Market Capitalization: Large / Small

Your feedback is important to us. Please take our client survey today. Highlights Portfolio Strategy Today we recommend investors shift to a small versus large cap size bias on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Recent Changes Prefer highly-cyclical small caps at the expense of more defensive large caps. Table 1 Vigilantes Gone Missing? Vigilantes Gone Missing? Feature The SPX was rudderless last week as another week of intense fiscal policy drama dominated headline news both in Washington, D.C. and on Wall Street, overshadowing Q3 earnings season. Markets remain hostage to the stimulus tug-of-war and the renewed uncertainty has cast a shadow on the short-term prospects of durable gains in the broad equity market. We continue to recommend investors stay patient and opt to put fresh cash to work after the election-related uncertainty lifts. Odds remain high that the SPX glides lower into November before it resumes its cyclical bull market. Recently, we read Marko Papic’s (Chief Strategist at Clocktower Group) seminal book Geopolitical Alpha and we participated in a vibrant webcast hosted by our sister Geopolitical Strategy service last Wednesday celebrating Marko’s milestone. Marko’s book is a page turner and lived up to our high expectations: he concisely delivered content full of bold out-of-consensus predictions. Pages 92/93 reveal Marko’s most important forecast in our view: “The transition from the Washington to Buenos Aires Consensus will dominate markets over the next decade. This transition is more relevant than the US-China geopolitical rivalry, risks to European integration, and technological change. All assets will be influenced by the deluge of fiscal and monetary policy”. In recent research, we have been writing about the transition to the fiscally irresponsible Buenos Aires Consensus, and COVID-19 has not only made the US government profligate, but also insensitive to rising debt loads (Chart 1). Chart 1Buenos Aires Consensus  Buenos Aires Consensus  Buenos Aires Consensus  However, borrowing from Marko’s framework and applying a material constraint in the form of interest rates is instructive. We turned cyclically bullish on the SPX in mid-March and on March 23 we published the QE shaded chart that we are updating today; from the three asset classes we showcase only the 10-year US Treasury yield has yet to rise to a level consistent with some semblance of economic normality (Chart 2). The Fed has likely slayed all the Bond Vigilantes, but the Fed itself is the mega Vigilante, at the moment in a multi-year hibernation. Pundits use the 1994 example for the massive selloff in the bond market (the one that produced Democratic political adviser James Carville’s great quote: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”). However, they neglect to mention that the Fed doubled the fed funds rate (FFR) from 3% to 6% in a short time span, first igniting and then turbocharging the selloff in the bond market (Chart 3). Chart 2QE Is Always Bullish QE Is Always Bullish QE Is Always Bullish Chart 3Lessons From History Lessons From History Lessons From History This cycle, the Fed is acting as an enabler of the transition to the Buenos Aires Consensus. Thus the interplay between the Fed and the bond market will be critical to monitor in coming quarters and years. More specifically, understanding the Fed’s reaction function to a potential doubling in the 10-year US Treasury yield and jump in the FFR change expectations is essential. The most recent and relevant example was during the GFC, when the Fed held the FFR near zero from December 2008 until December 2015. In this seven-year period, the interplay between the FFR change expectations and the 10-year US Treasury yield reveals that the sensitivity of interest rates to FFR change expectations stood near 2-to-1; i.e. a 50bps increase in the FFR change expectations would push the 10-year yield 100bps higher and vice versa (Chart 4). Chart 4Rates Sensitivity At The Zero-Bound Back Then... Rates Sensitivity At The Zero-Bound Back Then... Rates Sensitivity At The Zero-Bound Back Then... The most important divergence occurred in May 2013, with the now infamous Bernanke taper tantrum speech, following which the bond market sold off violently, but the FFR change expectations stayed relatively calm near the zero line (Chart 4). Year-to-date, the 10-year US Treasury yield’s sensitivity to FFR change expectations has ranged between 1-to-1 and 2-to-1 (Chart 5). Looking ahead post the election, the odds are rising of a mammoth fiscal package, especially if there is a “Blue Sweep” but also potentially in a renewed Trump administration. Under such a backdrop the 10-year US Treasury yield would spike and so will FFR hike expectations. Tack on the real possibility of a vaccine landing some time in 2021 and the economy will likely roar, creating a feedback loop further underpinning long bond yields. The only regulatory mechanism for fiscal prudence comes from the bond market. Put differently, only rising interest rates on an expanding debt pile can concentrate politicians’ minds (Chart 6). Therefore, the Fed’s reaction function will be critical in how they deal with the looming increase in interest rates and FFR hike expectations. Chart 5...And Today ...And Today ...And Today Chart 6Interest Rates Are The Only Constraint               Interest Rates Are The Only Constraint               Interest Rates Are The Only Constraint               In that scenario, will the Fed try to talk the bond market down, utilize some form of yield curve control (YCC), or do nothing? With the YCC option similar to the 1940s as the most likely outcome as we posited in late summer, we expect that inflation will make a comeback and that would aid the Fed as it will accomplish its recent mission to finally generate inflation. It will also aid the government by inflating its way out of a debt trap by reversing the current dire debt-to-GDP arithmetic (please refer to our June 1 Inflation Special Report for more details on US equity sector implications). From an equity market’s perspective, the Fed’s reaction function poses a short-term risk: an unchecked selloff in the bond market will trigger a more pronounced tech sector underperformance period and unlock excellent value in beaten down financials (Chart 7). This week we continue to add more cyclicality to our portfolio and recommend a small versus large cap size bias on the back of rising odds of a “Blue Trifecta” and a massive stimulus package, and in accordance with our reopening of the economy theme we have been recently exploring. Chart 7Rotation Looming Rotation Looming Rotation Looming   It’s A Small World After All We recommend investors implement a small size bias either via the Russell 2000 IWM:US exchange traded fund versus the SPY or via the S&P small cap IJR:US exchange traded fund at the expense of the SPY. These two small cap ETFs offer the most liquidity and each have roughly $40bn AUM. On March 20 in the middle of the pandemic and then on April 28 we monetized handsome gains for our portfolio by closing out our high- conviction and cyclical large cap bias, respectively. In hindsight, we should have flipped and implemented a small cap bias as up until early June, small caps were outshining large caps. Since then, they have retraced almost half the gains and now present an exploitable opportunity (top panel, Chart 8). The bearish small cap story is by now well ingrained. Small caps are plagued by a heavy debt load, have no or little trailing earnings to show for let alone nearly 1 in 3 small caps have no forward EPS and profit margins have collapsed near the zero line (Chart 8). While debt saddled small caps are a tough pill to swallow, the untold story is warranting some attention. First, according to a recent FT article, there is so much sloshing liquidity around that asset managers cannot raise private debt funds fast enough.1 Not only is the fiscal stimulus providing a lifeline to debt burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, top panel, Chart 9). Chart 8All The Bad News Is Priced In All The Bad News Is Priced In All The Bad News Is Priced In Chart 9Catch Up Phase… Catch Up Phase… Catch Up Phase… Second, the sector composition of small versus large caps represents a high-octane version of the SPX cyclicals/defensives portfolio bent that we have been exploring since late-July/early August. Table 2 shows that industrials comprise the largest market cap weight in small cap indexes. Tack on the materials and energy laggards and the deep cyclical (ex-tech) weight increases to 26% or twice the SPX weight. With regard to defensives the small caps have lower exposure compared with the SPX to the tune of 700bps (ex-telecom services). Taken together, the relative cyclicals (ex-tech)/defensives (ex-telecom) gap is 20 percentage points, confirming the small cap universe’s higher beta status. As a result we expect a narrowing of the gap as laggard small caps play catch up (bottom panel, Chart 9). Meanwhile, inflation expectations have recovered smartly from the depths of the COVID-19 accelerated recession and have formed an unmistakable V-shape (top panel, Chart 10). However, the small/large share price ratio has yet to follow suit. In fact, the Commodity Research Bureau’s overall index is also on fire signaling that commodity inflation is making a comeback. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirting around with two-year highs (not shown). Table 2S&P 600/S&P 500 Sector Comparison Table Vigilantes Gone Missing? Vigilantes Gone Missing? If our thesis that the economic recovery will accelerate in the New Year as a vaccine will make possible a full reopening of the economy, then the upshot is that relative share prices will converge higher to rising commodity prices (bottom panel, Chart 10). Chart 10…Looms Large …Looms Large …Looms Large Another way to depict the deep cyclicality of the small cap index is to compare it with the emerging markets (EMs). The small/large ratio is back to where it was at the turn of the century, giving back 15-20 years of outperformance depending on which small cap index one uses (Russell 2000 or S&P 600). Similarly, EMs performance versus the SPX has returned to a depressed level last seen in the aftermath of the dotcom bust and is a carbon copy of the small/large ratio (middle panel, Chart 11). The implication is that small caps go as EMs go and an EM recovery bodes well for a small cap outperformance phase. Circling back to Table 2, the financials sector delta is also significant, with small caps’ exposure relative to their large cap brethren clocking in at over 700bps. Already, the yield curve is steepening and there are high odds of a selloff in the bond market as the economy continues up the reopening path and a vaccine is nearing (bottom panel, Chart 11). Similarly, the VIX has collapsed from north of 80 to below 30 recently confirming that the intense ‘risk off’ phase is over. Nevertheless, there is ample room for the VIX to fall further as it remains stubbornly at an historically elevated print 10 points above the mean. Importantly, the VIX has remained above 20 for over 160 trading days. Were it not for the GFC this would be a record streak (VIX shown inverted, top panel, Chart 11). Finally, the two year drubbing of small caps has worked off some of the overvaluation and our relative Valuation Indicator has returned back to the neutral zone. Importantly, small caps are so unloved and under-owned that our relative Technical Indicator is probing multi-decade lows. Historically, such a depressed relative positioning level has been contrarily positive and served as a launch-pad to significantly higher relative share prices on a cyclical time horizon (Chart 12). Chart 11High Beta ‘Risk On’ Beneficiary High Beta ‘Risk On’ Beneficiary High Beta ‘Risk On’ Beneficiary Chart 12What’s Not To Like? What’s Not To Like? What’s Not To Like? Adding it all up, a small versus large cap outperformance period looms on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Bottom Line: Initiate a long small caps/short large caps trade today with a 9-12 month time horizon via the long IWM:US/short SPY:US exchange trade funds.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.ft.com/content/b7e29f0d-d906-421c-9a0a-910099e6eed9 Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Rotation Rotation Rotation Rotation Rotation Rotation Rotation out of the tech titans is a high probability scenario given that the easy money has already been made as AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization near the peak on September 2. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out. Using a concrete rebalancing example to illustrate such a rotation is instructive.1 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift. Bottom Line: As the economy opens up, it pays to rotate out of fully priced tech titans and into the beaten down deep cyclicals.    Footnotes 1 Our example assumes benchmark allocation in all sectors for illustrative purposes.

Highlights Along with momentum, quality has been the best performing factor over the past 30 years. It has also been less volatile and has exhibited milder drawdowns than other factors. There are multiple traits that are considered as signs of quality. However, profitability explains the lion’s share of the quality premium, though accounting quality and payout dilution also play a role. The reason why quality stocks outperform remains a mystery, though the preference for lottery stocks as well as the failure to account for the persistence of quality are plausible explanations. Both small caps and value stocks have negative tilts to quality. Adjusting for this tilt by buying small-cap quality indices or value indices with quality filters, can help investors exploit these factors more effectively. Feature “Investment must always consider the price as well as the quality of the security” – Benjamin Graham & David Dodd, Security Analysis, Principles and Technique, 1934 Legendary investor Benjamin Graham is one of the most significant figures in the history of finance. His two books, The Intelligent Investor and Security Analysis, stand as foundational pillars in the field of fundamental analysis. Moreover, as the mentor of the most famous investor ever, Warren Buffet, he has influenced a generation of investors into caring deeply about not overpaying for stocks. Thanks to these feats, Graham has come to be known as the “father of value investing”. And yet this moniker, though well-deserved, ignores a substantial portion of his legacy. Graham was not solely concerned with valuations.1 In fact, out of the seven criteria that he used to pick securities, only two of them focused on valuation measures. The rest, focused on metrics like profitability, leverage, and stability. These attributes encompass what is broadly known today as quality. But what exactly is quality? While certain traits have historically been associated with this factor, quality was not seen until more recently as something that you could easily define. Instead, a more holistic approach to quality was preferred.2 It wasn’t until the work of Robert Novy-Marx in the early 2010s, and US investment firm AQR thereafter, that the possibility of measuring quality, as well as systematically exploiting it, became prominent within the factor literature. Since then, quality has become a more popular strategy, with various commercial providers offering quality indices in recent years. However, much remains unknown about this newly discovered factor. Thus, in this report we take a deep dive into quality with the intent of providing some clarity on the following three issues: Definition of quality: What metrics are used to determine if a stock is a “quality” stock? Which of the many quality traits have the best track record? Characteristics of quality: What has been the historical performance of quality? What is its sector exposure? Why does it work? Implementation of quality: How can the quality factor be used in conjunction with other factors to increase returns? In order to answer these questions, we explore the historical performance of the MSCI Quality indices – though we also touch on quality indices by other providers. Moreover, we survey the academic literature around quality, and we propose a couple of ways by which investors can use this factor to exploit the value and small-cap premia more effectively. Definition Of Quality There is no universal agreement on how to measure quality, though there are some general traits that are agreed upon by the academic literature. An often used definition of quality is the “Quality Minus Junk” (QMJ) factor by AQR. In their research, Assness et al. use three traits, each of which is measured by five to six different metrics3 (Table 1). All the metrics are standardized and then averaged to arrive at a single quality measure. This quality measure is then used to build a quality portfolio. Table 1Metrics Used In AQR's Quality Minus Junk Factor (QMJ) Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets However, not all quality indices take so many measures into account. In fact, most commercial providers limit themselves to three or four variables to construct their quality indices. As an example, MSCI determines quality using three criteria: Return on equity, earnings variability, and leverage. All three variables are then winsorized,4 standardized, and then averaged to create a quality score. This quality score determines the weight of each stock within the index. Table 2 expands on the methodology of the quality benchmarks offered by various index providers. Table 2Quality Metrics For Popular Index Providers Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets The lack of a homogenous definition for quality makes performance evaluation of quality problematic. After all, the outperformance of quality could simply be a function of data mining by optimizing for a group of variables that produce excess returns in a backtest. This approach can lead to a large outperformance in-sample, but which might not necessarily replicate when applied in a real-world portfolio.5 To address this issue, some academics have tried to pinpoint which among the many quality traits truly add value in order to build a simpler and more parsimonious factor. In “What is Quality?”, Hsu et al. found that profitability is the most important quality characteristic, having a large and significant multifactor alpha6 (Table 3). Accounting quality and payout dilution have also been relatively reliable sources of excess returns. On the other hand, there is little evidence that most metrics for capital structure, profitability growth, or earnings stability, provide a premium that is not captured by other factors. Table 3Drivers Of The Quality Premium Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets Given the preponderance that profitability has in the overall performance of the quality factor, some academics have suggested that the quality factor should be reduced to profitability.7 However, not everybody agrees with this approach. In fact, other researchers have advocated for including more metrics such as ESG or corporate governance, in an effort to bring back the more holistic approach that Graham practiced.8 Overall, much disagreement about how to measure quality remains, and the subject is still an open debate. Characteristics Of Quality Historical Performance, Composition And Valuation Over the past 30 years, the MSCI Quality Index has, along with momentum, been the best performing factor in the equity markets (Chart 1, top panel). During this time frame, quality stocks have outperformed minimum volatility stocks by 2.6% per year, the global benchmark by 3.5% per year, and value stocks by 4% per year. The performance of quality has also been relatively robust, though the factor has performed better in some countries than others (Chart 1, bottom panel). Quality has performed best in European countries and Canada, while its outperformance has been more muted in Australia and Japan. Historically, quality has been the second most defensive factor after minimum volatility (Chart 2, panels 1 and 2). Moreover, it has exhibited lower volatility, and smaller drawdowns than the overall market. The defensive tilt of quality seems to arise because of the “flight to quality” phenomenon, where investors flock to higher quality assets during periods of markets stress. Interestingly, quality tends to outperform in equity markets and bond markets at the same time (Chart 2, bottom panel). This suggests that quality might be a common risk factor that is captured across asset classes. Chart 1Quality Has Outperformed Most Other Factors Quality Has Outperformed Most Other Factors Quality Has Outperformed Most Other Factors Chart 2Quality Is A Defensive Factor Quality Is A Defensive Factor Quality Is A Defensive Factor Chart 3Quality Overweights Expensive Sectors Quality Overweights Expensive Sectors Quality Overweights Expensive Sectors What about composition? Within the global index, the quality factor currently has a large country bias to defensive markets like the US and Switzerland. This is mostly the result of its overweight to Information Technology, Consumer Staples and Health Care, and a large underweight position in Financials (Chart 3, top panel). This sector positioning also results in quality having high valuations relative to the overall market (Chart 3, bottom panel). It must be noted that valuations for quality stocks have risen significantly over the past few years. It is hard to know how this valuation compares to the past for the MSCI indices, given that valuation measures for MSCI Quality are only available starting in 2013. However, research by AQR has shown that relatively high prices for quality tend to result in lower returns.9 Thus, high valuations could pose a risk for quality going forward. Explanations For The Quality Anomaly Using a dividend-discount framework, one can show that, in theory, high-quality companies should trade at higher price-to-book values than low quality ones (for more details please see Appendix 1). Asness et at have shown that this is the case empirically – high-quality stocks trade at a valuation premium to low-quality stocks (Chart 4, top panel). Chart 4Analysts Are Most Optimistic On Low Quality Stocks Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets However, the mystery of quality lies in the fact that this premium does not appear to be as large as it should be. In other words, while analyst and market participants correctly assign higher multiples to high-quality stocks, this multiple is not large enough, and results in high-quality stocks being undervalued. Ultimately, this leads to the outperformance of high-quality stocks versus low-quality ones (Chart 4, bottom panel). Why do market participants overvalue low quality/junk stocks and undervalue high quality stocks? One reason could be a preference for lottery-like stocks. As we discussed in our January report on the low- volatility anomaly, investors tend to prefer “home-run” stocks – a result of behavioral biases as well as the incentives in the money management industry.10 Thus, distressed companies with low levels of profitability and large levels of debt, may attract some investors betting on a turnaround in the hope of a large windfall if the company survives.11 On the flip side, investors might perceive that high-quality companies – which are usually stable, profitable, and more expensive – cannot produce the same type of extreme payoff, and may even be prone to mean reversion, given that their success is evident and well known.  But this last assumption is a mistake. Quality is a highly persistent characteristic, which means that a high-quality stock today is very likely to remain a high-quality stock in the future (Table 4). It is easy to see why this is the case. A company with very high levels of profitability has likely achieved this by building a moat around its business through a strong brand, proprietary technology, or network effects. It is possible that failure to take this into account results in an undervaluation of high-quality stocks.  Table 4Quality Is Persistent Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets BOX 1 The Behavior Of Quality In Equity And Credit Markets Chart 5Quality Delivers A Different Premium In Different Asset Classes Quality Delivers A Different Premium In Different Asset Classes Quality Delivers A Different Premium In Different Asset Classes While there is a very tight correlation between the performance of quality in credit and equity markets, the structural premium obtained from this factor in each market is very different. Over a long period, investors are rewarded for investing in high-quality equities, while the opposite occurs when investing in high-quality credit issues (Chart 5). Why would the same risk factor provide a positive premium in one market but provide a negative one in another? The exact reason remains unclear, but the behavioral explanations for the quality factor might provide a clue. As opposed to equity markets, returns in credit markets – even if very high – are naturally capped. As an example: An investor who buys a low-quality issue with a 20% yield-to-maturity, knows that in the absence of a default, the most he or she can earn from holding the issue to maturity is 20%. The fact that the maximum return is well established beforehand might prevent investors from displaying behavioral biases. Specifically, a well-defined upside might cause investors to think more rationally and mechanically about an investment. In contrast, securities where the upside is high but not well-defined might make it more likely for investors to see a very risky investment as a lottery, since extraordinary returns are technically within the realm of possibility. Whatever the reason is, the different premium that this factor offers in these two asset classes presents a potentially attractive opportunity for asset allocators. We will explore how investors could take advantage of this discrepancy in future reports on factor allocation.   Implementation Of Quality Using Quality And Size Chart 6The Small-Cap Premium Is Higher When Adjusted For Quality The Small-Cap Premium Is Higher When Adjusted For Quality The Small-Cap Premium Is Higher When Adjusted For Quality Historically, small-cap stocks have delivered excess returns over large cap-stocks – a well-documented phenomenon known as the size premium. However, this premium has been very unstable and extremely seasonal, occurring mostly in the month of January, and providing no excess returns in all other months. Moreover, some research has suggested that the size premium cannot be harvested easily in practice, since most of the premium is concentrated in the very smallest stocks (microcaps), which are highly illiquid.12 The issues surrounding the size premium have prompted some academics to question its existence. However, recent research on the interaction of quality and size has brought back interest to this topic. In the paper “Size Matters, If You Control Your Junk”, Assness et al show that many of the problems with the size premium are caused by the bias that small caps have to low quality. Once this low-quality bias is accounted for, the size premium becomes much larger and stable – a result that also holds when controlling for a quality proxy like profitability (Chart 6). Notably, the concentration of returns in January and in microcaps also disappears when the bias is removed.13 This bias to low quality is a significant problem in most popular small-cap indices. The profitability of indices like the S&P 600 has historically been lower than its large-cap counterparts (Chart 7,  top panel). Moreover, a similar story holds for leverage: While the much maligned increase in corporate debt is evident in small-cap indices, it is virtually nonexistent when looking at large-cap indices like the S&P 500, where leverage measures stand barely above 30- year lows (Chart 7, bottom panel). How can this bias be removed? Stock-level filters for quality might be difficult to implement for many investors. Instead, an easier solution is to exploit the size premium through a small-cap quality index. S&P currently offers the S&P 600 Quality Index, which selects the 120 highest-quality stocks out of the S&P 600. Importantly, since this quality adjustment removes some of the low-quality bias from the S&P 600, the S&P 600 Quality index is able to maintain performance on the upside, while also limiting the sharp periods of underperformance that usually affect small caps during bear markets (Chart 8). Chart 7Small-Cap Stocks Have A Lot Of Junk Small-Cap Stocks Have A Lot Of Junk Small-Cap Stocks Have A Lot Of Junk Chart 8Small-Cap Quality Is A Better Way To Exploit The Size Anomaly Small-Cap Quality Is A Better Way To Exploit The Size Anomaly Small-Cap Quality Is A Better Way To Exploit The Size Anomaly   Using Quality And Value The intersection between value and quality – a pair of factors that have a negative correlation – has been a topic of interest since quality was first discovered.14 They stand as perfect complements of each other: The value factor tries to find cheap stocks, regardless of their quality, while the quality factor tries to find quality stocks regardless of their price. Together they make for a powerful combination: Quality stocks at affordable prices. Some research has suggested that this combination of value and quality lies behind the success of Graham’s greatest student. According to the seminal paper titled “Buffet’s Alpha”, the biggest factor exposures of the Berkshire Hathaway portfolio from 1980 to 2011, outside of overall market risk, were quality and value15 (Chart 9). Exposure to these factors, along with low beta, as well as the ability of Berkshire Hathaway to obtain cheap leverage thanks to its insurance business, explained most of the excess returns that Warren Buffet was able to achieve. Chart 9Buffett's Motto: High Quality, Cheap, And Low Risk Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets Commercial providers have started to offer indices which combine value and quality. As an example, MSCI offers the Prime Value indices, where stocks are first screened for quality and then ranked according to a value score. This methodology has outperformed its normal value counterparts in both the euro area and the US (Chart 10). Chart 10Quality Adjustments By MSCI Improve Value In The Euro Area Quality Adjustments By MSCI Improve Value In The Euro Area Quality Adjustments By MSCI Improve Value In The Euro Area Chart 11Stronger Quality Filters Are Needed In The US To Enhance Value Stronger Quality Filters Are Needed In The US To Enhance Value Stronger Quality Filters Are Needed In The US To Enhance Value   Interestingly, despite value’s recent doldrums, the quality adjustment done in the Prime Value index has helped value perform relatively well in the euro area for the past couple years. However, the same cannot be said in the US where performance of Value and Prime Value has been almost identical since 2003. This suggest a couple of options: It could be that, even when adjusting for quality, value behaves fundamentally differently in different countries. Alternatively, it could also mean that the US market is more efficient at pricing quality, which would imply that a simple quality filter would not do much, since quality at an attractive valuation would be harder to find. We suspect the reason might be the latter. In this case a stronger quality filter might be needed to substantially enhance the performance of value. The newly released Russell 1000 QARP (Quality At A Reasonable Price) Index follows this methodology. It applies a double quality filter and then compounds it by a value score. This index has substantially enhanced performance relatively to the Russell 1000 Value index (Chart 11). Moreover, it has also been able to fare better relative to the broad market and has avoided the large underperformance that value has undergone since 2018. Bottom Line Quality has been one of the most successful factors over the past three decades. But will this performance continue? While the exact reason behind the quality anomaly remains unclear, the evidence suggests that institutional incentives and behavioral biases, which are likely to persist in the future, might be responsible for the outperformance of quality in the market. Thus, investors should consider adding quality stocks to their portfolios. Moreover, quality can also be used to enhance the performance of other popular factors in the following ways: Correcting for the low-quality bias of small caps, makes the small-cap premium larger and much more stable over the long term. A practical way to correct for this low-quality bias is to buy small-cap quality portfolios such as the S&P 600 Quality Index. Value stocks also tend to have low quality. Investors can improve the performance of the value factor by using quality filters to find quality stocks that are also cheap. The quality filters in the MSCI Prime Value Index has significantly improved the performance of value in the euro area. Meanwhile, the Russell 1000 QARP index, which selects for value stocks using a stronger quality filter than MSCI, has kept pace with the overall market even amidst value’s collapse.   Juan Correa Ossa, CFA  Associate Editor juanc@bcaresearch.com Appendix 1 Junk Disposal: The Quality Factor In Equity Markets Junk Disposal: The Quality Factor In Equity Markets Footnotes 1  Robert Novy-Marx, “Quality Investing,” Working Paper, 1-28 (2014) 2  In Graham’s own words: “An indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.” 3  Asness, C.S., Frazzini, A. & Pedersen, L.H. “Quality minus junk,” Rev Account Stud 24, 34–112 (2019). 4 Winsorization is a way to remove the effects of outliers in the data. In this case all the values above the 95th percentile are set to the 95th percentile value and all the values below the 5th percentile are set to the 5th percentile value. 5 Robert Novy-Marx, “Backtesting Strategies Based on Multiple Signals,” NBER Working Paper No. w21329 (2015). 6 Jason Hsu, Vitali Kalesnik, Engin Kose, “What Is Quality?” Financial Analysts Journal, 75:2, 44-61 (2019). 7 Amanda White, “Quality is Explained by Profitability,” Top1000funds.com, (2015). 8 Dan Hanson and Rohan Dhanuka, “The ‘Science’ and ‘Art’ of High Quality Investing,” Journal of Applied Corporate Finance, 27:2 (2015). 9 C.S. Asness, A. Frazzini, and L.H. Pedersen, “Quality minus junk,” Rev Account Stud 24, 34–112 (2019). 10 Please see Global Asset Allocation Special Report, “Less Risk And More Reward? The Low-Volatility Factor In Equity Markets”, dated January 29, 2020. 11 This theory on the quality anomaly might explain the different performance of quality in credit and equity markets. For more details, please see Box 1. 12 Please see Global Asset Allocation Special Report, “Small Cap Outperformance: Fact Or Myth?” dated April 7, 2020. 13 Cliff S. Asness, Andrea Frazzini, Ronen Israel, and Lasse Heje Pedersen, “Size Matters, If You Control Your Junk,” CEPR Discussion Paper, No. DP12684 (2018). 14 Robert Novy - Marx, “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, 108(1) , 1 - 28, (2013) and “The Quality Dimension of Value Investing,” University of Rochester, Working Paper (2014). 15 Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen,  "Buffett’s Alpha," Financial Analysts Journal, 74-4, 35-55 (2018).    

Highlights A weak dollar and low bond yields have pushed up the S&P 500 more than anticipated. Cyclical forces favor loftier stock prices in 12 months. Froth creates short-term vulnerabilities that higher yields could catalyze. The lack of yield curve control along with an improving economic outlook and a decline in deflationary risks indicate that Treasury yields will move toward 1% in the coming months. Long-term investors should begin to add small-cap stocks to their core US holdings. Feature The S&P 500 recent all-time high flies in the face of a long list of tactical indicators that flag an elevated risk of correction. The strength of the US equity market is a testament to the power of policy stimulus, the perceived invincibility of tech titans and the hopes that the powerful economic recovery will continue. Although equities will climb in the coming year, a move up in yields should transfer the leadership from tech and growth stocks to value and traditional cyclicals. While these shifts usually do not spell the end of bull runs, often they generate periods of elevated volatility, especially when the displaced leaders account for 40% of market capitalization. Small-cap stocks look increasingly attractive. A Post Mortem We have been cyclically bullish since late March,1 but on June 25th we warned that the S&P 500 would churn between 2800 and 3200 for the rest of the summer.2 This view did not materialize for several reasons. We underestimated the impact of a weak dollar, which has given a second life to the equity bull market. When expressed in euros, the S&P 500 has been flat since June 5 (Chart I-1). Relative to gold, the S&P 500 is down by 9% since June 8, which further highlights how equities have been supported by a weak US currency and a plentiful money supply. Meanwhile, the S&P 500 has outperformed the EURO STOXX 50 by 7.8% since June 5; however, when we factor in the effect of the strong euro, US equities have steadily underperformed the Eurozone benchmark since early May (Chart I-1, bottom panel). Low bond yields have also buttressed US equities. Near-zero interest rates have allowed the valuation of growth stocks to hit extraordinary levels. The NASDAQ trades at 32-times 2020 earnings and 27-times 2021 EPS. The S&P tech is valued at 29-times 2020 EPS and 25-times next year’s profits. In the most extreme cases, the five tech stocks that have accounted for 31.7% of market gains since March 23 (Apple, Amazon, Microsoft, Alphabet and Facebook) trade on average at 40-times 2020 EPS and 32-times 2021 earnings. Low bond yields have also buttressed US equities. Importantly, COVID-19 has had a positive influence on these same tech stocks. According to our European Investment Strategy colleagues, while spending on restaurant, entertainment and retail collapsed during the pandemic, outlays surged on Amazon, Apple products, Netflix subscriptions, etc.3 At the apex of the crisis, online retail sales expanded by 26.3% annually in the US, while bricks-and-mortar sales contracted by an unprecedented -17.7%. Meanwhile, global shipments of personal computers and servers are expanding by 11.2% and 21.5% annually, respectively (Chart I-2, top panel). Therefore, the largest sector of the S&P 500 is outperforming relative to the rest of the market (Chat I-2, bottom panel). As long as investors continue to expect COVID-19 to affect consumer behavior, they will pay a premium for tech stocks that benefit from the pandemic. Chart I-1The Weak Dollar Is Fueling The Recent Rally The Weak Dollar Is Fueling The Recent Rally The Weak Dollar Is Fueling The Recent Rally Chart I-2Earnings Have Supported Tech Stocks Earnings Have Supported Tech Stocks Earnings Have Supported Tech Stocks   Can Stocks Remain Unscathed? The outlook for stocks is positive, but near-term risks have not dissipated because short-term market conditions remain frothy. Watch for higher bond yields as the force to concretize the tactical risks. The following cyclical forces continue to act as crucial tailwinds for equities: The equity risk premium (ERP) remains low. Computations of ERP must factor in the expected expansion of earnings. To incorporate this alteration, we assume that long-term cash flows will grow in line with potential nominal GDP growth. However, we must also consider the absence of stability of the ERP’s mean. After this adjustment, the ERP is still consistent with significant additional gains for the S&P 500 (Chart I-3). Monetary policy is extraordinarily accommodative. Even when we account for the S&P 500’s elevated multiples, the exceptional jump in the BCA Monetary Indicator is large enough to push up equity prices (Chart I-4). Moreover, the strength of US housing activity indicators confirms that the Federal Reserve has pulled the right levers to boost domestic economic activity. For example, the NAHB Housing Market Index has reached a 22-year record, building permits in July grew at their fastest monthly rate in 30 years, and the Mortgage Applications Index for purchases rocketed to a 11-year high in August. Chart I-3A Low ERP Underpins Equities... A Low ERP Underpins Equities... A Low ERP Underpins Equities... Chart I-4...So Does Monetary Policy ...So Does Monetary Policy ...So Does Monetary Policy   The US economy continues to heal. For stocks to climb further on a cyclical basis, the market will need more than five tech giants leading the charge. Hence, earnings expectations for the rest of the market must also mount. Practically, the economy must recover its output loss and the pandemic must ebb. For now, the four-week moving average of initial unemployment claims is drifting lower, and the ISM New Orders-to-Inventories spread is consistent with a faster and more solid business cycle upswing. The ERP is still consistent with significant additional gains for the S&P 500. The global industrial sector outlook is brightening. Manufacturing and trade disproportionately contribute to fluctuations in global economic activity, therefore, they exert an outsized influence on the earnings of non-tech multinationals. The strength in Singapore’s electronics shipments indicates that our Global Industrial Activity Nowcast will accelerate (Chart I-5, top panel). Moreover, the rapid expansion in China’s credit flows points to a marked increase in Chinese imports, which will help industrial and commodity exporters around the world (Chart I-5, bottom panel). Core producer prices have bottomed. Core producer prices are a direct input in the corporate sector’s pricing power. A trough in this inflation gauge leads to stronger EPS and widening profit margins for the S&P 500 (Chart I-6). Chart I-5The Global Industrial Cycle Is Turning The Corner The Global Industrial Cycle Is Turning The Corner The Global Industrial Cycle Is Turning The Corner Chart I-6Easing Deflationary Pressures Will Help Profits Easing Deflationary Pressures Will Help Profits Easing Deflationary Pressures Will Help Profits   Investors should still wait to allocate new funds to the stock market. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism, especially because the market advance has been concentrated in a small group of equities. Chart I-7Tactical Froth Tactical Froth Tactical Froth The Exposure Index of the National Association of Active Investment Managers has hit 100.1 (Chart I-7). Such a lofty reading indicates that the price of stocks already incorporates optimistic expectations. From a contrarian perspective, this development boosts the probability that swing traders will face disappointments in the near future and will sell their equity holdings. Similarly, the put/call ratio is near a 10-year low, which confirms that traders have bought a lot of upside exposure to stocks without much protection against a pullback. This level of confidence is often a precursor to a significant correction. Finally, our Tactical Strength Indicator is 1.7-sigma above its mean. Historically, when this risk gauge has hit a reading above 1.3, there is a good probability that the S&P 500 will correct or move sideways (Chart I-8). A catalyst must emerge for those aforementioned vulnerabilities to morph into a correction. If Treasury yields move closer to 1%, then stocks will experience a significant pullback of 10% or more as the market rotates away from the leadership of growth stocks. This risk would be especially salient if real yields move up. As Chart I-9 illustrates, falling TIPS yields have been a pillar of the powerful rally of growth stocks. Moreover, low real yields are arithmetically necessary to justify the current level of market multiples exhibited by the S&P 500 (Chart I-9, bottom panel). Chart I-8The S&P 500 Is Vulnerable To A Correction The S&P 500 Is Vulnerable To A Correction The S&P 500 Is Vulnerable To A Correction Chart I-9Falling Real Yields Have Helped Growth Stocks Falling Real Yields Have Helped Growth Stocks Falling Real Yields Have Helped Growth Stocks   Growth and high-P/E ratio stocks are heavily represented in the tech and healthcare sectors, which together account for 42% of the S&P 500. This means that higher yields will likely temporarily drag down the entire market. Ultimately, leadership changes are painful events, but they rarely mark the end of bull markets. Can Yields Move Up? Chart I-10Positive Signs For Inflation Positive Signs For Inflation Positive Signs For Inflation It is time to tweak our bond market view because yields should soon move higher. For the past five months, we have written that yields offer minimal downside and that their asymmetric risk profile made government bonds an unappealing investment. We underweighted this asset class relative to stocks and recommended investors bet on higher inflation breakeven rates. However, forces are aligning to expect real rates to rise and thus, nominal yields should move up. The sequencing of the market’s response to QE increasingly favors lower bond prices. Our US Equity Strategy team recently highlighted that in 2009 stocks were the first asset to reflect the implementation of QE1 by the Fed.4 A weaker dollar followed. Bond yields started to perk up only after the USD deteriorated by enough, after stock prices had climbed by enough and after corporate spreads had narrowed by enough to ease financial conditions to stimulate the economy. So far, 2020 echoes the 2009 pattern and our Financial Conditions Index is more stimulatory than it was prior to the COVID-19 outbreak (see Chart III-36 in Section III). Chart I-11Commodities Point To Higher Yields... Commodities Point To Higher Yields... Commodities Point To Higher Yields... Inflation momentum confirms the risks to bonds. The apex of the deflationary shock has already passed. In July, core CPI excluding shelter rose by 0.84% month-on-month, which was the highest reading since 1981 when the Fed was combating the most violent inflation outbreak in generations. The upturn in core producer prices also warns that the annual inflation rate of core CPI should accelerate meaningfully by early 2021 (Chart I-10). The dollar’s weakness is another inflationary force. Import prices from China have already bottomed, which points to an escalation in goods inflation in the coming months. Firming commodity prices constitute another risk for yields. Our Commodities Advance/Decline line has recently broken out. This technical development is consistent with higher commodity prices and higher bond yields (Chart I-11). Rallying natural resources are inflationary, but they also indicate that the global economy is strengthening, which should put upward pressure on real interest rates. Strength in the housing sector also confirms that government bond yields have upside. As we highlighted above, a robust housing market is an important validation that monetary policy is very accommodative. By definition, the objective of loose policy is to boost future economic activity and eradicate deflationary pressures. The surge in lumber indicates bond prices are showing downside risk (Chart I-12). Additionally, the upswing in mortgage issuance is occurring as the Treasury and corporations boost their borrowings, which will generate more demand to use savings generated in the economy. The price of those savings will be higher real interest rates. Chart I-12...Especially Lumber ...Especially Lumber ...Especially Lumber The ebbing of COVID-19 also suggests that economic activity has scope to accelerate. Moreover, the House of Representatives reconvened to address the problems plaguing the US Postal Service ahead of the November elections. This early return to work gives Washington another opportunity to negotiate the stimulus bill that it failed to pass earlier this month. We still expect such a bill to ultimately become law because both Democrats and Republicans have too much to lose in November if the economy relapses in response of political paralysis. Declining infections and increased government support will bolster aggregate demand and put upward pressure on rates. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism. Market dynamics are also very negative for bonds. Our Valuation Index highlights that Treasurys are incredibly expensive (Chart I-13, top panel). Moreover, our Composite Technical Indicator remains overbought, though it has lost momentum. In this context, the lack of appetite for yield curve control or more QE demonstrated by the Federal Open Market Committee creates a genuine danger for bonds. Without these policies, bond yields will have trouble resisting the upward push created by our rising US Pipeline Inflation Pressures Index, our rebounding Nominal Cyclical Spending proxy (which is an average of the ISM Manufacturing headline index and Prices Paid component), and the uptick in the amount of liquidity sitting on commercial banks’ balance sheets (Chart I-14). Chart I-13Treasurys Are Expensive And Losing Momentum Treasurys Are Expensive And Losing Momentum Treasurys Are Expensive And Losing Momentum Chart I-14Building Cyclical Risks For Bonds Building Cyclical Risks For Bonds Building Cyclical Risks For Bonds   Thus, equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%, including a rise in TIPS yields. The US election creates an additional near-term hurdle for stocks. As we wrote last month, President Trump will likely become more belligerent toward the US’s trading partners in the coming months. Moreover, Vice-President Joe Biden, who has a comfortable lead in the polls including in key swing states such as Florida, Michigan, Pennsylvania, and Wisconsin wants to cancel half of the 2017 tax cuts.5  Small Over Big Long-term investors should expect stocks to beat bonds on a 5- to 10-year horizon, but equities will generate paltry real returns compared with the past 40 years. Elevated valuations for US equities are consistent with long-term annualized real rates of return of only 0.5% (Chart I-15). Moreover, the long-term outlook for profit margins is poor. As we wrote three months ago, mounting populism will result in redistributive policies that will lift the share of wages relative to GDP.6 Moreover, the shift of the US population to the left on economic matters will push up corporate tax rates. Increased labor costs and corporate taxes are negative for profit margins. If profit margins normalize, then equities will probably underperform the uninspiring expected returns implied by current market multiples. The surge in lumber indicates bond prices are showing downside risk. Investors can still generate generous returns through geographical and sectoral selection. We have highlighted how value stocks, industrials and materials, and EM and European equities will likely beat US equities.7 This month we will explore how US small-cap equities are also well placed to best the dismal projected real returns offered by their large-cap counterparts. Our BCA Relative Technical Indicator shows that small-cap stocks are 1.8-sigma oversold when compared with the S&P 500, which indicates a capitulation among investors toward these equities. The bifurcation is even greater if we compare small-cap equities with the S&P 100’s mega-caps that have driven up the US market in recent years. Incorporating these influences, our Cyclical Capitalization Indicator has moved in favor of small-cap stocks, which suggests that small-cap stocks will be rerated if the yield curve can steepen further (Chart I-16). Equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%. Chart I-15Valuations And Profit Margins Threaten Long-Term Stock Returns Valuations And Profit Margins Threaten Long-Term Stock Returns Valuations And Profit Margins Threaten Long-Term Stock Returns Chart I-16Indicators Favor Small Cap Stocks Indicators Favor Small Cap Stocks Indicators Favor Small Cap Stocks Chart I-17A Debt Turnaround Would Help Small Cap Stocks A Debt Turnaround Would Help Small Cap Stocks A Debt Turnaround Would Help Small Cap Stocks Debt dynamics could also increasingly beneficial to small-cap equities. In the past few years, the heavy debt-to-EBITDA of smaller firms created a major headwind for small-cap investors. The indebtedness of small-cap stocks often decreases relative to large-caps when an economic recovery begins. This shift in leverage portends an increase in small-caps’ relative future returns (Chart I-17). Our negative bias toward the dollar and our positive view on commodities also benefit small-cap stocks. Since the early 1990s, increasing real commodity prices and a falling Dollar Index have coexisted with a robust performance of small-cap firms (Chart I-18). The negative US balance-of-payment dynamics, coupled with escalating inflation risks, will continue to weigh on the dollar, especially as various large EM nations try to diversify their reserves and payment systems away from the dollar.8 Meanwhile, a declining dollar, expanding global growth, monetary debasement, populism, inflation and a lack of investment in supply, all will accentuate the appeal of natural resources. The sectoral bias of small-cap indices will capitalize on these trends. Chart I-18Small Is Beautiful Small Is Beautiful Small Is Beautiful Chart I-19Small Cap Stocks Like Higher Yields Small Cap Stocks Like Higher Yields Small Cap Stocks Like Higher Yields   Finally, cyclical timing is also moving in favor of small-cap firms. Since 2014, the Russell 2000 has outperformed the S&P 500 when real yields moved higher (Chart I-19). Small-cap firms display a more marked pro-cyclicality than large firms. Additionally, the S&P 500 growth bias implies that the US large-cap benchmark underperforms the small cap indices when real yields increase.   Mathieu Savary Vice President The Bank Credit Analyst August 27, 2020 Next Report: September 24, 2020   II. Global Semiconductor Stocks: A Hiatus Is Overdue In A Structural Bull Market The strength in global semiconductor sales in recent months has been due to one-off factors stemming from pandemic-related lockdowns. As the one-off demand surge subsides, global semiconductor sales will decline modestly toward the end of this year. In the near term, global semiconductor stock prices are vulnerable due to overbought conditions, excessive valuations and demand disappointment. The global semiconductor industry is at the epicenter of the US-China confrontation, and more US restrictions on chips sales to China are probable. This is another risk for this sector's share prices.   Nevertheless, the structural outlook for global semiconductor demand is constructive. Its CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024.  Investor euphoria has taken hold of semiconductor stocks. Global semiconductor stock prices have skyrocketed by 68% from March lows and 96% from December 2018 lows. Meanwhile, global semiconductor sales during March-June rose only by 5% from a year ago. As a result, the ratio of market cap for global semiconductor stocks relative to global semiconductor sales has reached its highest level since at least the inception of data in 2003 (Chart II-1). Chart II-1Global Semi Sector: Market Cap-To-Sales Ratio Has Surged Global Semi Sector: Market Cap-To-Sales Ratio Has Surged Global Semi Sector: Market Cap-To-Sales Ratio Has Surged With semi equity multiples very elevated, their share prices have become even more sensitive to global semiconductor demand growth. Hence, the focus of this report is to try to gauge the strength of global semiconductor demand, both in the near term and structurally. The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. Near-term semiconductor stock prices could disappoint due to weak chip demand from the smartphone sector and diminishing purchases of personal computers (PCs) and servers. However, structurally, we are positive on global semiconductor demand, which is underpinned by the continuing rollout of 5G networks and phones, a wider adoption of data centers, and further technological advancements in artificial intelligence (AI), cloud computing, edge computing and smaller nodes for chip manufacturing (Box II-1). Box II-1 Key Technologies Underpinning Potential Global Semiconductor Demand AI refers to the simulation of human intelligence in machines, for example, computers that play chess and self-driving cars. The goals of AI include learning, reasoning and perception. Cloud computing is the delivery of computing services – including servers, storage, databases, networking, software, analytics and intelligence – over the Internet (“the cloud”) to offer faster innovation, flexible resources and economies of scale. Edge computing is a form of distributed computing, which brings computation and data storage closer to where it is needed, to improve response times and save bandwidth. Technology node refers to the width of line that can be processed with a minimum width in the semiconductor manufacturing industry, such as technology nodes of 10 nanometers (nm), 7nm, 5nm and 3nm. The smaller the nodes are, the more advanced they are. Near-Term Headwinds Semiconductor demand worldwide grew by 6% year-on-year in the first half of this year. There has been a remarkable divergence between world semiconductor sales and the global business cycle (Chart II-2). The divergence between semiconductor sales and economic activity was most striking in the US and China. Semiconductor sales in China rose by 5% year-on-year in Q12020, and in the US they grew by 29% year-on-year in Q22020, despite a contraction in their aggregate demand during the same period. By contrast, Q2 annual growth of semiconductors sales was -2.2% for Japan, -17% for Europe and 1.8% for Asia ex. China and Japan (Chart II-3). Chart II-2World Semi Sales Diverged From The Global Business Cycle World Semi Sales Diverged From The Global Business Cycle World Semi Sales Diverged From The Global Business Cycle Chart II-3Strong Semi Sales In The US And China, But Not Elsewhere Strong Semi Sales In The US And China, But Not Elsewhere Strong Semi Sales In The US And China, But Not Elsewhere   The reasons why the US and China posted a surge in semiconductor demand while Europe and Japan experienced a contraction in domestic semiconductor sales are as follows: Most data center investment is occurring in the US and China. Chart II-4 shows that 40% of global hyperscale data centers are operating in the US, much larger than any other countries/regions. China, in turn, ranked second, with a global share of 8%. Chart II-4The US Has The Most Global Hyperscale Data Centers September 2020 September 2020 Demand contraction in Europe and Japan is due to semiconductor demand in these regions mainly originating from the automobile sector, where production was severely hit by the global pandemic. About 37% of European semiconductor sales were from last year’s automotive market. We believe the divergence between global economic activity and semiconductor sales, as demonstrated by Chart II-2 on page 3, has been due to one-off factors, as the global pandemic lockdowns have spurred semiconductor demand. Such a one-off demand boost will likely dissipate in the coming months. Traditional PCs and tablets: There has been a surge in demand for traditional PCs9 and tablets in the past six months. This was due to the significant increase in online activities, such as working from home, education, e-commerce, gaming and entertainment. Data from the International Data Corporation (IDC) has revealed that shipments of traditional PCs and tablets in volume terms had a strong year-on-year growth of 11.2% and 18.6%, respectively, in the period of April-June (Chart II-5). Looking forward, even renewed lockdowns will not lead to a similar rush to buy these products. Many households are already equipped to work from home and for other online activities. With many countries gradually opening their economies, such demand will diminish. The traditional PC and tablet sectors together account for about 13% of global chip demand (Chart II-6). Chart II-5Personal Computers Sales Have Surged Amid Lockdowns Personal Computers Sales Have Surged Amid Lockdowns Personal Computers Sales Have Surged Amid Lockdowns Server demand: Another major semiconductor demand contribution in Q2020 was from the server sector, which spiked by 21% year-on-year (Chart II-7). The surge in online activities triggered a strong demand for cloud services and remote work applications, both of which require computer servers to run on. Chart II-6The Breakdown Of Global Semiconductor Sales By Type Of Usage September 2020 September 2020 However, demand from the server sector is also set to diminish in 2H2020 and Q1 2021. Provided the inventories at major data center operators, including Microsoft, Google and Amazon, remain at high levels,10 global cloud service providers will likely reduce their orders of servers next quarter.11  Enterprises will also likely cut their investment in computer servers in 2H2020, as many of them had already increased their purchases of servers to prepare employees and business processes for remote working. We expect global server demand growth to soften in 2H2020. The Digitimes Research forecasted a 5.6% quarter-on-quarter contraction in 3Q2020 and a further cut in global sever shipment in the 4Q2020.10 The global server sector accounts for about 10% of global chip demand and, together with PCs and tablets, they make for 23% (please refer to Chart II-6 on page 5). Further, the smartphone sector – accounting for 27% of global semiconductor demand – will continue struggling in H2 this year. Chart II-7Server Sales Have Surged Amid Lockdowns Server Sales Have Surged Amid Lockdowns Server Sales Have Surged Amid Lockdowns Chart II-8Global Smartphone Shipments Will Likely Remain Weak In 2020H2 Global Smartphone Shipments Will Likely Remain Weak In 2020H2 Global Smartphone Shipments Will Likely Remain Weak In 2020H2   The global total smartphone demand has been hit severely, as households delayed their new smartphone purchases. According to Canalys’ data, global smartphone shipments dropped by 13% and 14% year-on-year in Q1 and Q2, respectively. We expect smartphone shipments to continue contracting over the next three-to-six months (Chart II-8). We believe global consumers will remain cautious in their spending on discretionary goods, such as smartphones, due to lowered incomes and increased job uncertainty. The IDC also forecasted that global smartphone shipments would not grow until 1Q2021.12 The Chinese smartphone sales showed a considerable weakness in July, with a 35% year-on-year contraction, which is much deeper than the 20% decline in H1 this year. 5G smartphone shipments also slowed last month, with a 21% drop from the previous month. The global semiconductor industry is at the epicenter of the US-China confrontation. Bottom Line: The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. As this one-off demand subsides, global semiconductor sales will decline modestly toward the end of this year. Given the overbought conditions and the elevated equity valuations, global semiconductor stocks are currently vulnerable to near-term disappointments in semiconductor demand. At The Epicenter Of The US-China Rivalry Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance. That is access to technology and the capability to develop new technologies. China currently accounts for about 35% of the global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers constitute a major risk to semiconductor stock prices. On August 17, the US announced fresh sanctions that restrict all US and foreign semiconductor companies from selling chips developed or produced using US software or technology to Huawei, without first obtaining a license. In May, the US had already limited companies, such as the Taiwan Semiconductor Manufacturing Company (TSMC), from making and supplying Huawei with its self-designed chips. In addition, the US recently threatened bans on Chinese-owned apps TikTok and WeChat, and signaled that it could soon restrict Alibaba’s operations in the US. Chart II-9Global Semi Companies' Sales To China Are Substantial September 2020 September 2020 The global semiconductor sector is highly vulnerable to further escalation in the tension between these two superpowers. Major global semiconductor companies’ sales are heavily exposed to China, and their revenue from China ranges from 16% to 50% of total (Chart II-9). We have been puzzled why global semi share prices have been rallying in spite of US limitations on semiconductor shipments to Huawei and its affiliated entities. One explanation could be that the Chinese companies that are not affiliated with Huawei are able to import semiconductors and then supply them to Huawei. If this is true, the US will have no other choice but to limit all semiconductor sales to China. This will be devastating for global semi producers given their large exposure to China. In anticipation of US punitive policies limiting its access to semiconductors, China had boosted its semiconductor imports over the past 12 months (Chart II-10, top panel). Chinese imports of integrated circuits rose by 12% year-on-year in 1H2020, which is much higher than the 5% year-on-year increase in Chinese semiconductor demand during the same period (Chart II-10, bottom panel). This gap suggests the country had restocked its semiconductor inventories. China has particularly restocked its imports of non-memory chips with imports of processor & controller and other non-memory chips in H1, surging by 30% and 20%, respectively, in US dollar terms (Chart II-11). For memory chips, the contraction in Chinese imports was mainly due to a decline in global memory chip prices. Chart II-10China Had Likely Restocked Its Semi Inventories China Had Likely Restocked Its Semi Inventories China Had Likely Restocked Its Semi Inventories Chart II-11Strong Chinese Imports In Non-Memory Chips Strong Chinese Imports In Non-Memory Chips Strong Chinese Imports In Non-Memory Chips   Bottom Line: The global semiconductor industry is at the epicenter of the US-China confrontation, and more restrictions on sales to China are probable. In turn, the restocked semiconductor inventory in China raises the odds of weakening mainland semiconductor import demand in H2 of this year. Structural Tailwinds Table II-1Global Semiconductor Demand CAGR Forecast Over 2020-2024 By Device September 2020 September 2020 We are optimistic on structural global semiconductor demand. Its nominal CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024 in US dollar terms. Table II-1 shows our demand growth forecasts for global chips in the main consuming sectors over the next five years. The major contributing sectors during 2020-2024 will be 5G smartphones, servers, industrials, electronics and automotive manufacturing. The underlying driving forces are the continuing rollout of 5G networks and phones, the development of data centers, and further technological advancements in AI, cloud computing and edge computing. Currently, the world is still in the early stages of 5G network development. AI, cloud computing and edge computing are constantly evolving. With increasing adoption of 5G smartphones, computer servers and IoT devices, global semiconductor demand is in a structural uptrend (Box II-2). Box II-2 Key Components For The Virtual World In Development Data centers and cloud computing allow data to be stored and applications to be running off-premises and to be accessed remotely through the internet. Edge computing allows data from Internet of things (IoT) devices to be analyzed at the edge of the network before being sent to a data center or cloud. IoT devices contain sensors and mini-computer processors that act on the data collected by the sensors via machine learning. The IoT is a growing system of billions of devices — or things — worldwide that connect to the internet and to each other through wireless networks. AI technology empowers cloud computing, edge computing and IoT devices. 5G is at the heart of the IoT industry transformation, making a world of everything connected possible. Chart II-125G Phone Shipments In China Will Continue To Rise 5G Phone Shipments In China Will Continue To Rise 5G Phone Shipments In China Will Continue To Rise 5G Smartphone Currently, China is the world’s largest 5G-smartphone consumer and the leading 5G-adopter in the world. According to Digitimes Research, global 5G smartphone shipments will reach over 250 million units in 2020, with 170 million (68%) in China and only 80 million units in the world ex. China. Looking forward, 5G smartphone shipments are set to accelerate worldwide over the coming years. The 5G phone shipments in China will continue to rise. The 5G phone sales penetration rate in China is likely to rise from 60% in July to 95% by the end of 2022. In such a case, we estimate that the monthly Chinese 5G phone shipments will increase from the current 16 million units to about 25-30 million units in 2022 (Chart II-12). In the rest of the world, the 5G smartphone adoption pace will also likely speed up over the next five years. The 5G phone selling prices in the world outside China will drop, as more models are introduced and become more affordable. 5G smartphone prices have already fallen in China and will inevitably fall elsewhere. Chinese 5G smartphone producers will ship their low-priced 5G phones overseas, putting pressure on other producers to lower their prices. The 5G infrastructure development is accelerating in China and will accelerate in the rest of the world. Both China and South Korea have been very aggressive in their respective 5G network development. As of the end of June, China's top three carriers: China Mobile, China Unicom, and China Telecom – which together serve more than 1.6 billion mobile users in the country – had installed 400,000 5G base stations against an annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations.13  As the US is competing with China on the 5G front, the country will likely boost its investment in 5G network development aggressively over the next five years in order to catch up to, or even exceed, China. Importantly, the 5G smartphone has more silicon content than 4G smartphones. More silicon content means higher semiconductor value. Rising 5G smartphone sales and higher silicon content together will more than offset the loss in semiconductor sales due to falling global 4G smartphone shipments. Overall, global semiconductor stock prices have diverged from their sales and profits. Based on our analysis, we expect a CAGR growth of 4% in semiconductor demand from the global smartphone sector over the next five years, slightly lower than the 5% in previous five years (Table II-1 on page 10). This also takes into consideration that the 5G network will be more difficult and more expensive to develop than the 4G network. Servers Global server shipment growth will be highly dependent on both the pace and the scale of data center development (Box II-3). Data centers account for over 60% of global server demand.  Box II-3 Data Centers There are four main types of data centers – enterprise data centers, managed services data centers, colocation data centers, and cloud data centers. Data centers can have a wide range of number of servers. Corporate data centers tend to have either 200 (small companies), or 1000 servers (large companies). In comparison, a hyperscale data center usually has a minimum of 5,000 servers linked with an ultra-high speed, high fiber count network. Outsourcing and a move towards the cloud are driving the growth of the hyperscale data center. Instead of companies investing in physical hardware, they can rent server space from a cloud provider to both save their data and reduce costs. Amazon, Microsoft, Google, Apple and Alibaba are all top global cloud service providers. The more hyperscales to be built up, the higher the demand for servers. In 2019, about 13% of the total number of data centers in China were of the hyperscale and large-scale varieties. The plan of new infrastructure development announced earlier this year by Beijing was aiming to increase the number of hyperscale and large-scale data centers in China. Among current data centers either under construction or to be developed in the near future, 36% of them are hyperscale and large-scale data centers.   The future growth of data centers is promising. The global trend of data localization14 due to the concerns of data privacy and national security will also bolster a boom of data centers over the next five years. A growing number of countries are adopting data localization requirements, such as China, Russia, Indonesia, Nigeria, Vietnam and some EU countries. While the Chinese data center market is expected to expand by a CAGR of about 28% over 2020-2022,15 a report recently released by Technavio forecasted the global data center industry’s CAGR at over 17% during 2019-2023.  We forecast that the global semiconductor demand from servers will grow at a CAGR of 12% over 2020-2024. IoTs Technological advancements in AI, cloud computing and edge computing, in combination with 5G network development, will facilitate the IoTs adoption. According to the GSMA,16 46 operators in 24 markets had launched commercially available 5G networks by 30 January 2020. It forecasted that global IoT connections will be increased from 12 billion mobile devices in 2019 to 25 billion in 2025 with a CAGR at 13%.17   IoTs chips include the Artificial Intelligence of Things (AIoT) – a powerful convergence of AI and the IoT. IoTs is an interconnected network of physical devices. Every device in the IoT is capable of collecting and transferring data through the network. Looking forward, global demand of AI chips and IoT chips will have significant potential to grow with creation of “smarter manufacturing”, “smarter buildings”, “smarter cities”, etc. AI applications can be used in manufacturing processes to render them smarter and more automated. Productivity will be enhanced as machines achieve significantly improved uptime while also reducing labor costs. There are plenty of upsides in industrial semiconductor demand (Chart II-13). We expect the CAGR of industrial electronics to increase from 3.4% during 2014-2019 to 8% during 2020-2024. AI applications can create smart buildings by increasing connectivity across enterprise assets, enabling home network infrastructure (e.g., routers and extenders) and employing home-security devices (e.g., cameras, alarms and locks). AI applications can be used to create smart cities. A smart city is an urban area that uses different types of IoT electronic sensors to collect data. Insights gained from that data are used to manage assets, resources and services efficiently; in return, that data is used improve operations across the city. China has already developed about 750 trial sites of smart cities with different degrees of smartness in the past decade. As AI and 5G technology advances, the existing smart cities’ “smartness” will be upgraded and new trial smart cities will be implemented. Based on IDC data, China’s investment in smart cities will rise at a CAGR of 13.5% over 2020-2023 (Chart II-14). Globally, the U.S., Japan, European countries and other nations are also actively developing smart cities. According to a new study conducted by Grand View Research, the global smart cities market size is expected to grow at a CAGR of 24.7% from 2020 to 2027.18  Chart II-13Plenty Of Upside In Industrial Semi Demand Plenty Of Upside In Industrial Semi Demand Plenty Of Upside In Industrial Semi Demand Chart II-14China’s Investment In Smart Cities Will Continue To Grow September 2020 September 2020   Automotive We expect the global automotive chip market to grow at a CAGR of 9% during 2020-2024, as in 2014-2019. The increase in consumption of semiconductors by the auto industry will continue to be driven by the market evolution toward autonomous, connected, electric and shared mobility. Most new vehicles now include some level of advanced driver assist systems (ADAS), such as adaptive cruise control, automatic brakes, blind spot monitoring, and parallel parking. The whole industry is progressing toward fully autonomous vehicles in the coming years. Increasing adoption of automotive chips and recovering car sales will revive automotive chip sales. In addition, rising penetration of new energy vehicles (NEVs) is beneficial to semiconductor sales, as NEVs contain higher semiconductor content than conventional vehicles. Conventional vehicles contain an average of a $330 value of semiconductor content while hybrid electric vehicles can contain up to $1,000 and $3,500 worth of semiconductors.19 Regarding other sectors, we are also positive on structural demand of storage and consumer electronics. AI applications generate vast volumes of data — about 80 exabytes per year, which is expected to increase by about tenfold to 845 exabytes by 2025.20 In addition, developers are now using more data in AI and deep learning (DL) training, which also increases storage requirements. With massive potential demand for storage, we estimate a CAGR of 7% over 2020-2024 (Table II-1 on page 10). A recent report from ABI Research predicts that the COVID-19 pandemic will increase global sales of wearables (such as a Fitbit or Apple Watch) by 29% to 30 million shipments of the devices this year. With contribution from wearables, we expect global semiconductor demand from the consumer sector to grow at a CAGR of 3% over 2020-2024, the same rate as in the previous five years. Bottom Line: Continuing rollout of 5G networks and phones, development of data centers, and further technological advancements in AI and cloud computing will provide tailwinds to structural global semiconductor demand, accelerating its CAGR growth from 3% during 2014-2019 to 5% during 2020-2024. Valuations And Investment Conclusions Most global semiconductor stocks are currently over-hyped. Critically, both DRAM and NAND prices have been deflating since January, reflecting weak demand for memory chips. Yet, share prices of memory producers have rallied (Chart II-15). Overall, global semiconductor stock prices have diverged from their sales and profits (Chart II-16). Chart II-15Falling Memory Prices Pose Risk To Memory Stocks Falling Memory Prices Pose Risk To Memory Stocks Falling Memory Prices Pose Risk To Memory Stocks Chart II-16Global Semiconductor Stocks Have Deviated From Profits Global Semiconductor Stocks Have Deviated From Profits Global Semiconductor Stocks Have Deviated From Profits   Consequently, the multiples of semiconductor stocks have spiked to multi-year highs (Chart II-17).  Even after adjusting for negative US real bond yields, valuations of semiconductor stocks are not cheap. Chart II-18 illustrates the equity risk premium for global semiconductor stocks is at the lower end of its range of the past 10 years. The ERP is calculated as forward earnings yield minus 10-year US TIPS yields. Chart II-17Global Semi Stocks: Elevated Valuations Global Semi Stocks: Elevated Valuations Global Semi Stocks: Elevated Valuations Chart II-18Equity Risk Premium For Global Semi Stocks Is Historically Low Equity Risk Premium For Global Semi Stocks Is Historically Low Equity Risk Premium For Global Semi Stocks Is Historically Low   It is impossible to time a correction or know what the trigger would be (US-China tensions have been our best guess). Nevertheless, we do not recommend chasing semiconductor stocks higher due to their overstretched technicals and valuations on the one hand and potential weakening demand in H2 on the other. In addition, the ratio of global semi equipment stock prices relative to the semi equity index correlates with absolute share prices of global semi companies. This is because equipment producers are higher-beta as they outperform during growth accelerations and underperform during growth slumps. The basis is that semi manufacturers have to purchase equipment if there is actual strong demand coming up and vice versa. The recent underperformance by global semi equipment stocks relative to the semi equity index might be an early sign of a potential reversal in semi share prices in absolute terms (Chart II-19). Chart II-19A Signal Of A Potential Reversal In Semi Share Prices A Signal Of A Potential Reversal In Semi Share Prices A Signal Of A Potential Reversal In Semi Share Prices Meanwhile, we believe the subsector- memory chip stocks - will outperform the overall semiconductor index amidst the potential correction, because they have lagged and are less over-extended. Finally, we remain neutral on Taiwanese and Korean bourses within the EM equity space for now. Escalation in US-China confrontation, as well as their exposure to semiconductors, put these bourses at near-term risk. That said, we are reluctant to underweight these markets because fundamentals in EM outside North Asia remain challenging.   Ellen JingYuan He Associate Vice President Emerging Markets Strategy III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but equities are increasingly vulnerable because short-term sentiment and positioning measures are growing increasingly stretched. Three forces can prompt a correction. First, a rebound in yields toward 1% would cause turbulence for the S&P 500, because the index is dominated by growth stocks that are highly sensitive to fluctuations in the risk-free rate. Second, a dollar bounce would hurt the S&P 500 because a depreciating USD has fueled the US stock market rally since June. Finally, the US presidential election is drawing nearer; hence, the risk of potentially damaging political headlines is growing.  Despite these short-term risks, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative and the chance of inflation moving high enough to spook central bankers is minimal in the near future. Additionally, the fiscal spigots are open and governments around the world will ultimately continue to support their economies. Hence, any correction in the S&P 500 is unlikely to move beyond 15% or a level of 2900. Our cyclical indicators confirm the positive backdrop for stocks. While our Valuation Indicator has reached overvalued territory, our Monetary Indicator remains extremely accommodative. Moreover, our Technical Indicator is now flashing a clear buy signal. Putting all those forces together, our Intermediate-Term Indicator continues to support equities. Finally, our Revealed Preference Indicator strongly argues in favor of staying invested in equities. That being said, our Speculation Indicator has surged back up, thus the volatility of the rally should increase. Bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. So far, government bond yields have managed to remain stable at very low levels even if they have not declined further. Nonetheless, bonds have underperformed equities, which is a trend that will remain in place for many more quarters. Moreover, the pick-up in commodity prices and in various gauges of the business cycle suggests that bond yields should soon move higher, especially because the Fed is far from enthused at the concept of yield curve control. Our Cyclical Bond Indicator has turned higher and will soon flash an outright sell signal. The dollar continues to weaken after its recent breakdown. For now, the USD’s weakness has been concentrated among DM currencies. For the dollar to weaken further, EM currencies must begin to rally more markedly than they have until now, especially in Latin America. The firmness of the CNY is a good sign for the EM complex, but another clear up-leg in global growth must emerge before EM currencies can fully blossom. As a result, we are likely to have entered a temporary period of consolidation for the US dollar. The extremely oversold nature of our Dollar Composite Technical Indicator supports the idea that the dollar needs to digest its recent losses before its poor fundamentals force it lower once again. Finally, commodities have been a prime beneficiary of the weakness in the dollar and the combination of stable yields and improving economic activity. Our Composite Technical Indicator is now well into overbought territory which makes natural resource prices vulnerable to a pullback. A move up in yields as well as a short-term rebound in the dollar will likely catalyze any underlying technical risks to commodities. Gold will be particularly vulnerable to any such pullback, especially if higher real yields are the cause of the correction in natural resource prices. Despite these short-term worries, the outlook for commodities remains bright. As a result, we would use any correction to add exposure to the commodity complex. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "April 2020," dated March 26, 2020, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 3 Please see European Investment Strategy "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs," dated July 30, 2020, available at eis.bcaresearch.com 4 Please see US Equity Strategy "Inversely Correlated," dated August 25, 2020, available at uses.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 8 Diversifying away from the dollar does not mean that the USD will lose its reserve status. However, a return to the share of FX reserves that prevailed in the first half of the 1990s will hurt the dollar, especially because the US net international investment position has fallen from -4.6% of GDP in 1992 to -57% today. 9 Traditional PCs are comprised of desktops, notebooks, and workstations. 10 Global server shipments to contract 5.6% sequentially in 3Q2020, says Digitimes Research 11 Global server shipments forecast to increase by 5% this year: TrendForce 12 IDC Expects Worldwide Smartphone Shipments to Plummet 11.9% in 2020 Fueled by Ongoing COVID-19 Challenges 13 America does not want China to dominate 5G mobile networks 14 “Data localization” can be defined as the act of storing data on a device that is physically located within the country where the data was created. Data localization requirements are governmental obligations that explicitly mandate local storage of personal information or strongly encourage local storage through data protection laws that erect stringent legal compliance obligations on cross-border data transfers. 15 The big data center industry ushered in another outbreak 16 The GSMA represents the interests of mobile operators worldwide, uniting more than 750 operators with almost 400 companies in the broader mobile ecosystem, including handset and device makers, software companies, equipment providers and internet companies, as well as organizations in adjacent industry sectors. 17 GSMA: 5G Moves from Hype to Reality – but 4G Still King 18 Smart Cities Market Size Worth $463.9 billion By 2027 19 The Automotive Semiconductor Market – Key Determinants of U.S. Firm Competitiveness 20 AI is data Pac-Man. Winning requires a flashy new storage strategy.

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Garry Evans, Chief Global Asset Allocation Strategist. Garry will be discussing the social and industrial changes that will remain in place even after the COVID-19 pandemic is over, and how investors should tilt their portfolios to take advantage of them. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights The number of coronavirus cases in the US appears to have peaked. Negotiations to avert a fiscal cliff continue in Washington. While we expect a deal to be reached, markets could tread nervously until this happens. The US dollar will weaken further over the next 12 months. Narrowing interest rate differentials, a revival in global growth, deteriorating momentum, and pricey valuations all bode poorly for the greenback. Global equities in general, and non-US stocks in particular, tend to fare well in a weak dollar environment. Small cap and value stocks usually outperform when the dollar weakens. Bank shares should start to do better as yield curves steepen and faster economic growth reduces concerns over non-performing loans. US Virus Wave Cresting, But Fiscal Risks Intensifying Chart 1US: Number Of New Cases Seems To Be Peaking The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Last week, we argued that the two biggest near-term threats to stocks and other risky assets were the rising number of coronavirus cases in parts of the US and the looming fiscal cliff.1 Since then, the news on the virus has been broadly positive, while developments on the fiscal front have been mixed. Chart 1 shows that the number of new cases seems to have peaked in the US. In Texas, Florida, California, and Arizona, the share of doctor visits linked to suspected Covid infections is trending lower. This metric leads diagnoses by about one-to-two weeks (Chart 2).   Chart 2Doctor Visits, Which Lead Diagnoses, Are Trending Lower The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Over half the US population lives in states that have either suspended or reversed reopening plans (Chart 3). Assuming the number of infections keeps falling and fiscal policy is not unduly tightened, household spending and employment growth – which appear to have stalled out in the second half of July – should begin to pick up. Chart 3Not So Fast The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Unfortunately, the assumption that fiscal policy will remain stimulative looks somewhat shaky. Expanded unemployment benefits for 30 million Americans, consisting mainly of an additional $600 per week for unemployed workers, are set to expire at the end of July. Congressional Republicans have suggested trimming benefits to $200 per week. However, even that would represent a fiscal tightening of nearly 3% of GDP. A Question Of Incentives The Republican position is understandable, given that two-thirds of unemployed workers are currently receiving more in unemployment benefits than they earned while working. Thus, some scaling back of benefits is not only inevitable, but desirable. The question is one of timing. While job openings have risen from their lows, they are still 23% below where they were at the start of the year. According to the NFIB survey, the share of small businesses reporting difficulty in finding qualified workers has also fallen from year-ago levels. When the binding constraint on employment is a shortage of jobs rather than a shortage of workers, higher unemployment benefits will likely boost hiring. This is because increased benefits will increase spending on goods and services across the economy, thus augmenting the demand for labor. Debt, Gold, And The Dollar Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields Gold Prices Have Risen On The Back Of Falling Real Yields Gold Prices Have Risen On The Back Of Falling Real Yields Does the inevitable increase in government debt due to ongoing fiscal stimulus portend disaster down the road? According to many commentators, the recent drop in the dollar and the surge in gold prices is surely telling us that it does. While it is a compelling story, it is mainly false. The yield on the 30-year Treasury bond currently stands at 1.20%, down from 1.5% in mid-June and 2.33% at the start of the year. Bondholders may be many things, but masochistic is not one of them. If they really thought a fiscal crisis was around the corner, yields would be a lot higher. So why is the dollar falling and gold rallying? The answer is inflation expectations have risen off very low levels, which has pushed down real yields. Gold prices are almost perfectly correlated with real interest rates (Chart 4). The Real Reason The Dollar Has Fallen Going into this year, US real yields had a lot more room to decline than rates abroad. For example, at the start of 2019, US real 2-year yields were 221 bps above comparable euro area yields. Today, US real rates are 35 bps lower – a swing of 256 bps. Yield differentials have narrowed against other economies as well, which has pushed down the value of the dollar (Chart 5). In addition, relative growth dynamics have hurt the greenback. The US economy tends to be less cyclical than most of its trading partners. While the US benefits from faster global growth, the rest of the world benefits even more. This causes capital to flow from the US to other countries, leading to a weaker dollar (Chart 6). Chart 5The Greenback Has Been Losing Interest Rate Support The Greenback Has Been Losing Interest Rate Support The Greenback Has Been Losing Interest Rate Support Chart 6The Dollar Usually Weakens When Global Growth Accelerates The Dollar Usually Weakens When Global Growth Accelerates The Dollar Usually Weakens When Global Growth Accelerates   Chart 7The Dollar And Cycles The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar BCA Research’s Foreign Exchange Strategist, Chester Ntonifor, has stressed that the dollar typically fares worst in the initial stages of business cycle recoveries (Chart 7). That is the stage we are in today. Indeed, the gap in growth between the US and the rest of the world is likely to be larger than usual over the next few quarters because the pandemic has hit the US harder than most other developed economies. Momentum is also working against the dollar. Being a contrarian is usually a smart investment strategy. That is not the case when it comes to trading the dollar. With the dollar, you want to follow the herd.  This is because the dollar is a high momentum currency (Chart 8). A simple trading rule that buys the dollar when it is trading above its 50-day or 200-day moving average, and sells the dollar when it is trading below its respective moving averages, has historically made a lot of money. Likewise, the dollar performs best prospectively when sentiment is bullish and improving (Chart 9). Currently, the dollar is trading below its various moving averages. Sentiment is also poor and deteriorating (Chart 10).   Chart 8USD Is A High Momentum Currency The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Chart 9Trading The Dollar: The Trend Is Your Friend The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Chart 10The Dollar Has Started Breaking Down The Dollar Has Started Breaking Down The Dollar Has Started Breaking Down   Chart 11The Dollar Is Still Fairly Expensive The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar If the dollar were cheap, all the factors discussed above could be overlooked. But the dollar is not cheap. It is still pricey based on purchasing power parity measures which compare the common-currency cost of identical consumption bundles from one country to the next (Chart 11). A Weaker Dollar is Bullish For Stocks, Especially Non-US Stocks Global equities in general, and non-US stocks in particular, tend to perform well when the dollar is weakening (Chart 12). Chart 12A Weaker Dollar Should Help Global Equities A Weaker Dollar Should Help Global Equities A Weaker Dollar Should Help Global Equities   Chart 13Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclical sectors such as industrials, energy, and materials normally outperform defensives in a weak dollar environment (Chart 13). Relative profit growth in these sectors tends to rise when the dollar depreciates (Chart 14). To the extent that cyclicals are overrepresented in stock market indices outside the US, this gives non-US equities a leg up. Chart 14Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates EM Is The Big Winner From Dollar Weakness A weaker dollar is particularly beneficial to emerging markets. Commodity prices usually rise when the dollar drops (Chart 15). Rising resource prices are good news for many emerging markets. EM debt dynamics also tend to improve when the dollar weakens. EM external debt has grown in recent years (Chart 16). About 80% of EM foreign currency denominated debt is in dollars. A falling dollar reduces the local-currency value of US dollar-denominated liabilities, thus strengthening the balance sheets of many EM companies and governments. Emerging markets with large current account deficits and significant dollar liabilities such as Brazil, Indonesia, Turkey, and Mexico will outperform EMs that generally run current account surpluses and have little in the way of foreign-currency debt. Chart 15Commodity Prices Usually Rise When The Dollar Falls Commodity Prices Usually Rise When The Dollar Falls Commodity Prices Usually Rise When The Dollar Falls Chart 16EM External Debt Has Grown In Recent Years EM External Debt Has Grown In Recent Years EM External Debt Has Grown In Recent Years The Federal Reserve today is trying to engineer an easing in US financial conditions. A weaker dollar is facilitating that goal. Historically, EM stocks have been almost perfectly inversely correlated with US financial conditions (Chart 17). Chart 17EM Equities Benefit From Easier US Financial Conditions EM Equities Benefit From Easier US Financial Conditions EM Equities Benefit From Easier US Financial Conditions What About DM? The impact of a weaker dollar on the stock markets of developed economies is more nuanced. Consider the euro area, for example. On the one hand, a stronger euro hurts the euro area economy, which can ultimately push down domestic profits. A stronger EUR/USD also reduces the profits of European companies with operations in the US when those profits are converted back into euros. That can also hurt European stocks. On the other hand, the overall reflationary effect of a weaker dollar on global growth tends to push up profits. In practice, the latter effect usually dominates the former. Thus, euro area stocks, just like stocks in most other markets, generally outperform the US when the dollar is weakening (Chart 18). Chart 18ANon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Chart 18BNon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Small Caps And Value Stocks Tend To Outperform When The Dollar Weakens Even though companies in the small cap Russell 2000 index generate less of their sales from abroad than those in the S&P 500, small caps still tend to outperform large caps in weak dollar environments (Chart 19). This is partly because smaller companies are more cyclical in nature. It is also because the US dollar performs best in a risk-off setting when investors are pouring money into the safe-haven Treasury markets. In contrast, small caps excel in a risk-on environment. Value stocks tend to outperform growth stocks in a weaker dollar environment (Chart 20). Like small caps, cyclical equity sectors are overrepresented in value indices. Financials also tend to punch above their weight in value indices. Chart 19Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Chart 20...The Same Goes For Value Stocks ...The Same Goes For Value Stocks ...The Same Goes For Value Stocks Small caps and value stocks outperformed between 2000 and 2008, a time when the US dollar was generally weakening. That period saw both a commodity boom and a wave of debt-fueled housing booms. The former lifted commodity prices, while the latter buoyed financials. Commodity prices should rise over the next 12 months thanks to a rebound in global growth and copious Chinese stimulus. Chart 21 shows that the Chinese credit impulse is on track to reach the highest levels since the Global Financial Crisis, while the fiscal deficit will probably hit a record 8% of GDP. The Outlook For Financial Stocks Gauging the outlook for financials is trickier. Credit growth has slowed sharply since the Global Financial Crisis, which has weighed on bank profits. The structural decline in bond yields has also been toxic for bank shares (Chart 22). Lower bond yields tend to translate into flatter yield curves, which can depress net interest margins. Chart 21China Has Opened The Spigots China Has Opened The Spigots China Has Opened The Spigots Chart 22The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks A falling dollar has historically been associated with higher bond yields (Chart 23). As global growth recovers over the next 12 months, bond yields will edge higher. That said, central bank bond purchases, coupled with aggressive forward guidance, will keep bond yields from rising as much as they normally would. And even if nominal yields do rise, inflation expectations will rise even more, implying that real yields will fall further. Falling real yields tend to benefit growth stocks more than they benefit value stocks. Chart 23Bond Yields Tend To Rise When The Dollar Weakens Bond Yields Tend To Rise When The Dollar Weakens Bond Yields Tend To Rise When The Dollar Weakens Still, even a modest steepening of the yield curve will be good for bank earnings. A recovery in economic activity should also dampen concerns about a spike in bad loans. Credit spreads normally fall when economic growth is improving and the dollar is weakening (Chart 24). Banks have significantly increased provisions since the start of the year, which has depressed reported earnings. If some of those provisions are reversed, profits will jump. Chart 24Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Chart 25Bank And Value Stocks Are Quite Cheap The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Moreover, bank stocks in particular, and value stocks in general, are extremely cheap by historic standards (Chart 25). Thus, while the case for favoring value over growth is not as clear-cut as it could be, it is strong enough that long term-oriented investors should consider moving capital from high-flying tech stocks to unloved value stocks.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Will Bond Yields Ever Go Up?” dated July 24, 2020. Global Investment Strategy View Matrix The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Current MacroQuant Model Scores The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar  

Dear Client, Next Monday, July 20, we will be hosting our quarterly webcast, one at 10am EST for our US and EMEA clients and one at 9pm for our Asia Pacific, Australia and New Zealand clients; our regular weekly publication will resume on Monday July 27, 2020. Kind Regards, Anastasios Highlights A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. A Biden presidency would lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. Democrats would remove the Senate filibuster. Yet the macro agenda is reflationary. A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps. While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Feature Online political betting markets are still not fully pricing our “Blue Wave” scenario for the US election this year. The odds are closer to 50%-55% than 35%. Hence the equity market, especially the NASDAQ, is complacent about rising political risks to US equity sectors (Chart 1). The immediate risk to the rally is not politics but the pandemic, namely the COVID-19 resurgence in the United States, which is causing governors of major states like Texas, California, and Florida to slow down the economic reopening. The US’s failure to limit the spread of the virus has not yet led to a spike in deaths in aggregate, but it is leading to a spike in major states like Texas and Florida (Chart 2). Deaths are ultimately what matter to politicians and financial markets, since governments will not shut down all of society for less-than-lethal ailments. Fear will weigh on consumer and business confidence, including fear of a deadly second wave this winter. Near-term risks to the equity rally are elevated. Chart 1Blue Wave Expected, Equities Unconcerned Blue Wave Odds Rising, Equities Hesitate Blue Wave Odds Rising, Equities Hesitate Chart 2COVID-19 Outbreak Still A Risk Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Beyond this risk, the driver of the cyclical rally is the gargantuan monetary and fiscal stimulus – and more is on the way. President Trump wants another $2 trillion coronavirus relief package, while House Democrats already passed a $3 trillion package to demonstrate their election platform that government should take a greater role in American life. Senate Republicans (and reportedly Vice President Mike Pence) want a smaller $1 trillion bill but will capitulate in the face of a growing outbreak and any financial turmoil. Congress is highly likely to pass a new relief bill before going on recess on August 10. If COVID-19 causes another swoon in financial markets and the economy, then this congressional timeline will accelerate. America’s total fiscal stimulus for 2020 is rapidly approaching 20% of GDP, or 7% of global GDP (Chart 3). Thus it is understandable that the market has not reacted negatively to an impending blue wave election. Bipartisan reflation is overwhelming the Democratic Party’s market-negative agenda of re-regulation, tax hikes, minimum wage hikes, energy curbs, price caps, and anti-trust probes. Moreover the Democrats’ agenda also includes social and infrastructure spending, cheap immigrant labor, and less hawkish trade policy ex-China, which are all reflationary. Chart 3US Stimulus Greater Than Global – And Rising Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications In short, over the next year, the US is not lurching from massive stimulus to a mid-term election that imposes budget controls and “austerity,” as occurred in 2010, but rather from massive stimulus to a likely Democratic sweep that will be fiscally profligate (Charts 4A & 4B). After all, Democrats are openly flirting with modern monetary theory. Chart 4ADeficits Would Soar Under Democrats Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Chart 4BDemocrats Would Be Ultra-Dovish On Fiscal Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Debt monetization is the big change, regardless of the election, which makes investors cyclically bullish. China is also bound to provide massive fiscal-and-credit stimulus because its first recession since the 1970s is threatening the Communist Party’s source of legitimacy (Chart 5). The European Union is uniting under a banner of joint debt issuance to fend off deflation. Bottom Line: Near-term risks to the exuberant post-lockdown rally abound, but the cyclical view remains constructive due to the ultimate policymaker stimulus put. Chart 5China Loosens Credit And Fiscal Taps China Loosens Credit And Fiscal Taps China Loosens Credit And Fiscal Taps Pre-Election Volatility And Post-Election Equity Returns Volatility normally rises ahead of US elections and it could linger in the aftermath given extreme polarization and the risk of vote recounts, contested results, Supreme Court interventions, and refusals by either candidate to concede. This is a concern in the short run but not the long run. US equities will grind higher over the long run regardless of the election outcome. Stocks normally rise by 10% in the 12 months after a presidential election that yields single-party control, though the upside is smaller and the initial downside is bigger than is the case with a gridlocked government (Chart 6, top panel). In cases of gridlock – which is virtually assured if Trump wins – the equity pullback after the election is just as deep but tends to be later in coming. On average stocks rise by the same amount after 12 months in either case (Chart 6, bottom panel). Thus political risks are primarily relevant in their regional or sectoral effects, though investors should take note that a Democratic sweep probably limits next year’s upside. Chart 6Equities Have Less Upside Under Democratic Sweep Equities Have Less Upside Under Democratic Sweep Equities Have Less Upside Under Democratic Sweep There are two likely scenarios. The first is the risk that President Trump makes a historic comeback and wins re-election, with Republicans retaining the Senate. Subjectively we put Trump’s odds at 35% though our quantitative model suggests they could be as high as 44%. The second scenario is our base case that the Democratic Party wins the Senate as well as the White House. In this scenario, the Democrats will prove more left-wing and anti-corporate than the market currently expects. Bottom Line: A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. However, history shows that a clean sweep limits the market’s upside risk. And full Democratic rule entails major political risks that have a regional and sectoral character. Biden And The Blue Wave Our expectation of a blue sweep is not based only in polling – which is uniformly disastrous for Trump as we go to press – but in the surge in unemployment. The basis for investors to view Biden as a risk-on candidate is driven by the macro and market views outlined above, not political fundamentals. From the political point of view, Biden may prefer to govern as a centrist, but victory in the Senate would remove constraints on his party’s domestic agenda. He would move to the left. Indeed, a Democratic sweep would mark a paradigm shift in domestic economic policy that is negative for corporate profits and the capital share of national income. It would unleash pent-up ideological and generational forces in favor of redistributing wealth and restructuring the economy. Progressivism would have the tendency to overshoot and create negative surprises for investors (Chart 7). Unlike 2008-10, when Republicans were last out of power, Republicans this time would be divided over Trump and populism and would be unlikely to recuperate as quickly. Chart 7Democratic Party Would Focus On Inequality Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Biden would end up governing to the left of the Obama administration, promoting Big Government while restricting Big Business and re-regulating Wall Street banks. A sharp leftward turn would be in keeping with the trend in the Democratic Party and the generational shift in the electorate (Chart 8). Only if Republicans pull off a surprise and keep the Senate despite losing the White House (~10% chance) would Biden be forced to govern as a true centrist. Even then Biden would oversee a large re-regulation of the economy through executive powers alone (Chart 9).1 Chart 8Generational Shift Favors Wealth Redistribution Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Chart 9Biden Would Re-Regulate The Economy Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Additional reasons to expect a left-wing policy overshoot:  · Presidents tend to succeed in passing their initial legislative priority after an election. This is incontrovertible when they control both chambers of Congress, as Obama showed in 2009 and Trump showed in 2017.2 · Biden will have huge tailwinds. He will not be launching a new agenda so much as restoring a policy status quo in most cases (laws and agreements that Trump either revoked or refused to enforce). He will also benefit from majority popular opinion and support of the bureaucracy and media (Chart 10). · Biden and the Democrats will be even more determined not to “let a good crisis go to waste” after having witnessed the Obama administration’s frustrations the last time the party took over in a sweeping victory on the back of a national disaster. · Democrats will not hesitate to use the budget reconciliation process to pass their first priority legislation with a mere 51 votes in the Senate. This is how Trump passed the Tax Cut and Jobs Act (TCJA). This is also how progressive stalwart Howard Dean believed the party should have passed a public health insurance option in 2009. This means Biden will be capable of increasing the corporate tax rate higher than 28%, pass a minimum 15% tax rate for corporations, and raise the capital gains tax and individual taxes. Chart 10Popular Opinion Would Boost Biden Administration Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications · Contrary to consensus, Democrats are likely to remove the filibuster in the Senate – enabling bills to pass with a simple majority rather than the 60/100 votes required to close off debate. Yes, some moderate Democrats have already spoken out against “going nuclear” and changing such a critical norm. But populism and polarization are the driving forces in US politics today and we would advise investors not to bet heavily on “norms.” If Republicans prove capable of obstructing major legislative initiatives in the Senate, then Democrats, remembering obstructionism in the Obama years, will go nuclear to enact their progressive agenda. This would mark a massive increase in uncertainty for investors on everything from taxes to wages to anti-trust laws. Bottom Line: Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. If Republicans are obstructionist, Democrats will remove the filibuster. Biden’s Legislative Priorities First, Biden would seek to restore and expand the Affordable Care Act (Obamacare). The party has fixated on health care since 1992. Investors are complacent about Biden’s plan. A public health insurance option will be a major new progressive initiative that would undercut private health insurers over time (Chart 11). The bill will also impose caps on pharmaceutical prices and allow imports, reducing Big Pharma’s pricing power (Chart 12). Chart 11Health Insurers Will Be Undercut By Biden Public Option Health Insurers Would Be Undercut By Biden's Public Option Health Insurers Would Be Undercut By Biden's Public Option Investors are also complacent about taxation. Biden will pay for health care reform by partially repealing the Tax Cut and Jobs Act. He has proposed raising the corporate rate from 21% to 28%, but this could go higher and still fall well below the 35% that Trump inherited in 2017. Chart 12Big Pharma Faces Price Caps Big Pharma Faces Price Caps Big Pharma Faces Price Caps A rate above 28% would be a major negative surprise for financial markets and yet it is an obvious way for Democrats to raise much-needed revenue. Biden also intends to pass a 15% minimum tax that would hit large firms adept at paying lower effective taxes. Capital gains taxes and individual income taxes for high-earners could also rise by more than is expected (Table A1 in Appendix). Second, Biden will seek to offset the negative growth impact of falling stimulus and rising taxes by enacting large “Great Society” fiscal spending on infrastructure, the Green New Deal, education, and other non-defense discretionary spending (Table A2 in Appendix). Even defense spending will be largely kept flat due to rising geopolitical conflicts. As mentioned, this part of the agenda is reflationary, especially relative to a scenario in which fiscal largesse is normalized more rapidly by a Republican Senate. The redistribution effects would be marginally positive for household consumption, but marginally negative for corporate investment. On immigration, Biden will follow the Obama administration in pursuing a path to citizenship for “Dreamers” (illegal immigrants brought to the US as children) and taking executive action to allow more high-skilled workers and refugees, defer deportation of children and families, and reduce border security enforcement. There will be some constraints due to the risk of provoking another populist backlash, but comprehensive immigration reform is possible. This would be positive for potential GDP, agriculture, construction, and housing demand on the margin (Chart 13). On trade, Biden will have to steal some thunder back from Trump if he is to win the election and maintain the Rust Belt. He will concentrate his protectionist policy on China, while removing virtually all risk of a trade war with Europe, Mexico, or other partners. China may get a reprieve at first but Biden will ultimately prove hawkish (Chart 14). Investors are underrating the use of import duties to punish countries like China for carbon-intensive production. Chart 13Biden Lax Immigration Policy A Boon For Housing Biden Lax Immigration Policy A Boon For Housing Biden Lax Immigration Policy A Boon For Housing Biden will take a multilateral approach and restore international agreements that Trump revoked. Joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) is not a massive change given that even Trump agreed to trade deals with Canada, Mexico, and Japan. But it is marginally positive for the US-friendly trade bloc while contributing to the US economic decoupling from China (Chart 15). Chart 14Watch Out, Biden Won’t Be Too Dovish On China In Office! Watch Out, Biden Won’t Be Too Dovish On China In Office! Watch Out, Biden Won’t Be Too Dovish On China In Office! Chart 15Biden Eliminates Risk Of Global Trade War Ex-China Biden Eliminates Risk Of Global Trade War Ex-China Biden Eliminates Risk Of Global Trade War Ex-China On foreign policy, Biden will face the ongoing US-China cold war. He will also seek to restore the Iranian nuclear deal of 2015. The removal of Iran risk is positive for European companies with a beachhead in Iran as well as for the euro more generally, since regional instability ultimately threatens the EMU with waves of refugees (Chart 16). Chart 16Biden Removes Tail-Risk Of Iran War Biden Would Remove Tail-Risk Of Iran War (But Still A Risk Under Trump) Biden Would Remove Tail-Risk Of Iran War (But Still A Risk Under Trump) Bottom Line: A Biden presidency will lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. But Biden’s agenda is mostly reflationary in other respects. Blue Wave Equity Market And Sector Implications The most profound implication of a blue sweep of government is an SPX profit margin squeeze that will weigh heavily on EPS. Importantly, there are two clear avenues through which net profit margins will suffer: An increase in the corporate tax rate. A rise in labor’s share of national income. As a reminder these are two of the four primary profit margin drivers we discussed in detail in our “Peak Margins” Special Report last October (Chart 17). The other two are selling price inflation and generationally low interest rates. Odds are high that all four drivers are slated to dent S&P 500 margins. With regard to corporate tax rates, the mirror image of the one time fillip that SPX EPS enjoyed in 2018, owing to Trump’s 1.2% increase in fiscal thrust that year, is a drop in S&P 500 profits given that a Biden presidency will boost the corporate tax rate from 21% to 28% or higher. In early-December 2017 we posited that SPX EPS would jump 14% on the back of that fiscal easing package, which is very close to what actually materialized. Chart 18 compares S&P 500 EBIT growth with S&P 500 net profit growth. The 2018 delta hit a zenith of 16%. Chart 17Profit Margin Drivers Profit Margin Drivers Profit Margin Drivers Chart 18Spot Trump's Tax Cut Spot Trump's Tax Cut Spot Trump's Tax Cut Assuming a blue wave, the opposite would happen, i.e. net profit growth would suffer an 11% one-time contraction according to our calculations (Table 1). The bill would pass in 2021 and take effect in 2022. Importantly, Table 1 reveals that the hardest hit GICS1 sectors are real estate, tech and health care, and the ones faring the best are consumer staples, industrials and energy. Table 1What EPS Hit To Expect? Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Table 2S&P 600/S&P 500 Sector Comparison Table Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications The second way SPX margins undergo a squeeze is via climbing labor costs. Labor costs have been increasing since 2008/09 (labor’s share of income shown inverted, second panel, Chart 17), coinciding with the apex of globalization (third panel, Chart 17). A Biden presidency would also more than double the federal minimum wage to $15 per hour for all workers over six years. These policies would take a bite out of corporate profits by knocking down profit margins. While S&P 500 EPS maybe recover back to trend near $162 in 2021, they would gap lower in 2022 which is not at all priced in sell side analysts’ EPS expectations of $186. A blue sweep would produce some other US equity sore spots. Small caps would suffer disproportionately compared with their large cap brethren as would banks, health care, and parts of tech (see below). Chart 19 shows that according to the National Federation of Independent Business (NFIB) survey, small and medium enterprise (SME) owners grew extremely concerned about higher taxes and red tape by the end of the Obama presidency. When President Trump got elected, he cut back these fears drastically. Today concerns about taxes and regulation are probing multi-decade lows, which implies that SMEs are not prepared for the regulatory shock that a Biden administration has in store for them (Chart 19). These small business concerns will resurface with a vengeance if there is a blue sweep this November. The implication is that at the margin small caps would underperform their large cap peers, especially given that small cap indexes sport 1.5x the financials sector market cap weight compared with the SPX (Table 2). Bottom Line: A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps as they will have to vehemently contend with rising red tape and taxes. Chart 19Re-Regulation Will Weigh On Small Business Sentiment Re-Regulation Will Weigh On Small Business Sentiment Re-Regulation Will Weigh On Small Business Sentiment Historical Parallel Of Blue Sweeps And Select Sector Performance A more detailed discussion on banks, health care, and technology sectors is in order, as they are the likeliest candidates to be at the forefront of Biden’s regulatory, wage, and tax policies. There are two recent episodes when US presidential elections resulted in a blue sweep, namely in 1992 and 2008. Both times, Democrats took control of both chambers of Congress and the White House but eventually surrendered this trifecta two years later during the 1994 and 2010 mid-term elections.3 Charts 20 & 21highlight the S&P banks, S&P health care, and S&P IT sectors’ performance during the last two blue waves. In both cases, banks remained flat to down; health care equities went down sharply; while tech stocks had mixed results. Tech took off in 1993-1994, but remained flat in 2009-2010 (excluding the recovery rally off the recessionary trough). Armed with this general roadmap, we now dive deeper into each of these three sectors for a more detailed discussion. Chart 20Not Everyone Is A Fan... Not Everyone Is A Fan… Not Everyone Is A Fan… Chart 21...Of The Blue Sweeps ...Of The Blue Sweeps ...Of The Blue Sweeps Banks Face High Risk Of Re-Regulation There is little doubt that Biden will re-regulate Wall Street, especially after the recent COVID-19-related watering down of the Dodd-Frank Act. Big banks are popular scapegoats. In fact, Biden already moved to the left on bankruptcy reform by adopting Massachusetts Senator Elizabeth Warren’s progressive proposal after a long drawn-out battle over this issue between them. Both of the earlier blue wave elections proved challenging for the banking sector. In addition, banks are already under pressure from the recent Fed stress tests. There are high odds that a number of banks will further cut or suspend dividend payments in coming quarters in line with the Fed’s guidance, especially if profits take a big hit, as we expect. Currently, the market is underestimating the Biden threat to the banking sector as a substantial divergence has materialized between the banks’ relative performance and the blue sweep probability series (Chart 22). As the election draws closer, a repricing in the banking sector is likely looming. Chart 22Mind The Divergence Mind The Divergence Mind The Divergence Health Care Stands To Lose The Most From A Blue Sweep The health care sector was the only sector we analyzed that clearly underperformed in both 1992 and 2008 blue waves. Health care reform will be Biden’s top priority, as outlined above. Biden will also go after pharma manufacturers. As a reminder, while Medicare has substantial bargaining power with hospitals and other drug providers due to the number of Americans enrolled, it has no leverage when it comes to pharma manufacturers leaving them free to set prices at will. Biden intends to end such practices, enabling Medicare to bargain for prices. He also wants to link the rise in drug prices to inflation and allow foreign imports. These actions will put a cap on pharma manufacturers’ pricing power. Importantly, the S&P pharmaceuticals index is the dominant player within the S&P health care universe comprising 29% of the entire health care sector. A direct hit to pharma earnings will be a hard pill to swallow, especially if the S&P biotech index (comprising 17% of the S&P health care market cap weight) is included that are similar to Big Pharma as they manufacture blockbuster drugs. In fact, as the American electorate is getting more interested in Biden’s campaign, the market is pricing in a tougher environment for US pharmaceuticals (Chart 23). Markets can rely on the fact that Biden has rejected a single-payer government health system (“Medicare For All”) – this policy position helped him beat Vermont Senator Bernie Sanders for the Democratic nomination. However, he is proposing a public insurance option, which will have the ability to absorb losses indefinitely and will have the insurance regulators at its side. Thus private health insurers will be undercut. Chart 23Beginning Of The End Beginning Of The End Beginning Of The End A public option is also seen even by promoters as a “Trojan Horse” that will increase the odds that Democrats will move toward a single-payer system in 2024 or thereafter. Thus the risk/reward ratio skews further to the downside for the S&P health care sector. Will Technology Escape Unscathed? In the wake of COVID-19, and facing geopolitical competition in cyber space, a Biden administration will also seek a much stronger regulatory handle on Big Tech. Social media companies are already buttering up to the Democrats to ensure that Biden maintains the Obama administration’s alliance with Silicon Valley and does not pursue extensive anti-monopoly and anti-trust investigations. Yet the tech sector cannot avoid heightened scrutiny due to its conspicuous gains in the midst of an economic bust – this is what normally prompts anti-trust actions (Chart 24). The Democrats will pursue probes into data privacy and excessive market concentration and will demand stricter patrolling of the ideological space in battles that will be adjudicated by the courts. Chart 24How Much Is Too Much? How Much Is Too Much? How Much Is Too Much? Should the monopolistic tech stocks – including FB and GOOGL, which are now classified under the GICS1 S&P communication services index – be forced to sell their crown jewel assets, then a hit to earnings is a given. The S&P technology sector plus FB & GOOGL commands more than one third on the SPX index, meaning that a dent in tech earnings will have negative ramifications for the entire market. In previous research, we drew a parallel with the chemicals industry and the regulatory shock that came in 1976 when the Toxic Substance Control Act (TSCA) was introduced.The bill pushed chemical stocks off the cliff as investments in the index became dead money for a whole decade – until 1985 when chemicals finally troughed (Chart 25) In the near future, a similar shock might come as a result of privacy-related regulation. A series of anti-monopoly or anti-trust probes, whether by the US or the EU, would make investors cautious about their tech exposure. While the probes may not result in a break-up, the heightened uncertainty would dampen the allure of tech stocks. The pattern of anti-trust probes in US history is that a probe first causes a selloff in the stock of the company investigated; then another selloff occurs when it is clear that a break-up is a real option under consideration; then a buying opportunity emerges either when the company is cleared or when the long dissolution process is completed. Bottom Line: While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Chart 25Will History Rhyme? Will History Rhyme? Will History Rhyme?     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Appendix Table A1Biden Would Raise $4 Trillion In Revenue Over Ten Years Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Table A2Biden Would Spend $6 Trillion In Programs Over Ten Years Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications   Footnotes 1     Republicans have 13 Senate seats at risk this cycle while Democrats have only four. More conservatively, Republicans have nine at risk while Democrats have two. Opinion polling has Democrats leading in seven out of nine top races, and tied in the other two – including states like Kansas where Democrats should have zero chance. Most of these races are tight enough that they will hinge on whether the election is a referendum on Trump. If so, Democrats will likely win the net three seats they need to control the chamber. Most likely they will have a 51-49 majority if Biden wins, though a 52-48 balance is possible.   2     The Republican failure to repeal and replace Obamacare in 2017 but success in passing the Tax Cuts and Jobs Act reflects the fact that political constraints are higher on taking away an entitlement than they are on giving benefits (tax cuts). 3    As noted above, however, investors today cannot be assured that Republicans will come roaring back in 2022 to impose constraints. Trump’s populism threatens to divide the party if he loses and delay its ability to regroup and recover.  

Highlights Policymakers vs. the virus remains the story at the macro level: Fiscal support is the wild card, but we expect Senate hawks, caught between the House and the White House, will roll over in the end. The economy is perking up, but it is still too vulnerable to stand on its own: The direction is improving as the economy reopens, but the level still stinks and COVID-19 has not gone away. We’ve reached an accommodation with rich index valuations, … : The alternatives are dismal, the preponderance of professional investors have to participate and the possibility of positive virus surprises cannot be dismissed. … but there’s plenty of silliness at the individual stock level: Retail investors, running amok like Donald Duck’s nephews, appear to have triggered some remarkable moves, especially in small stocks. Feature The big picture remains unchanged, but the view from ground level is becoming increasingly disorienting. The dizzying activity in vulnerable industries and select micro-caps resembles nothing so much as a beach bar after final exams. Sun, noise, adrenaline and a sense of overdue release have come together to wash away any and all inhibitions or standard rules. The pull has been especially strong for newcomers to the scene. We suspect that some of the unusual action in individual equities over the last several weeks may have its origins in an upsurge of active retail participation. Waves of retail interest come and go like the tides, albeit irregularly, and the only thing new about the current iteration, with its smart phone apps and zero commissions, is that it is nearly frictionless. We have nothing against retail investors – we’ve been one since directing our paper route earnings to the purchase of odd lots in Ronald Reagan’s first term – and don’t see them as a portent of doom. Their moves are drawing attention, though, so we review freely available daily data to try to gain some insight into their recent activity and ongoing interest. Novices Versus Experts Chart 1Baseline Change In Robinhood Equity Ownership The Democratization Of Equity Investing The Democratization Of Equity Investing Robinhood is a deep-pocketed retail brokerage oriented toward novice investors. Although its customers’ balances are almost certainly small, it has over 10 million of them, and it has made a profound impact on the industry by pioneering commission-free trading. Data on its customers’ holdings are aggregated and uploaded several times throughout the day to the dedicated website robintrack.net. They are cumbersome – the full database contains over 8,000 spreadsheets – so we focused our analysis on Robinhood customers’ holdings in airlines, cruise ships and selected mortgage REITs. We found that the number of Robinhood accounts owning these stocks exploded since late March, but that datapoint cannot be considered in isolation because the number of accounts has been rising. Robinhood added over 3 million new accounts in the first four months of the year, an increase of as much as 30% from its year-end customer base.1 A blizzard of anecdotal reports characterizing day trading as a substitute for following professional sports reinforce the notion that ownership of all stocks has risen. To get a sense of how baseline equity holdings have changed since the S&P 500 peak on February 19th, we looked at the number of Robinhood accounts holding Apple (AAPL) and the iShares (SPY) and Vanguard (VOO) S&P 500 Index ETFs, and found they have all roughly doubled (Chart 1). Making equity investing more democratic may be a noble aim, but democracy can be messy. By contrast, the number of Robinhood accounts holding six large- and mid-cap airlines has risen 48 times, with component holdings of United (UAL) and Spirit (SAVE) leading the way at 87 and 81 times, respectively (Chart 2, top two panels), and Southwest (LUV) and Jet Blue (JBLU) bringing up the rear at 12 and 21 times, respectively (Chart 2, bottom two panels). The number of accounts owning cruise lines is up 177 times, on average, powered by Norwegian (NCLH), which has increased a remarkable 365 times (Chart 3, top panel). If Robinhood’s customers are representative of the retail investor population, betting that the pandemic will not be fatal for passenger airlines and cruise lines has become an extremely popular pursuit. Chart 2Buying The Dip In The Airlines The Democratization Of Equity Investing The Democratization Of Equity Investing Chart 3Stampeding Into The Cruise Lines The Democratization Of Equity Investing The Democratization Of Equity Investing Chart 4Unafraid Of Falling Knives The Democratization Of Equity Investing The Democratization Of Equity Investing Robinhood customers have also eagerly attempted to rescue ailing mortgage REITs. Mortgage REITs apply several turns of short-term leverage to their mortgage portfolios to fund generous dividend yields that typically range between the high single and low double digits. Mortgage REITs that invest solely in agency mortgage-backed securities (MBS) were stressed when credit spreads blew out in March, but hybrid REITs with sizable concentrations of illiquid non-agency MBS and whole loans faced an existential crisis. Three hybrids – Invesco Mortgage Capital (IVR), MFA Financial (MFA) and AG Mortgage Investment Trust (MITT) – failed to meet margin calls from their repo lenders. MFA and MITT have indefinitely suspended their dividends, while IVR cut its dividend by 96% last week. The companies’ futures were in doubt in late March and early April, but Robinhood customers have poured into the breach. The number of accounts holding the stocks has risen 93-fold, on average, since the S&P 500 peaked in February, with IVR leading the way at 149 times (Chart 4, top panel). Robinhood customer interest began to surge when the three stocks bottomed but increasing numbers of accounts have added them to their portfolios all throughout a turbulent May and June. The stocks are not yet out of the woods and sell-side analysts have panned their recent surges, as it is unclear who else will want to own them when they don’t pay dividends. Stocks from the groups we highlighted all face daunting current predicaments. They might deliver sizable returns if they can emerge mostly unscathed but that is a big if. They have come to account for an outsized share of Robinhood customers’ holdings (Table 1), especially relative to their market capitalizations. Retail treasure hunting may account for some of the recent surges that seemed to spite fundamentals, but we doubt that a community of first-time investors has the heft to move any but the smallest stocks. We suspect that algorithms, hedge-funds and other fast-money pools of capital may be amplifying the momentum that retail activity has set in motion. Retail investors have provided institutions with an opportunity to exit stocks in the three stressed groups. Per weekly data on the level of institutional holdings from Bloomberg, the composition of ownership of all twelve stocks we examined has shifted materially from institutions to individuals (Table 2). In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. Instead of amplifying volatility, they may have tamped it down, while helping to speed the redeployment of institutional capital. Table 1Searching The Bargain Bin The Democratization Of Equity Investing The Democratization Of Equity Investing Table 2Individuals Have Replaced Institutions The Democratization Of Equity Investing The Democratization Of Equity Investing   Direction Versus Level Many investors lament that the equity rally has occurred without regard for fundamental conditions or in seeming defiance of them. The imposition of rigorous social distancing measures to slow the spread of COVID-19 immediately induced a sharp recession, but the economy has begun to bounce back, and a further rollback of virus containment measures will help it build forward momentum. The latest NAHB survey demonstrated that housing is making rapid strides, with buyer traffic smartly reviving (Chart 5, third panel) and builders’ sales expectations snapping back (Chart 5, bottom panel). May housing starts came in well short of the consensus expectation, but leading building permits indicate that a pickup is just around the corner, and the purchase mortgage applications index hit its highest level in eleven years last week (Chart 6). Chart 5Housing Is Coming Back Fast Housing Is Coming Back Fast Housing Is Coming Back Fast Chart 6Low Rates Help The Real Economy, Too Low Rates Help The Real Economy, Too Low Rates Help The Real Economy, Too The various regional Fed manufacturing surveys all bounced in May, and the June Philly Fed (Chart 7, top panel) and Empire State (Chart 7, second panel) readings extended the trend, zooming far past expectations. Their moves bode well for the Richmond, Kansas City and Dallas Fed readings due out this week and next. They are not all the way back to their pre-pandemic levels, but they’re moving in the right direction and point to a continued pickup in manufacturing activity (Chart 8). Chart 7Gaining Traction Gaining Traction Gaining Traction The economic surprise index hit an all-time high last week (Chart 9), reinforcing the point that the improvement in the direction of economic activity is widespread. Activity has not returned to pre-pandemic levels, and it won’t for a while, but it is beginning to pick up or at least weaken at a slower rate. As states progress through their reopening phases, the direction will continue to improve and the level will get closer to its previous position. Chart 8Weak Level, Improving Direction Weak Level, Improving Direction Weak Level, Improving Direction Chart 9Uncoiling The Spring Uncoiling The Spring Uncoiling The Spring A resurgence in infection rates, or a second wave like the one that appears to be emerging in China, is a threat to ongoing economic improvement. Some states which have moved more rapidly to reopen are experiencing increasing infection rates, but they will only see reversals in economic activity if they revert to strict social distancing measures. It is becoming steadily apparent that most communities, here and abroad, no longer have the stomach for broad lockdowns. It seems that government officials are willing to trade a modest pickup in infections for a pickup in economic growth and individuals are willing to trade an increased risk of infection for a return to some sense of normal life. A severe re-emergence could change the calculus, but for now there is powerful momentum to advance along the path to restarting the economy. Policymakers Versus The Virus A record-high economic surprise index distills the improved direction across a broad sweep of indicators. Our view that Washington will extend fiscal lifelines to households, businesses and state and local governments is still intact. Negotiations over an infrastructure spending initiative are progressing, and we expect a successor to the CARES Act will follow before the end of July. As we’ve discussed before, it is simply too risky politically for Senate Republicans to obstruct aid efforts heading into the homestretch of the campaign. Robust fiscal support, combined with whatever-it-takes monetary support from the Fed, should be enough to see the economy across the pandemic abyss provided that testing bottlenecks are resolved and treatment protocols advance. Investment Implications Wagging a finger at retail investors is not our style. Increased retail participation has probably catalyzed some unexpected equity outcomes but the only outright distortions we’ve seen have occurred in micro-cap stocks and do not have a larger macro resonance. Retail participation in the stock market has always waxed and waned, but major market and economic impacts like the dot-com bubble are rare. We therefore do not believe that equities have become unmoored from reality and that a threatening bubble has formed. The fundamental backdrop has improved. The economy is nowhere near recovering its pre-pandemic levels, but the stock market is a forward-discounting mechanism and direction regularly trumps level. There is surely some froth in the market, and 24 times forward four-quarter earnings is a pricey multiple for the S&P 500, especially when it seems that earnings expectations beyond 2020 are overly optimistic. Retail participation in equities comes and goes, and it rarely proves disruptive at the overall index level. There are also plenty of ways that the virus could spring a nasty surprise, and financial markets seem to be ignoring them. Our geopolitical strategists see scope for turbulence at home, as the administration tries to improve its re-election prospects, and abroad, as any of several hot spots from Iran to North Korea to the South China Sea could flare up. The potential for negative surprises, as well as the furious equity rally, keeps us equal weight equities and overweight cash over the tactical timeframe. We remain constructive on equities over a 12-month horizon, however, as things are moving in the right direction and the alternatives – cash with zero yields and Treasuries with microscopic yields – are so unappealing.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Robinhood announced that it had surpassed the 10-million-customer mark in December.

Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q:  And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around   Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Stocks That Are Popular With Retail Investors Are Outperforming Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Equity Risk Premium Is Still Quite High Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Day Trading Is Back In Vogue These Days Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3  For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017.   Global Investment Strategy View Matrix Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Current MacroQuant Model Scores Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A