Equities

Highlights Lower-income Chinese households are overly indebted, while higher-income groups hold too much cash.  Apart from real estate and cash, ordinary Chinese people have few choices in allocating their assets. Household consumption has not been stimulated to the same degree as during previous cycles. The recently announced “dual circulation” strategy may not be an imminent solution to China’s chronic high debt, high savings issue. However, an acceleration in policy actions of late may be steps in the right direction in encouraging Chinese households to spend more domestically and to invest in domestic companies. Feature The post-COVID 19 recovery in China’s household consumption has lagged behind other economic segments, such as production and exports. Notably, the pace of consumer spending growth started decelerating almost two years before the pandemic struck the country (Chart 1). Chart 1Chinese Consumers Scaled Back Spending Before COVID-19 Chart 2Chinese Households Save Cash, Lots Of It Furthermore, Chinese households have added a total of 8.3 trillion yuan to their bank deposits so far this year, or about 8% of China’s 2019 national output (Chart 2). Outsized cash savings helped to cushion consumers from the pandemic’s economic impact and will support a consumption rebound as China’s economic and service sector activities continue to normalize. However, an acceleration in cash savings and decline in households' propensity to spend would not bode well for a structurally balanced economic growth model. Chinese policymakers recently announced a new “dual circulation” strategy, and fast-tracked several policy actions to facilitate easier access for households to consume luxury goods and participate in the domestic capital markets. The policies will likely have a small, near-term economic impact. But in the long run they can set up a trend which will benefit domestic consumption growth and better utilize the substantial cash holdings among Chinese domiciles. Too Much Saving Or Too Much Debt? While Chinese households have excessive cash savings, they also carry too much debt. Families hold a total of 55 trillion yuan of debt, or 94% of their aggregate disposable income. The debt-to-income ratio is fast approaching that in the US (Chart 3). At the same time, their debt-to-cash ratio, on an aggregate basis, is extremely low relative to other countries (Chart 4). Chart 3Chinese Households Are Almost As Leveraged As The US Ones Chart 4But They Also Hold Way More Cash Than The US Ones Chinese people are net savers, and only about 30% of Chinese families are in debt, which is less than half of the number in the US (Chart 5 and Table 1). This means approximately two-thirds of households have a positive net worth. On the other hand, Chinese consumers who borrow are deeply indebted. China’s median debt-to-income ratio is around 180%, according to recent surveys, with the lowest income group carrying debt loads that are a whopping 12 times their income (Table 2). Chart 5Two Thirds Of Chinese Households May Be Debt Free Table 1Chinese Household Credit Participation Rate Table 2Chinese Household Debt-To-Income Ratio, By Income Groups Bottom Line: Lower-income groups are heavily indebted, while higher-income families have too much cash on hand.  Too Few Investment Choices Chinese households hold a majority of their assets in real estate investments and cash. The former has seen prices skyrocket, crowding out the discretionary spending capability of lower-income families.1 On the other hand, cash and cash equivalents such as CDs, currently earn a meager 2%. The obsession with holding properties has been reinforced by the astonishing pace of money creation in the past 10 years (Chart 6). Despite sky-high prices, real estate has been the main counter-inflation measure in China. According to the 2019 China Household Finance Survey, nearly 60% of Chinese household debt is in home loans, which is about twice the number compared with the US. Furthermore, the share of second-home loans (as a share of all residential housing loans) escalated from less than 30% in 2011 to 65.9% in 2018, greatly exceeding the share of first home loans. Post-pandemic demand for housing has remained strong and household debt is still expanding faster than nominal disposable income growth (Chart 7). Even though lower-income groups have significantly scaled back on mortgages, given that such a large portion of household assets is tied up in real estate means that any deflation in property prices will have a devastating impact on consumer net worth (Table 2 on Page 4). Consequently, discretionary spending by even middle- and high-income households will be curtailed. Chart 6Helicopter Money In China Chart 7Household Credit Still Expands Faster Than Income Growth In addition to the long-standing issue of a lack of social safety net, Chinese families’ high cash holdings are due to a lack of investment alternatives. Even though the country has the world’s second largest equity market by value, only 11% of Chinese residents participate in the stock market, a dismal number compared with a 50% equity market participation rate in the US.2 The low participation rate is not surprising: over a 10-year time span, returns on cash have more or less matched returns on A-share stocks (Chart 8). The extreme volatility in Chinese equities has curbed citizens’ enthusiasm to participate in the market. Chart 8Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Bottom Line: Chinese household profile is characterized by the heavy concentration of cash among higher-income households and the elevated indebtedness of low-income ones stemming from sky-high real estate prices. Is The New “Dual Circulation” Strategy A Solution? Consumer spending in China has been growing rapidly in the past 20 years, at a rate roughly in line with the increase in disposable incomes. Income and consumption growth peaked in 2007 but since then has been dwindling along with falling productivity (Chart 9). Cyclically, the consumption recovery will bring its growth rate back to the pre-COVID 19 level. Demand for real assets and consumer durable goods has been strong after the pandemic (Chart 10). Even the demand for luxury goods has made a comeback.3   Chart 9Chinese Consumption, Income, And Productivity Growth Chart 10Chinese Consumption Is Recovering However, for consumption to sustain an expansion rate similar to the past decade, China’s productivity growth must accelerate and, in turn, boost per capita income growth. Conversely, the country would need to maintain a high rate of credit expansion to generate enough economic growth and inflation to spur strong nominal income growth (Chart 11). Credit expansion can boost nominal growth but it is productivity growth that generates per capita income growth.  Chart 11Household Credit Impulse Has Been Muted Since 2018 The recently announced “dual circulation” strategy and an acceleration in policy actions by the Chinese leadership may suggest a different path than in previous cycles. Policymakers seem to focus on changing and upgrading the composition of China’s existing consumption base rather than boosting consumption growth through monetary stimulus in the household sector. Moreover, they are looking to change the configuration of family savings and investments. Our colleagues at BCA Research's Emerging Markets Strategy have stated that improvements in the turnover of consumers’ bank deposits and cash, if successful, may allow China to slow its overall credit and money growth but still sustain a steady nominal GDP growth rate.4 Details of the new “dual circulation” strategy are sparse, but we think the following developments in the past couple of months are relevant to investors: Bringing home overseas consumption and reducing the service trade deficit: China fast-tracked policies that target duty-free shopping venues, a strategy designed to lure Chinese consumers back to the domestic market. Beijing made unprecedented moves to invigorate Hainan province’s duty-free shopping and issue new licenses to allow companies to operate duty-free shops both online and offline. In the past five years, Chinese residents have spent an average of 250 billion USD annually shopping overseas. Purchases of duty-free products overseas account for a small share of China’s 12.5 trillion yuan retail industry. Nonetheless, repatriating some overseas consumption would allow China to not only narrow its service trade deficit, but also to create more service businesses and jobs internally (Chart 12).  The move signifies that Chinese policymakers are committed to change domestic consumer spending behavior while upgrading the retail industry. However, we remain cautious on retail stocks in the next 6 to 12 months. Retail growth has not yet rebounded to its pre-pandemic level, and the valuations in retail-sector stocks are overly stretched (Chart 13). Chart 12China Has Been Running A Huge Service Trade Deficit Chart 13Retail Sector Valuations Are Elevated   Increasing households’ equity holdings in domestic companies: Direct financing in the form of equities and corporate bonds only accounts for about 15% of total social financing, compared with 65% in bank lending. Chinese corporations rely mostly on bank loans and retained earnings, whereas US companies are heavily dependent on equity financing. The “dual circulation” strategy encourages more direct financing for SMEs, science and technology companies. It also explicitly calls for a greater household participation in the financial markets, which would guide more savings into domestic capital markets. In the past few months, the government has accelerated financial market reforms aimed at providing easier access for corporations and individuals to domestic equity markets. In the first half of this year, 119 companies went public in Shanghai and Shenzhen; these companies raised about 140 billion yuan, which was more than double the amount from a year ago. New individual investor accounts on the Shanghai exchange rose by 30% (year to date) from a year ago. Notably, both the IPO and household participation rates resemble the onset of the boom-bust cycle in 2015. However, this time Chinese regulators have been much more vigilant and restrictive about over-leveraging, acting early and removing some steam from retail investor rush (Chart 14). Chart 14Chinese Authorities Have Less Tolerance For Equity Market Leverage Chart 15Chinese Stocks Still Have Upside Potentials It remains to be seen whether the authorities will be able to boost and sustain consumer confidence in the domestic equity market. The efforts by the Chinese government will either succeed by securing a gradual and healthy secular bull market, or they will fail by triggering another boom-bust cycle in the domestic market. Either way, investors should stay overweight Chinese stocks on at least a 6-month horizon (Chart 15).   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Households in the bottom 40 percentile in China have no discretionary spending capacity. “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 2投保基金公司《2019年度全国股票市场投资者状况调查报告》and Pew Research Center. 3China ‘Revenge Spending’ Offsets Plunge in Luxury Goods Revenue 4Please see Emerging Markets Strategy Special Report "China’s Rebalancing: Will Consumers Rise To The Challenge?" dated August 29, 2019, available at ems.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Equities started the week off with a jolt on the back of a flurry of M&A deal as “Merger Mondays” is making a comeback, but we remain skeptical that the correction is over and caution investors to resist the temptation to bottom fish. While COVID-19-related uncertainty is dissipating, the quickly approaching election will make sure that volatility remains elevated. Importantly, market internals also suggest that there is likely more downside in the near-term. Trying to quantify the drawdown, we turn over to  CBOE’s equity put/call (EPC) ratio. The EPC ratio is nowhere near recent extreme readings. SPX pullbacks since the early-2018 “Volmageddon” have corresponded to significantly higher EPC ratio readings. In the past 10 such iterations, the median EPC ratio has been 0.86, the mean 0.93, with a range of 0.77 to 1.28 (see table on the right). Currently, the EPC ratio is hovering near 0.67 suggesting that downside risks persist (EPC ratio shown inverted, see chart below). Table 1 Bottom Line: Stay patient and refrain from deploying fresh capital in the broad equity market. A better entry point will likely materialize between now and the end of the year.

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

This week we introduced a structurally constructive US equity view with an SPX 7000 target for the year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye can see, underpins this bullish view. Since the late-1920s, EPS have grown by 7.5%/annum on average, effectively doubling every decade. More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10%. The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Bottom Line: Our new structurally bullish view calls for SPX 7000 by the year 2028. For more reasons underpinning this view, please refer to our most recent Weekly Report.

Highlights Stocks face near-term downside risks from further delays in passing a new US fiscal stimulus package, a potentially slower-than-expected rollout of a Covid-19 vaccine, and the unwinding of speculative call option positions in large-cap US tech companies. Nevertheless, we continue to favor equities over bonds over a 12-month horizon. One key reason is that the global equity risk premium – proxied by the difference between the stock market earnings yield and the real government bond yield – remains quite large. Many observers argue that the bond yield component of the equity risk premium is distorted by central bank manipulation. They also contend that low bond yields reflect poor economic prospects and that structurally low borrowing costs could lead to malinvestment down the road. In this report, we push back against these views. We argue that today’s low bond yields do, in fact, provide a reliable estimate of the risk-free component of the discount rate; that the drop in yields over the past year mainly reflects higher private-sector savings and easier monetary policy rather than pessimism about growth and earnings; and that instead of leading to overinvestment, the main effect of falling interest rates, at least so far, has been to inflate the rents earned by companies with monopoly power. All of this means that lower interest rates really do justify higher market valuations. The Correction Is Not Over, But We Are Sticking With Our Bullish 12-Month View On Stocks Chart 1Tech Stocks At Greatest Risk Of A Pullback After recouping some of their losses on Wednesday, stocks stumbled again on Thursday. Since reaching new highs last week, global equities have dropped by 5.3%. US equities have taken the brunt of the beating. They are down 7% from last week’s top, compared to 3% for non-US stocks (Chart 1). The tech-heavy Nasdaq remains 9.4% off its record high. We continue to see near-term downside risks to global stocks, particularly US equities. It has now been six weeks since emergency US federal unemployment benefits lapsed. The US economy is set to rebound at a brisk pace in the third quarter – the Atlanta Fed’s GDPNow model projects that output will grow 30% at an annualized pace – but GDP is rising from a very low base. In the absence of a new fiscal package, US growth could slow sharply in the fourth quarter and beyond, causing more workers to become permanently unemployed. Concern over the safety of the vaccines being developed to fight Covid-19 could also unsettle investors. On Wednesday, AstraZeneca announced that it had temporarily paused the Phase 3 trial of its vaccine co-developed with the University of Oxford after a patient suffered a severe reaction. Such delays are normal in the conduct of vaccine testing, but they do raise memories of the 1976 debacle with the Swine flu vaccine, which caused 450 Americans to come down with Guillain-Barré syndrome, a life-threatening neurological disorder.1 Chart 2Nasdaq Volatility Declined Even As Share Prices Tumbled These worries come on the heels of a six-month rally in tech stocks – one that was dangerously amplified by speculative call option purchases by retail investors. The preference among retail investors for short-dated calls allowed them to gain control of large swathes of shares at relatively little cost. Market makers and other counterparties who sold the calls were forced to buy the underlying stock to hedge their exposure. This created a self-reinforcing feedback loop where rising call option prices generated more purchases of the underlying stock, leading to even higher call prices. Starting last week, the process began to go in reverse. It is noteworthy that Nasdaq implied volatility actually fell on both Monday and Wednesday as tech stocks imploded, a possible sign that nervous investors were liquidating their call positions (Chart 2). It is difficult to know how much further this process has to run, but our guess is that a capitulation point has not yet been reached. This suggests that the correction is not yet over.   TINA’s Siren Song Despite our near-term concerns, we expect global equities to be higher in 12 months’ time. At least one of the nine vaccine candidates currently in Phase 3 trials is likely to produce a viable formula. Policymakers are also liable to heed the will of voters and maintain generous fiscal stimulus measures. All this should allow global growth to pick up. Stocks usually do well when global growth is accelerating (Chart 3). And then there is TINA. TINA — There Is No Alternative — has become a popular adage on Wall Street. As the argument goes, no matter how expensive stocks seem to get, bonds and cash are even less attractive. There is some logic to this view. Today, the dividend yield on the S&P 500 stands at 1.6%. While this dividend yield is well below its historic average of 4.3%, it is still higher than the 0.68% yield on the 10-year Treasury note (Chart 4). Chart 3Stocks Usually Do Well When Global Growth Is Accelerating Chart 4Bond Yields Have Fallen Below Dividend Yields Imagine an investor having to decide whether to place their money in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 9% over the next decade to equal the return on the 10-year note. Assuming that inflation averages 2% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50%. Elevated Equity Risk Premia Granted, stocks are riskier than bonds. However, based on a comparison of dividend yields with bond yields, stocks today are significantly cheaper than usual (Chart 5). Chart 5AStocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 5BStocks Would Need To Fall A Lot For Equities To Underperform Bonds The relative attractiveness of stocks can also be inferred by subtracting the real bond yield from the cyclically-adjusted earnings yield on stocks in order to get an implied equity risk premium (ERP)2 (Chart 6). Outside the US, the ERP is high both because earnings yields are elevated and because real bond yields are depressed. In the US, which accounts for 56% of global stock market capitalization, the earnings yield is below its long-term average. Nevertheless, the US ERP is still quite high because real bond yields reside deep in negative territory. In fact, the US ERP has barely fallen since March because the decline in real yields has largely offset the rise in stock prices (Chart 7). Chart 6Equity Risk Premia Are Elevated Chart 7The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices   Are Bond Yields Fake News? Stock market bears will argue that the ERP is overstated by the abnormally low level of bond yields. Their argument typically centers on three points: Quantitative easing, forward guidance, NIRP and ZIRP have distorted bond yields to such an extent that we can no longer use them as a reliable measure of the risk-free component of the discount rate. Even if one accepts the premise that current bond yields are a valid proxy for the risk-free rate, the fact that yields are so low is hardly a cause for celebration. This is because today’s low yields reflect dismal economic prospects, which justifies a higher-than-normal equity risk premium. Low bond yields are incentivizing all sorts of malinvestment. With time, this will depress the rate of return on capital, leading to lower stock prices. Let’s examine all three arguments in turn. Are Bond Yields Being Manipulated? The term financial repression gets bandied around quite often these days. There is no doubt that central banks would like to keep yields low, but how much higher would yields be in the absence of any unorthodox monetary measures? Our guess is not much higher. The simplest test of whether bond yields are above or below their equilibrium level is to look at whether growth is above or below trend. The recovery following the financial crisis was anemic, suggesting that monetary policy was only modestly accommodative. If anything, one can argue that in much of the world, bond yields would be even lower today were it not for the fact that nominal interest rates cannot go much below zero. Do Low Bond Yields Reflect Bad News? Bond yields can decline for many reasons. Some of these reasons are positive for equity investors, while others are negative. If yields fall on the expectation of weaker economic growth, that is clearly bad for stocks. On the flipside, if yields drop because monetary policy has turned more dovish, that is good for stocks. The impact on equities from other factors influencing bond yields can be ambiguous. For example, consider the case of an increase in private-sector savings. All things equal, higher savings will lead to less spending. A decline in spending is likely to result in lower output and diminished corporate profits. That is bad for stocks. However, if governments absorb the excess private-sector savings by running larger budget deficits, there may end up being no net loss in aggregate demand. In that case, stock prices may not fall. Indeed, one can very easily envision a scenario where an adverse shock to private-sector spending leads to an increase in equity valuations. To see this point, consider a standard dividend discount model. Suppose something happens that leads the private sector to spend less at any given interest rate. Let us also suppose that the central bank reacts to this shock by cutting interest rates all the way down to zero, at which point governments, taking advantage of cheaper borrowing costs, step in and increase fiscal stimulus. The upshot could be a lower interest rate but at the same level of aggregate spending (See Box 1 for a formal economic discussion of how this process works). If aggregate demand – and by extension, corporate earnings and dividends — drop temporarily, while interest rates fall permanently (or at least semi-permanently), the present value of cash flows will rise. As far-fetched as this scenario may seem, something along these lines appears to have happened over the past six months. Chart 8 shows that analysts expect global profits to contract by 19% in 2020, but then rebound by 29% in 2021 and rise a further 16% the following year, leaving 2022 profits 21% above 2019 levels. Like everywhere else, analysts expect US profits to return to their long-term trend over the next few years. Meanwhile, the 30-year TIPS yield – a proxy for the risk-free component of the discount rate – has fallen by 94 basis points since the start of the year. Even if one assumes, contrary to the optimistic forecasts of analysts, that the level of US EPS does not return to its pre-pandemic trend until 2030, this would still leave the fair value of the S&P 500 17.5% higher than it was at the start of the year (Chart 9). Chart 8Analysts Expect Global Profits To Contract This Year Before Rebounding Chart 9The Present Value Of Earnings: A Scenario Analysis Will Low Interest Rates Lead To Malinvestment? A drop in interest rates may seem like a free lunch for shareholders: It increases the present value of future cash flows without reducing the cash flows themselves. In fact, one could argue that lower rates actually increase future cash flows by shrinking net interest payments on outstanding debt. That might be all fine and dandy, but what about the effect of low interest rates on future investment decisions? To the extent that lower rates increase the market value of a firm’s capital stock relative to its replacement cost – the so-called Tobin’s Q ratio – lower rates could spur more investment. Higher investment, in turn, could drive down the rate of return on capital, leading to lower profits (Box 2 illustrates this point with a simple example featuring a lemonade stand). While there is some truth to this logic, it is less compelling than it once was. This is because much of the capital stock of listed companies today takes the form of intangible capital – which is often difficult to reproduce – rather than physical capital. Such intangible capital may include patents and trademarks as well as monopoly power. In particular, internet companies have gained significant monopoly power from network effects: The more people use their service, the more valuable their service becomes. This is a key reason why falling interest rates have helped the tech giants more than other companies. The Path Ahead The section above argued that today’s low bond yields do, in fact, provide a reliable estimate of the risk-free component of the discount rate; that the drop in yields over the past year mainly reflects higher private-sector savings and easier monetary policy rather than pessimism about growth and earnings; and that instead of leading to overinvestment, the main effect of falling interest rates, at least so far, has been to inflate the rents earned by companies with monopoly power. All this means that lower interest rates really do justify higher market valuations. Looking out, while bond yields are unlikely to rise significantly over the next two years in the absence of any meaningful inflationary pressures, yields are unlikely to fall either given how low they already are. This is not necessarily bad news for stocks. As mentioned above, the equity risk premium is quite high, which means that stocks can rise even if bond yields do edge somewhat higher. The more interesting action is likely to occur beneath the broad indices. If bond yields stabilize, this will remove a major headwind to bank shares (Chart 10). On the flipside, the reopening of economies will benefit companies that were crushed by lockdown measures. Money will shift from “pandemic plays” to “recovery plays.” Chart 10Stabilization In Bond Yields Would Remove A Major Headwind To Bank Shares Chart 11US Stocks Are More Expensive   As we predicted three weeks ago in a report titled “The Return Of Nasdog,” tech and health care stocks will go from leaders to laggards. The US has a higher concentration of tech and health care stocks than most other regions. US stocks are also quite expensive based on standard valuation measures, including the Tobin's Q ratio discussed above (Chart 11). The bottom line is that investors should remain overweight global equities over a 12-month horizon, while pivoting towards value stocks and non-US markets.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Box 2Fancy Some Lemonade? An Example Of Tobin’s Q Footnotes 1 Rick Perlstein, “Gerald Ford Rushed Out a Vaccine. It Was a Fiasco,” The New York Times, September 2, 2020. 2 It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019.   Global Investment Strategy View Matrix Current MacroQuant Model Scores

In July we first highlighted the monstrous contribution of the top five stocks to the S&P 500’s return and cautioned that such a high concentration of returns in a handful of tech titans was not sustainable. More recently, we warned again about the danger of concentrated returns, and currently the same stocks that were pushing the market higher are the ones pulling it down. In other words the pendulum is swinging the opposite way, as concentration of returns cuts both ways. Table 1 shows MAGAF stocks losses in index points since the September 2nd peak and highlights that they are responsible for 46% of total SPX losses despite having “only” a 25% market cap weight in the index. Bottom Line: A healthy rotation out of overvalued tech titans and into beaten down cyclical stocks is likely getting underway. As a reminder, in the most recent  Weekly Report we went long a basket of bombed out “back to work” stocks at the expense of a “Covid-19 winners” basket. Table 1