these programs. Granting Washington, DC statehood – This is unlikely to happen as two-thirds of Americans are against it. But without the filibuster, Democrats could conceivably railroad it through. Trump’s Agenda Trump’s signature is tariffs – and globally exposed stocks know it. If Trump wins, his domestic legislative agenda will be stymied, other than laws directly aimed at fighting the pandemic and reviving the economy. As mentioned, Trump is unlikely to pass a law building a wall on the southern border. It is conceivable that Trump could pass a comprehensive immigration reform bill with House Democrats, but that is not a priority on the platform and Trump would have to pivot toward compromise. That would depend on Democrats winning the Senate or forcing him to negotiate with the House. Hence a Trump second term will mostly focus on foreign and trade policy. The Republican platform is aggressive on economic decoupling from China, which is ranked third behind tax cuts and pandemic stockpiles.6 Trump, vindicated on protectionism, would likely go after other trade surplus nations. The Chinese could offer some concessions, producing a Phase Two deal early in his second term to avoid sweeping tariffs and encourage him to wage trade war against Europe (Chart 20). Chart 20Trump = Global Trade War Trump = Global Trade War Trump = Global Trade War Trump’s foreign policy would consist of reducing US commitments abroad. Withdrawing from Afghanistan and other scattered conflicts is hardly a game changer. Shifting some forces back from Germany and especially South Korea is far more consequential. It will create power vacuums. But the US is not likely to abandon the allies wholesale. Chart 21Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Trump has moderated his positions on NATO and other defense priorities over his first term. It is possible he could revert back to his original preferences in a second term, however, so global power vacuums and geopolitical multipolarity will remain a major source of risk for global investors. He will probably also succeed in maintaining large defense spending, despite a Democratic House, given the reality of great power struggle with China and Russia. Geopolitical multipolarity means that defense stocks will continue to enjoy a tailwind from demand both at home and abroad (Chart 21). Investment Takeaways Energy sector struggles most under Democrats. Biden and Trump are both offering reflationary agendas. Where the two agendas diverge most notably, the impacts are largely market-negative – Trump via tariffs, Biden via taxes. The current signals from the market suggest that growth stocks benefit more from a Democratic clean sweep than value stocks (bottom panel, Chart 22). However, the general collapse in value stocks versus growth suggests that there is not much more downside even if the Democrats win (top panel, Chart 22), especially if the 10-year yield rises, as we have been writing in recent research: a selloff in the bond market is the last QE5 puzzle-piece to fall into place. Fed policy, fiscal largess, and the dollar’s decline will support a global cyclical recovery and downtrodden value stocks regardless of the president. The difference is that Biden would slow their relative recovery by piling regulatory burdens on energy as well as health care, which in the US context are a value play. As a reminder, and contrary to popular belief, health care stocks are the largest constituent of the S&P value index with a market cap weight of 21%.7 Trump’s populist “growth at any cost” and deregulatory agenda would persist in a second term and clearly favor value. Yet, if his trade wars get out of hand, they would also weigh on the recovery of these stocks. The difference is that tech stocks are not priced for a Phase Two trade war. If Trump wins it will be a rude awakening. Not to mention that Trump and populist Republicans will seek to target the tech sector for what is increasingly flagrant favoritism in political and cultural debates. Democrats are much more clearly aligned with tech. While they have ambitions of reining in the tech giants as part of the progressive drive against corporate power writ large, Joe Biden will struggle to take on Big O&G, Big Pharma, Big Insurance, and Big Tech at the same time in a single four-year term. The logical conclusion is that he will spare Silicon Valley, which maintained a powerful alliance with the Obama administration. He cannot afford to betray his progressive base when it comes to climate policy, so the Obama alliance with domestic O&G producers will suffer. Tech will face regulatory risks but they will not be existential. Chart 22Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks The fact that the final version of the Democratic Party platform did not contain a section on removing federal subsidies for fossil fuels is merely rhetorical.8 The one clear market reaction from this election cycle is the energy sector’s abhorrence of Democratic policies (Chart 23). The difference is that energy is priced for it whereas tech is priced for perfection. Chart 23Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     In this report we work from the latest policy platforms available. See “Trump Campaign Announces President Trump’s 2nd Term Agenda: Fighting For You!” Trump Campaign, donaldjtrump.com  ; and the draft “2020 Democratic Party Platform” Democratic National Committee, demconvention.com. 2     Bill Barrow, “Biden Says he’d shut down economy if scientists recommended,” Associated Press, August 23, 2020, abcnews.go.com. 3    See Seth Hanlon and Christian E. Weller, “Trump’s Plan To Defund Social Security,” Center for American Progress, August 12, 2020, americanprogress.org; “The 2020 Annual Report Of The Board Of Trustrees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds,” Social Security Administration, April 22, 2020, ssa.gov. 4    Erica York, “Details And Analysis Of The CREATE JOBS Act,” Tax Foundation, July 30, 2020, taxfoundation.org. 5    See “The Biden Plan For A Clean Energy Revolution And Environmental Justice,” Biden Campaign, joebiden.com. 6    A Democratic Congress could take back the constitutional power over commerce that it delegated to the president back in the 1960s-70s, limiting Trump’s ability to wage trade war. If Republicans hold the Senate, they still might restrain Trump’s protectionism, as they did with his threatened Mexico tariffs in early 2019, but they would not do so until he has already taken a major disruptive action.    7     See “S&P 500 Value,” S&P Dow Jones Indices, spglobal.com. 8    Andrew Prokop, “The Democratic Platform, Explained,” Vox, August 18, 2020, vox.com.  

Highlights ‘Value’ sector profits are in terminal decline. Bank profits are in terminal decline, because private sector credit is now ‘maxed out’, and the intermediation between borrowers and savers can be done more cost-effectively by the blockchain. Oil and gas profits are in terminal decline, because we now rely less on the energy stored in ‘chemical bonds’ of portable fossil fuels, and rely more on the energy of ‘moving electrons’ generated from unportable alternative energy sources. Basic resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources. As such, structurally overweighting the value-heavy European market versus the growth-heavy US market is a ‘widow maker’ trade. The caveat is that a vicious snapback out of growth into value is possible when a universally accepted treatment for Covid-19 is found. Or if bond yields spike. This would create a burst of outperformance from Europe, but any such snapback would be a brief interruption to the mega downtrend. Fractal trade: Long RUB/CZK. Feature Chart of the WeekValue' Has Underperformed For 12 Years... But The Mega Downtrend Isn't Over Value' Has Underperformed For 12 Years... But The Mega Downtrend Isn't Over Value' Has Underperformed For 12 Years... But The Mega Downtrend Isn't Over I have just returned from a summer holiday, on which I took a clean break from the financial markets. A clean break that is highly recommended for anybody who looks at the markets day in, day out. Nevertheless, I made two market-relevant observations. First, that having to wear a face mask on an aeroplane was an unpleasant experience. Tolerable for a short-haul flight lasting a couple of hours, but something that would be unbearable for the duration of a long-haul flight. Second, that even the most popular bars and restaurants in the most popular places were operating at half capacity. They were fully booked, yet the requirements of physical distancing at the bar, and between tables, meant that their operating capacity and revenues had collapsed. Worse, the owners feared a further hit in the winter when eating and drinking in their outdoors spaces became impossible. The use of face masks and physical distancing cripples any economic activity that requires you to have your (uncovered) mouth and nose in proximity to others. These first-hand experiences simply confirm the message in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs.1 The use of face masks and physical distancing cripples any economic activity that requires you to have your (uncovered) mouth and nose in proximity to others – like flying, or drinking and eating out. Hence, if governments remove the financial incentives for employers to retain workers while the pandemic is still rampant, expect structural unemployment to rise sharply. In which case, expect bond yields to remain ultra-low, and where possible, go even lower. And expect ‘growth’ sectors to continue outperforming ‘value’ sectors. Explaining Recent Market Action Returning to the financial markets after a break, several things stood out. Apple has become America’s first $2 trillion company, while HSBC’s share price is within a whisker of its 2008 crisis low. This vignette encapsulates that growth sectors – broadly defined as tech and healthcare – have been roaring ahead, while value sectors – broadly defined as banks, oil and gas, and basic resources – have been struggling. Hence, the growth-heavy S&P500 has reached a new all-time high, while the value-heavy FTSE100 and other European indexes are still deeply in the red for 2020 and have recently drifted lower (Chart I-2). The combined effect is that the strong recovery in global stocks has taken a breather. Chart I-2US Market At All-Time High, But European Markets Still Deeply In The Red US Market At All-Time High, But European Markets Still Deeply In The Red US Market At All-Time High, But European Markets Still Deeply In The Red In turn, the breather in the stock market explains the recent support to the dollar. Significantly, the 2020 evolution of the dollar is a perfect mirror-image of the stock market. Nothing more, nothing less. If the stock market gives back some of its gains, expect the countertrend strengthening in the dollar to continue (Chart I-3). Chart I-3The Dollar Is A Mirror-Image Of The Stock Market The Dollar Is A Mirror-Image Of The Stock Market The Dollar Is A Mirror-Image Of The Stock Market Yet the best performing major asset-class in 2020 is not growth equities, nor is it gold. Instead, it is the US 30-year T-bond, which has returned a spectacular 32 percent (Chart I-4). Chart I-4The Best Performing Major Asset-Class Is The 30-Year T-Bond The Best Performing Major Asset-Class Is The 30-Year T-Bond The Best Performing Major Asset-Class Is The 30-Year T-Bond Suddenly, everything becomes crystal clear. If the ultra-long bond has surged, then other ultra-long duration investments must also surge. Within equities, this means that growth sectors, whose profits are skewed to the very distant future, must receive a huge boost to their valuations. Whereas value sectors whose profits are not growing will receive a smaller (or no) valuation boost. In fact, the value sectors have a much bigger structural problem. Not only are their profits not growing. Their profits are in terminal decline. Since 2008, Overweighting Value Has Been A ‘Widow Maker’ In the 34 years through 1975-2008, value trebled relative to growth.2 Albeit, with the occasional vicious countertrend move, such as the dot com bubble. But through 2009-2020, the tables turned. For the past 12 years, value has structurally underperformed growth and given back around half of its 1975-2008 outperformance (Chart of the Week). This means that for the past 12 years ‘proxy’ value versus growth positions have also structurally underperformed. The best example of such a proxy position is overweighting the value-heavy European market or Emerging Markets versus the growth-heavy US market. Since 2008, underweighting the US market has been a ‘widow maker’ trade. A widow maker trade is when you are on the wrong side of a megatrend. A widow maker trade is when you are on the wrong side of a megatrend. It is a widow maker because it can kill your career, or your finances, or both. The big danger is that a widow maker trade can last for decades. As the uptrend in value versus growth lasted more than three decades, there is no reason to suppose that the downtrend cannot also last a very long time. What drove value’s outperformance for 34 years, and what is driving its underperformance for the past 12 years? The simple answer is the structural trend in profits. Until 2008, the profits of banks, oil and gas, and basic resources kept up with, or even beat, the profits of technology and healthcare. This, combined with the higher yield on these value sectors, resulted in the multi-decade 200 percent outperformance of value versus growth. But since 2008, while the profits of technology and healthcare have continued their strong uptrends, the profits of banks, oil and gas, and basic resources have entered major structural downtrends. It is our high conviction view that these declines are terminal, and the reasons are nothing to do with the pandemic (Chart I-5). Chart I-5Value Sector Profits Are In A Major Structural Downtrend Value Sector Profits Are In A Major Structural Downtrend Value Sector Profits Are In A Major Structural Downtrend Sector Profit Outlooks In One Sentence Each When a sector’s profits flip from a multi-decade uptrend to a multi-decade downtrend, it is almost unheard of for them to reflip into a new uptrend. Essentially, the sector has entered a terminal decline. As strong believers in brevity, we can summarise the reason for the terminal declines in one sentence per sector, as follows: When a sector’s profits flip from a multi-decade uptrend to a multi-decade downtrend, it is almost unheard of for them to reflip into a new uptrend. Bank profits are in terminal decline, because private sector credit is now ‘maxed out’, and the intermediation between borrowers and savers can be done more cost-effectively by the blockchain (Chart I-6). Chart I-6Bank Profits In Terminal Decline Bank Profits In Terminal Decline Bank Profits In Terminal Decline Oil and gas profits are in terminal decline, because we now rely less on the energy stored in ‘chemical bonds’ of portable fossil fuels, and rely more on the energy of ‘moving electrons’ generated from unportable alternative energy sources (Chart I-7). Chart I-7Oil And Gas Profits In Terminal Decline Oil And Gas Profits In Terminal Decline Oil And Gas Profits In Terminal Decline Basic resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources (Chart I-8). Chart I-8Basic Resources Profits In Terminal Decline Basic Resources Profits In Terminal Decline Basic Resources Profits In Terminal Decline Conversely: Technology profits can grow, because we now rely more on information, ideas, and advice, and over half of the world’s population is still not connected to the internet (Chart I-9). Chart I-9Technology Profits Continue To Grow Technology Profits Continue To Grow Technology Profits Continue To Grow Healthcare profits can grow, because as economies (and people) mature, they spend a much greater proportion of their income on healthcare to improve the quality and quantity of life (Chart I-10). Chart I-10Healthcare Profits Continue To Grow Healthcare Profits Continue To Grow Healthcare Profits Continue To Grow Nevertheless, a vicious snapback out of growth into value is possible. Indeed, it is to be expected when a universally accepted treatment for Covid-19 is found. Or if bond yields spike. But any such snapback, even if vicious, will be a brief countertrend rally in a terminal decline. This is because the megatrends driving down value sector profits were already in place long before the pandemic hit. The pandemic just gave the megatrends an extra nudge. This is our high conviction view. Fractal Trading System* This week’s recommended trade is long RUB/CZK, with the profit target and symmetrical stop-loss set at 5 percent. In other trades, the explosive rallies in precious metals reached exhaustion as anticipated by their fragile fractal structures. This has taken our short gold versus lead position into profit. However, short silver was stopped out before its rally eventually ended. The rolling 1 year win ratio now stands at 60 percent. Chart I-11RUB/CZK RUB/CZK RUB/CZK 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 Please see the European Investment Strategy Weekly Report "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs", dated July 30, 2020 available at eis.bcaresearch.com. 2 In total return terms. 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Historically, soft-budget constraints have typically been followed by periods of poor equity market performance. Soft-budget constraints could produce two distinct economic scenarios: malinvestment or inflation. Both are negative for equity investors. Odds are that the US will continue to pursue easy money policies, sowing the seeds of US equity underperformance in the years ahead. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints, which will weigh on their growth in the near term. However, forced restructuring could boost efficiency and productivity leading to their equity and currency outperformance in the coming years. Unlike other developing economies, China is not currently facing hard-budget constraints. However, the structural overhang from the past 10 years of soft-budget constraints is lingering on and in some cases is increasing. The Thesis The consensus in the investment industry is that cheap money and ample stimulus are good for share prices. We do not disagree with this thesis when it is applied to the near and medium-term equity strategy. However, excessive stimulus and easy money policies — we refer to these as soft-budget constraints — bode ill for share prices in the long run. The investment relevance of this thesis is as follows. Since March, the US has implemented the largest fiscal and central bank stimulus in the world and will likely continue doing so in the coming years (Chart I-1). Such soft-budget constraints will likely support the US economy for now. Nevertheless, they will also sow seeds of future US equity underperformance and currency depreciation. Conversely, many emerging economies (excluding China) have failed to provide sufficient fiscal and credit support to their economies (Chart I-2). The resulting hard-budget constraints will foreshadow their economic underperformance vis-à-vis the US in the coming months. Chart I-1Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Chart I-2EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints   That said, hard-budget constraints will force companies in these EM economies into deleveraging, restructuring and improving efficiency. Ultimately, such hard-budget constraints will benefit EM shareholders in the long run. This thesis has been a key rationale behind our decision to close the short EM / long S&P 500 strategy on July 30, and to turn negative on the US dollar on July 9. In the months ahead, we will be looking for an opportunity to upgrade EM equities to overweight versus the S&P500. BOX 1 Gauging Budget Constraints In our opinion, the best way to gauge budget constraints for the real economy is by monitoring changes in the money supply. This is due to the following reasons: First, net changes in the money supply account for all net loan origination. Second, the money supply also reflects the monetization of public and private debt by the central bank and commercial banks. When a central bank and commercial banks acquire a security from or lend to a non-bank entity, they create new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not change the stock of money supply. We have deliberated on these topics at length in past reports. Securities transactions among non-banks do not create new or destroy existing deposits, i.e., they have no impact on the money supply. Rather, these constitute an exchange of securities and existing deposits between sellers and buyers. Provided these types of transactions do not expand the money supply, they do not, according to our framework, alter budget constraints. Finally, the broad money supply, not central bank assets, is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Commercial banks’ excess reserves at the central bank – a large item on the central bank balance sheet - do not constitute a part of the broad money supply. Empirical Evidence The following are examples of soft-budget constraints that were followed by periods of weakening productivity growth, diminishing return on capital and poor equity market performance: 1. China’s soft budget constraints in 2009-10 Due to the post-Lehman crisis stimulus, the change in broad money exploded above 40% of GDP (Chart I-3, top panel). The economy boomed from early 2009 until early 2011 as cheap and abundant money super-charged investment and consumption. Chart I-3China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance However, Chinese share prices — the MSCI China Investable equity index excluding technology, media and telecom (TMT)  — peaked in H1 2011 in absolute terms (Chart I-3, second panel). Relative to the global equity index excluding TMT, the Chinese investable stocks index began underperforming in late 2010 (Chart I-3, third panel). The basis for this equity underperformance was falling return on assets for non-financial companies due to capital misallocation, breeding inefficiencies and diminishing productivity gains (Chart I-3, bottom two panels). In China, the excessive stimulus of 2009 and 2010 and ensuing recurring rounds of soft-budget constraints put a floor under the economy but have destroyed shareholder value. 2. Money overflow in EM ex-China in 2009-10. China’s boom in 2009-10 produced a bonanza for other emerging economies. Not only Chinese imports from developing economies boosted the latter’s balance of payments and income but also international investors rushed into EM equity and fixed income. EM companies and banks took advantage of easy financing and their international borrowing skyrocketed. Finally, EM policy makers stimulated and domestic bank credit boomed. This period of soft-budget constraints led to complacency, lower productivity, falling return on capital and/or inflation in the following years (Chart I-4). Their financial markets performance in the 10 years that followed the soft-budget constraints in 2009-10 has been dismal. The share price index of EM ex-China, Korea and Taiwan as well as the total return on their currencies (including the carry) versus the US dollar have been in a bear market (Chart I-4, bottom two panels). 3. The credit and equity bubbles in Japan, Korea and Taiwan of the late 1980s Money and credit bubbles proliferated in Japan, Korea and Taiwan in the late 1980s (Chart I-5, Chart I-6 and Chart I-7).  Chart I-4EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market Chart I-5Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-6Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-7Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth   Their productivity growth rolled over in the late 1980s amid easy money policies. Share prices deflated in Japan, Korea and Taiwan in the 1990s (please refer to the middle and bottom panels of Charts I-5, I-6 and I-7). Chart I-8ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise 4. The boom-bust cycle in emerging Asia ex-China in the 1990s Soft-budget constraints prevailed in many emerging Asian economies in the first half of the 1990s. Foreign money inflows and domestic bank credit produced an economic boom. The consequences of such soft-budget constraints were debt-financed malinvestment, falling return on assets and massive current account deficits (Chart I-8). All of these culminated in epic currency and banking crises. 5. The credit bubbles in the US and Europe leading to the 2008 crash Lax credit standards propelled credit and property booms in the US and Southern Europe in the period of 2002-2007. Broad money ballooned in the euro area and swelled in the US (please refer to Chart I-1 on page 2). These property bubbles unraveled in 2007-08. These are well known, and we will not delve into the details. Soft-Budget Constraints Lead To Malinvestment Or Inflation Soft-budget constraints could produce two distinctive economic scenarios – malinvestment or inflation. Both are negative for equity investors. The malinvestment scenario occurs when easy money propels undisciplined capital spending. Easy and abundant money boosts medium-term growth and, thereby, creates the illusion of an economic miracle. The latter renders companies, creditors, investors and government officials complacent. Creditors lend a lot and do so based on optimistic assumptions while companies expand hastily and invest carelessly. The result is capital misallocation, i.e., companies pour money into projects that do not ultimately produce sufficient cash flow. Equity investors project high growth expectations into the future and bid up share prices. Government officials preside over an unsustainable growth trajectory overlooking lurking systemic risks and deteriorating economic fundamentals. Easy money and unlimited financing typically bode ill for efficiency and productivity— this is simply due to human nature. Companies neglect efficiency considerations and, as a result, productivity stagnates. Consequently, cost overruns and unprofitable investments suffocate corporate profits. Declining corporate earnings at a time of expanded capital base culminate in a collapse of return on capital. This is the crucial reason why share prices drop. As profits and return on capital decline, companies retrench by cutting costs and halting investment spending. Defaults mushroom, leading creditors to cut new financing. The inflation scenario transpires when easy money boosts consumption more than investment. Easy money and unlimited financing lift household income and consumption. This can arise from a large fiscal stimulus or private sector's borrowing and spending. On the one hand, robust household income growth inevitably leads to higher wage growth expectations. On the other hand, limited investment brings about productivity stagnation. Mounting wages and languishing productivity growth lead to rising unit labor costs and, ultimately, result in a corporate profit margin squeeze. Faced with corporate profit margin shrinkage, companies either raise prices, i.e., pass through higher costs, or retrench by shedding labor and shrinking capital spending even further. The latter produces a widespread economic downturn, and stifles business profits and share prices. A symptom of higher inflation is a wider current account deficit. With an economy’s productive capacity lagging behind demand, the gap between the two can be filled in by imports. In addition, escalating domestic costs make a country less competitive, which inhibits exports and bloats imports. When a central bank is unwilling to tighten monetary policy meaningfully amid high and rising inflation and/or a widening current account deficit, it falls behind the inflation curve. This constitutes a very bearish backdrop for the exchange rate. Currency depreciation erodes the country’s equity returns in common currency terms versus other bourses. Can an economy with soft-budget constraints, i.e., booming money growth, avoid both malinvestment and inflation? Yes, it can if it is able to boost productivity growth so that it avoids systemic capital misallocation (i.e., investments produce reasonable returns to pay off to creditors and shareholders) and escapes higher inflation by expanding output faster to meet growing demand. However, achieving higher productivity growth amid soft-budget constraints is easier said than done. Bottom Line: The scenario of malinvestment has been playing out in China since 2009. Capital misallocation also occurred in the US and parts of Europe during the 2002-2007 credit boom, and took place in Japan, Korea and Taiwan in the late 1980s. Malinvestment, with some elements of inflation, occurred in emerging Asian countries prior the 1997-98 crises as well as in many EM economies like India, Indonesia and Brazil in 2009-2012. Investment Implications It is fair to say that the unprecedented economic downturn in the US warranted an exceptionally large stimulus. The question for the next several months and years is whether US authorities will: overstay easy policies and make soft-budget constraints a permanent feature of the US economy, or tighten policy earlier than warranted, or navigate policy perfectly so that the economy is neither too hot nor too cold. Our sense is that US authorities will overstay their easy money policies. If the US continues to pursue macro policies in the form of soft-budget constraints, will the nation experience malinvestment or inflation? Our sense is that the US will likely experience asset bubbles and inflation. As the Federal Reserve stays behind the inflation curve in the coming years, the US dollar will be in a multi-year downtrend. Hence, the strategy should be selling the greenback into rebounds. We switched our short positions in select EM currencies— such as BRL, CLP, ZAR, TRY, KRW, IDR and PHP —away from the US dollar to an equal-weighted basket of the euro, CHF and JPY on July 9. For now, EM currencies will lag DM currencies. US equity outperformance versus the rest of the world is in the late innings (Chart I-9). The pillars of US equity underperformance in common currency terms will be excessive US equity valuations, a potential new era of US return on capital underperforming the rest of the world and greenback depreciation. Chart I-9US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages The top panel of Chart I-10 illustrates that the difference between US investors owning international stocks and non-US investors holdings of US equities is at a record low. This reveals that both US and foreign investors currently "over-own" US stocks versus non-US equities. Perfect timing of a structural trend reversal is impossible, but we believe US equity outperformance will discontinue before year-end. That was the rationale behind terminating our short EM / long S&P 500 strategy and upgrading EM equity allocation from underweight to neutral. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints which will weigh on their economic performance in the near term. This is why we are not rushing to upgrade EM stocks and currencies to overweight. However, the lack of cheap money will force these EM countries and their companies to do the right things: deleverage households and companies, clean up and recapitalize their banking systems and undertake corporate restructuring. Ultimately, hard-budget constraints will likely sow the seeds of high productivity and, with it, equity and currency outperformance in the years to come. China is a tricky case. On a positive note, it has not stimulated as much during the pandemic as it did in 2009. Besides, policymakers are now aware of the ills that come with soft-budget constraints and have been working hard to address these. Critically, the Chinese population, businesses and the authorities are all united in the nation’s confrontation with the US. Complacency in this context is not a major risk and the focus on efficiency and productivity will be razor sharp. On the negative side, the credit, money and property bubbles that had not been dealt with before the pandemic are now increasing with the stimulus. Continued malinvestment and falling return on capital in China’s old economy sectors is signified by the very poor performance of China’s cyclical “old economy” stocks (Chart I-11, top panel). In turn, bank share prices are making new cyclical lows underscoring their worsening structural outlook (Chart I-11, bottom panel). Chart I-10Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Chart I-11Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises   Weighing the pros and cons, we infer that the cyclical recovery in China has further to run. This will support China’s growth and equity outperformance for now. That is why we continue to recommend overweighting China within an EM equity portfolio. However, as the credit and fiscal impulses fade starting in H1 next year, structural malaises will resurface posing risks to China’s equity outperformance.  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, I will be on vacation next week. Instead of our regular report, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will explore the risks posed to commercial real estate and the banking system from work-from-home policies and the potential for urban flight towards less populated and more affordable areas. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights The Nasdaq 100 index is up 31% since the start of the year. The “Awesome 8” stocks (Amazon, Apple, Facebook, Google, Microsoft, Netflix, Nvidia, and Tesla) have gained a staggering 59%. Will tech outperformance continue? There are five reasons to think it will not: 1) The dismantling of pandemic lockdown measures, hopefully facilitated by a vaccine later this year, could shift some spending from the online realm back to brick-and-mortar stores; 2) Interest rates are unlikely to fall much further, which will remove one of the tailwinds propelling tech outperformance; 3) Tech valuations are now quite stretched; 4) Many marquee tech companies have become so big that further gains in market share may be difficult to achieve; 5) Regulatory and tax policy changes could negatively impact a number of prominent tech names. A pivot in market leadership from tech to non-tech is likely to foster the outperformance of value over growth and non-US over US stocks. Are The Awesome 8 At Risk Of Becoming The Awful 8? After plunging alongside the rest of the stock market in March, tech stocks have roared back. The tech-heavy Nasdaq 100 is up 31% since the start of the year. The “Awesome 8” stocks (Amazon, Apple, Facebook, Google, Microsoft, Netflix, Nvidia, and Tesla) have gained a staggering 59% on a market cap-weighted basis. Meanwhile, the median US stock has lost 14% this year (Chart 1). Will tech outperformance continue? There are five reasons to think it will not: Reason #1: The dismantling of pandemic lockdown measures could shift some spending from the online realm back to brick-and-mortar stores The pandemic has led to a major reallocation of spending from brick-and-mortar stores to online retailers. Sales at US online stores increased by 25% year-over-year in July versus -1% at physical stores (Chart 2). According to Bank of America, after rising steadily from about 5% in 2009 to 16% in 2019, the US e-commerce penetration rate has jumped to 33%, representing more than ten years of growth in only a few months. Chart 1Awesome 8 Propelling Tech Stocks To New Highs Awesome 8 Propelling Tech Stocks To New Highs Awesome 8 Propelling Tech Stocks To New Highs Chart 2Will The Dismantling Of Lockdown Measures Bring Brick-And-Mortar Retailers Back To Life? Will The Dismantling Of Lockdown Measures Bring Brick-And-Mortar Retailers Back To Life? Will The Dismantling Of Lockdown Measures Bring Brick-And-Mortar Retailers Back To Life?   There is little doubt that we are still in the midst of a secular transition towards e-commerce. However, it is likely that the dismantling of lockdown measures – hopefully facilitated by the release of a vaccine later this year – will bring back some spending to brick-and-mortar stores. This could produce a temporary air pocket in sales for online sellers, a risk that does not seem to be fully discounted (Chart 3). Chart 3Online Retail Spending Could Slow, At Least Temporarily, As Shopping Malls Reopen The Return Of Nasdog The Return Of Nasdog Chart 4The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge Meanwhile, other tech companies that have benefited from the pandemic could face headwinds. Netflix saw its global subscriber count jump 27% in the second quarter relative to a year earlier. If someone did not bother to purchase a Netflix subscription in March or April, how likely is it that they will subscribe for the first time in September? Along the same lines, global PC and server shipments surged to multi-year highs earlier this year as millions of people were forced to work from home (Chart 4). This likely brought demand for computers and peripheral equipment forward, which could produce a spending vacuum over the next few quarters. Reason #2: Interest rates are unlikely to fall much further, which will remove one of the tailwinds propelling tech outperformance Technology companies are used to cutting prices on older models as newer, more innovative versions come to market. In this sense, deflation is built into their business models. Many tech companies also trade on long-term growth prospects, which means that changes in discount rates have a disproportionately greater impact on the present value of their cash flows than for slower growing companies. All this means that tech stocks tend to outperform in environments where inflation and interest rates are falling. Chart 5Higher Bond Yields Will Benefit Financials Higher Bond Yields Will Benefit Financials Higher Bond Yields Will Benefit Financials We do not expect inflation to surge over the next two years. Nevertheless, the deflationary impulse from the pandemic is likely to abate as spare capacity is absorbed and overall demand recovers. Likewise, bond yields are likely to rise modestly over the next 12 months. Higher bond yields will benefit bank shares (Chart 5). Reason #3: Tech valuations have gotten increasingly stretched Based on full-year estimates, the Nasdaq 100 trades at 32-times 2020 earnings and 27-times 2021 earnings. The Awesome 8 stocks are even more pricey, trading at 43-time and 34-times this year’s and next year’s earnings, respectively (Table 1). Table 1Equity Valuations: Tech Versus Non-Tech The Return Of Nasdog The Return Of Nasdog Outside the IT sector, the S&P 500 trades at 26-times 2020 earnings and 20-times 2021 earnings. It should be noted that these numbers overstate how expensive the non-tech part of the S&P 500 index really is because Amazon resides in the consumer discretionary sector while Facebook, Google, and Netflix sit in the communication sector. In fact, only three of the Awesome 8 are in the S&P 500 IT sector (Tesla has yet to be admitted into the S&P 500, despite having a market cap that would now make it the 10th most valuable company in the index, right ahead of P&G).  While the PE ratio on tech stocks is still well below the nosebleed levels reached during the dot-com bubble, other valuation measures are approaching their prior peaks. The S&P 500 IT sector now trades at 6.2-times sales, not far below the peak price-to-sales of 7.8 reached in 2000. Tech stocks trade at 9.6-times book value, the highest level since early 2001, and more than double their peak valuation level in 2007 (Chart 6). Reason #4: Many marquee tech companies have become so big that further gains in market share may be difficult to achieve The Nasdaq’s lofty valuation presumes that earnings will continue to rise at a rapid pace for many years to come. That has certainly been true for the past decade. The Nasdaq 100 enjoyed annualized earnings per share growth of 16% since 2010, 2.5-times the pace of the S&P 500 index and 3.2-times faster than the non-IT constituents of the S&P 500. Indeed, most of the outperformance of tech stocks can be chalked up to their faster earnings growth (Chart 7). Chart 6Tech Stocks: Some Valuation Measures Are Quite Stretched Tech Stocks: Some Valuation Measures Are Quite Stretched Tech Stocks: Some Valuation Measures Are Quite Stretched Chart 7Most Of The Outperformance Of Tech Stocks Can Be Attributed To Faster Earnings Growth Most Of The Outperformance Of Tech Stocks Can Be Attributed To Faster Earnings Growth Most Of The Outperformance Of Tech Stocks Can Be Attributed To Faster Earnings Growth But will such earnings growth continue? That is far from certain. Bottom-up estimates foresee earnings per share among Nasdaq 100 members rising by 20% in 2021. This is actually below the projected earnings growth of 27% for the S&P 500. One sees a similar pattern within S&P 500 sectors: The IT sector is expected to see earnings growth of 15% in 2021 compared with 31% for non-IT sectors (Table 2). Table 2Earnings Growth Projections The Return Of Nasdog The Return Of Nasdog Admittedly, the faster projected earnings growth of non-tech companies in 2021 will constitute a reversal of this year’s pandemic-induced earnings collapse, from which tech was largely insulated. Thus, there is a base effect at work. Nevertheless, if most investors focus mainly on annual growth rates, they could become enamoured with non-tech stocks, at least temporarily. Looking further out, the rapid growth in tech earnings could decelerate as many of today’s marquee tech companies struggle to expand market share. 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. New opportunities for growth will undoubtedly arise, but there is no guarantee that today’s leaders will be able to take advantage of them. History is littered with tech companies that failed to keep up with a changing world: RCA, Kodak, Polaroid, Atari, Commodore, Novell, Digital, Sinclair, Wang, Iomega, Corel, Netscape, Altavista, AOL, Compaq, Sun, Lucent, 3Com, Nokia, and RIM were all major players in their respective industries, only to fade into oblivion. Stock market investors were very lucky that companies such as Microsoft, Cisco, Nvidia, Qualcomm, Oracle, Amazon, and Netflix issued shares to the public at an early stage in their development (Table 3). All seven had market caps below $1 billion when they went public. Such hidden gems are becoming less common: The number of publicly listed companies in the US is still well below what it was two decades ago (Chart 8). The median age of tech companies at the time of their IPO has risen from around 7 years in the 1990s to 11 years in 2019 (Chart 9). Table 3Big Gains From Once Small Companies The Return Of Nasdog The Return Of Nasdog Chart 8The Number Of US Publicly Listed Companies Is Not What It Once Was The Number Of US Publicly Listed Companies Is Not What It Once Was The Number Of US Publicly Listed Companies Is Not What It Once Was   Chart 9Tech Companies Entering The Public Arena Are Now More Mature The Return Of Nasdog The Return Of Nasdog Reason #5: Regulatory and tax policies could negatively impact a number of prominent tech names Historically, the US government has taken a laissez-faire approach towards the tech sector. As an avowedly pro-business party, the Republicans were happy to espouse deregulation and low corporate taxes, while lauding Silicon Valley’s dynamism and global dominance. The Democrats also had a cozy relationship with the tech sector. As Chart 10 shows, political donations from tech company employees are heavily skewed towards Democratic candidates. Chart 10Tech Company Employees Donate Heavily Towards Democrats The Return Of Nasdog The Return Of Nasdog Things may not be as easy for the tech sector going forward, however. Conservatives have accused social media companies of stifling their voices. According to a recent Pew Research study, 53% of conservative Republicans favor increasing government regulation of big tech companies, up from 42% in 2018 (Chart 11). For their part, Democrats have expressed concerns about the growing monopoly power of tech companies and their perceived insouciant attitude towards consumer privacy. Chart 11Conservatives Favor Increased Government Regulation Of Big Tech Companies The Return Of Nasdog The Return Of Nasdog A Biden administration would not be as tough on tech companies as say, an Elizabeth Warren administration. Nevertheless, Biden has said that breaking up big tech companies is "something we should take a really hard look at."1  He has also argued that online platforms should not be granted legal immunity for user-generated content. On the tax side, Biden has vowed to reverse half of Trump’s corporate tax cuts, while introducing a minimum 15% corporate tax. The latter could disproportionately affect a number of prominent tech companies that have taken full advantage of the current tax code to minimize their tax liabilities. Meanwhile, tech companies are increasingly finding themselves in the crossfire between China and the US. While Joe Biden would not be as quick to impose unilateral tariffs on China as Donald Trump, BCA Research’s  geopolitical strategists warn that the rivalry between the two nations will intensify over the coming decade as they reduce their economic interdependency and vie for military advantage in Asia.2 This could have adverse implications for tech firms’ ability to maximize global market share, never mind optimizing global supply chains. Pivot Towards Value And International Stocks Tech stocks are overrepresented in growth indices, while financials dominate value indices (Table 4). Thus, it is not surprising that the relative performance of tech versus financial stocks has closely mirrored the relative performance of growth versus value stocks (Chart 12). If tech stocks shift from being leaders to laggards, value stocks will shift from being laggards to leaders. Table 4Breaking Down Growth And Value By Sector The Return Of Nasdog The Return Of Nasdog Chart 12The Relative Performance Of Tech Stocks Has Closely Mirrored The Relative Performance Of Growth Versus Value The Relative Performance Of Tech Stocks Has Closely Mirrored The Relative Performance Of Growth Versus Value The Relative Performance Of Tech Stocks Has Closely Mirrored The Relative Performance Of Growth Versus Value Chart 13The Valuation Gap Between Value And Growth Is Larger Today Than At The Height Of The Dot-Com Bubble The Valuation Gap Between Value And Growth Is Larger Today Than At The Height Of The Dot-Com Bubble The Valuation Gap Between Value And Growth Is Larger Today Than At The Height Of The Dot-Com Bubble Value stocks usually appear “cheap” in relation to growth stocks, but the valuation gap is much larger today than in the past – larger, in fact, than at the height of the dot-com bubble (Chart 13). Despite their name, growth stocks usually underperform value stocks when global growth is on the upswing (Chart 14). Provided that progress is made towards developing a vaccine, global growth should remain above trend over the next 12 months, giving value stocks a lift. Chart 14Growth Stocks Usually Underperform Value Stocks When Global Growth Is On The Upswing Growth Stocks Usually Underperform Value Stocks When Global Growth Is On The Upswing Growth Stocks Usually Underperform Value Stocks When Global Growth Is On The Upswing Value stocks also generally do better when the US dollar is weakening. Recall that tech stocks did phenomenally well in the late 1990s when the dollar was rising, but faltered during the period of dollar weakness from 2001 to 2008 (Chart 15). As we discussed last week, the dollar is likely to depreciate further in the months ahead. Chart 15Value Stocks Generally Do Better When The US Dollar Is Weakening Value Stocks Generally Do Better When The US Dollar Is Weakening Value Stocks Generally Do Better When The US Dollar Is Weakening   Chart 16Stronger Global Growth And A Weaker US Dollar Tend To Be Good News For Non-US Stocks Stronger Global Growth And A Weaker US Dollar Tend To Be Good News For Non-US Stocks Stronger Global Growth And A Weaker US Dollar Tend To Be Good News For Non-US Stocks Stronger global growth and a weaker US dollar tend be good news for non-US stocks (Chart 16). As US tech stocks enter a holding pattern, stock markets outside the US will assume the upper hand. Investors should reallocate equity capital towards value stocks and overseas stock markets. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Hunter Woodall, “2020 hopeful Biden says he’s open to breaking up Facebook,” The Associated Press, May 13, 2019. 2 Please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War,” dated July 31, 2020. Global Investment Strategy View Matrix The Return Of Nasdog The Return Of Nasdog Current MacroQuant Model Scores The Return Of Nasdog The Return Of Nasdog