Market Returns

Highlights European small-cap equities have structurally outperformed large-cap stocks. This outperformance echoes the desirable sectoral biases of small-cap stocks. It also reflects the inability of European large-cap stocks to expand their markups, unlike US large caps. The pro-cyclicality of European small-cap stocks and the limited correlation of their relative performance to the Chinese credit cycle make them an attractive play in European portfolios. The current risk-off phase in global markets suggests it is still too early to buy European small-cap stocks, but an opportunity to overweight them will emerge in the coming weeks. Feature Markets last week were volatile and corrected sharply. This fit with the view expressed in our previous strategy report, which argued that the near-term outlook for European equities was still clouded by the confluence of the coming Fed tightening and a Chinese economic slowdown.  Chart 1Ebbing COVID Allows For Central Bank Repricing Ebbing COVID Allows For Central Bank Repricing Ebbing COVID Allows For Central Bank Repricing The market seems especially concerned by the deterioration in liquidity conditions. The Delta wave is ebbing around the world (Chart 1) and inflation is proving to be stickier than policymakers had originally anticipated. As a result, investors appear to be pricing in the potential implications of central banks moving from being behind the curve to ahead of the curve. Moreover, surging natural gas prices in Europe, empty gas stations in the UK, labor shortages around the world, and steep automobile production cuts by major players like Toyota and GM raise the specter of stagflation. In this context, bond yields are rising and stocks are agitated. The dollar’s rally further tightens global financial conditions and adds to the systemic stress, which intensifies the very unsettling environment for investors. Consequently, seasonal October weakness remains on the table. Chart 2Tactical Vulnerabilities Remain Tactical Vulnerabilities Remain Tactical Vulnerabilities Remain We continue to see this selling phase as temporary. Sentiment will be consistent with a trough in risk assets soon (Chart 2). Additionally, Chinese authorities will reflate the economy much more aggressively than they have so far, even if it probably takes more market pain first. In this context, we focus on what to buy to take advantage of the eventual rebound in cyclical plays. This week, we look at European small-cap stocks that have handsomely outperformed their larger counterparts over the past ten years. In Europe, Small Is Beautiful Chart 3Small Caps Lead In Europe Small Caps Lead In Europe Small Caps Lead In Europe The underperformance of European stocks relative to the US over the past 13 years is well known by investors. Less known is that, since 2012, European small-cap stocks have performed roughly in line with their US counterparts. In other words, European small-cap stocks have massively outperformed Euro Area equity benchmarks (Chart 3). Two forces explain the ability of European small caps to beat their larger competitors by 85% since the Great Financial Crisis. The sectoral composition of European small-cap indexes helped them outperform their larger competitors. Using MSCI benchmarks, the small-cap index largest overweight are industrials and real estate, compared to financials, healthcare, and consumer staples for large caps (Table 1). Industrials have been one of the best performing sectors in the cyclicals and value categories, while financials have greatly suffered. Meanwhile, real estate equities enjoy falling yields, while financials hate them. This dichotomy explains why European small caps outperformed as European yields collapse (Chart 4). It is also why, unlike in the US, the relative performance of European small-cap equities exhibits little correlation with the slope of the yield curve. Table 1Small Caps Overweighs The Right Sectors Small Caps Win Big? Small Caps Win Big? Chart 4European Small Caps Like Lower Bund Yields European Small Caps Like Lower Bund Yields European Small Caps Like Lower Bund Yields The poor performance of the European large-cap stocks is the second element explaining the outperformance of European small caps. The European large-cap stocks lie at the heart of Europe’s underperformance relative to the US, not the smaller firms. According to researchers De Loecker, Eeckhout, and Unger, US firms have grown their markups massively since the 1980s (Chart 5).1 These expanding markups reflect a growing market power, which is the result of rising market concentration among the dominant players in nearly all the industries.2 In fact, Grullon, Larkin & Michaely show that industries with a greater level of concentration also display higher levels of RoA (Chart 6).3 The problem for European large firms is that they have not experienced the same increase in industry concentration as US businesses. Research by the OECD demonstrates that industry concentration rose significantly more in the US than in Europe over the past 20 years (Chart 7). This is particularly true in the service sector (Chart 7, middle panel) and the less digital-intensive industries (Chart 7, bottom panel).4 Chart 5Higher US Markups Small Caps Win Big? Small Caps Win Big? Chart 6As Concentration Increases, So Do RoAs Small Caps Win Big? Small Caps Win Big? Chart 7Europe Did Not Witness The Same Increase In Concentration Small Caps Win Big? Small Caps Win Big? Without this increase in market power, European large caps could not experience a meaningful pick up in their RoEs relative to those of small-cap stocks. They have therefore been fully victim to their sector composition and massively underperform smaller firms as well as US large businesses. Bottom Line: The structural outperformance of European small caps relative to large-cap stocks reflects the former’s large overweight in industrials and real estate stocks compared to the latter’s overrepresentation of financials, healthcare, and consumer staples names. Additionally, the inability of large-cap European names to increase industrial concentration has prevented them from mimicking the extraordinary growth in markups and RoE witnessed in the US. As a result, European small-cap names could massively beat their larger counterparts. Can The Outperformance Continue? The structural outperformance of small caps will become challenged if Europe experiences a structural increase in yields, which will hurt real estate stocks while helping financials. This sectoral effect will result in a structural outperformance of European stocks. On a cyclical horizon, however, the outlook continues to favor small-cap over large-cap equities in Europe and the Eurozone. Chart 8The Relative Performance Of European Small Caps is Procyclical Small Caps Win Big? Small Caps Win Big? As in the US, the relative performance of European small-cap stocks is pro-cyclical. As Chart 8 shows, small-cap stocks generate the largest excess returns at the beginning of business cycle upswings. They continue to outperform, as long as the business cycle points up. Only once a slowdown begins do small- cap names underperform. Similarly, the relative performance of small-cap equities correlates closely with the Euro Area Manufacturing PMI (Chart 9). It also displays a negative correlation with high-yield spreads (Chart 9, middle panel). Additionally, small-cap stocks track the evolution of inflation swaps (Chart 9, bottom panel). This behavior of small caps means that they remain an attractive bet over the next 18 to 24 months. The European economy is likely to continue to grow robustly over the coming two years and thus stay in the quadrant where small caps outperform. Moreover, the ECB’s policy will generate very accommodative monetary conditions for an extended period. Hence, European high-yield bonds will continue to outperform safe havens and the labor market will tighten further, which will help CPI swap climb up. Despite this procyclicality, the relative performance of small-cap stocks displays only a loose correlation with the European cyclical/defensive split (Chart 10). Moreover, small caps do not correlate closely with commodity prices (Chart 10 middle panel). These two observations reflect the limited relationship between the relative performance of small-cap equities and the Chinese credit impulse (Chart 10, bottom panel). The small caps’ lack of sensitivity to the Chinese economy is the consequence of their lower international bent compared to that of large-cap firms. Chart 9More Signs Of Procyclicality More Signs Of Procyclicality More Signs Of Procyclicality Chart 10Low Correlation To China Plays Low Correlation To China Plays Low Correlation To China Plays This low correlation with Chinese economic variables is likely to prove another asset for small-cap equities. As we have witnessed with the Evergrande saga or the rotating crackdowns from one industry to the next, China will remain a source of uncertainty for the global economy and global capital markets for the foreseeable future. Thus, a low-correlation relative performance is an attractive attribute. Chart 11Not Particularly Cheap Not Particularly Cheap Not Particularly Cheap European small-cap stocks are not without blemish. Unlike in the US, they trade at a premium to large-cap stocks on many valuation metrics. For example, their price-to-forward earnings, price-to-trailing earnings, price-to-cash flow ratios and dividend yields stands at 21 vs 16, 35 vs 35, 18 vs 10 and 1.2% vs 2%, respectively. True, small-cap indexes carry a large proportion of companies with negative earnings. Adjusting for this characteristic, the forward P/E ratio falls to 15.12, which is just under the similarly adjusted forward P/E ratio of the Eurozone benchmark. Our Composite Small Cap Relative Valuation Indicator, which amalgamates this information, is directly in the neutral zone (Chart 11). The neutral relative valuation of small-cap stocks is a handicap because they sport operating metrics that are worse than their larger cousins. Their RoE are a meagre 6.3% vs 7.7%. Moreover, forward earnings have rebounded sharply already and long-term growth expectations are lofty (Chart 12). This leaves the euro as the ultimate arbiter of the path of European small caps. As Chart 13 illustrates, the trade-weighted euro closely tracks the relative performance of the Euro Area small-cap benchmark. This reflects the more domestic nature of small caps, but also, their procyclicality, which mimics that of the euro. Chart 12Some Good News In The Price Some Good News In The Price Some Good News In The Price Chart 13A Play On The Euro A Play On The Euro A Play On The Euro Chart 14A Weaker Yuan Could Lift The Dollar A Weaker Yuan Could Lift The Dollar A Weaker Yuan Could Lift The Dollar The euro continues to face near-term hurdles, which creates a problem for small-cap stocks. The dollar is catching a bid as the Fed moves closer to its tapering and eventual rate hike. Moreover, interest rate differentials between China and the US are narrowing, which will weigh on the yuan (Chart 14). A weaker CNY often causes EM currencies to depreciate and puts downward pressure on the euro. Furthermore, if the global equity correction perdures a few more weeks, the dollar will benefit from additional risk-off flows, which will also hurt the euro. Beyond these near-term risks, BCA’s foreign exchange strategists continue to hold a positive cyclical outlook on the dollar. The greenback’s defining characteristic is its counter-cyclicality. Thus, BCA’s expectation that the period of risks to global growth is temporary also means that the dollar’s rally has a finite life. As we argued last week, Chinese policymakers are unlikely to let the economic deterioration fester for too long, as it would risk uncontrolled deleveraging pressures. Moreover, global capex and inventory trends also point toward a growth re-acceleration in the first half of 2022.  In this environment, the euro—which still behaves as the anti-dollar—will be able to regain its footing. Therefore, we will not chase EUR/USD below the 1.15 - 1.12 zone.  Chart 15History Rhymes History Rhymes History Rhymes The near-term risks to the euro and small-cap stocks create a buying opportunity for investors with a 12- to 18-month investment horizon. A short period of small-cap underperformance will allow small-cap equities to digest completely the period of outperformance that took place between March 2020 and June 2021 (Chart 15). It will also follow the pattern of the past ten years, wherein periods of outperformance last 18 to 24 months and are followed by a short decline before resuming anew.  Bottom line: Small-cap stocks are an attractive vehicle to bet on pro-cyclical assets in Europe. They have benefited from a structural outperformance as a result of their attractive sectoral profile. Moreover, their relative performance strengthens when the global business cycle is in expansion, yet it is a rare cyclical asset with a limited correlation to Chinese credit trends. European small-cap stocks are tightly correlated with the trade-weighted euro. In the near term, this could cause a period of underperformance to develop; however, this is a buying opportunity for investors with a 12- to 18-month investment horizon. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1J. De Loecker, J. Eeckhout, G. Unger, “The Rise Of Market Power And The Macroeconomic Implications,” Mimeo 2018. 2Please see The Bank Credit Analyst Section II "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bcaresearch.com 3G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 4Bajgar, M., et al. (2019), “Industry Concentration in Europe and North America,” OECD Productivity Working Papers, No. 18, OECD Publishing, Paris, https://doi.org/10.1787/2ff98246-en. Tactical Recommendations Small Caps Win Big? Small Caps Win Big? Cyclical Recommendations Small Caps Win Big? Small Caps Win Big? Structural Recommendations Small Caps Win Big? Small Caps Win Big? Closed Trades Small Caps Win Big? Small Caps Win Big? Currency Performance Fixed Income Performance Equity Performance

HighlightsSince 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance.There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon.In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples.Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US.The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements.Feature Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis  The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities.In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar.We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements.A Deep Examination Of US Outperformance Since 2008Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are:Total revenue growth for each equity market, in local currency termsThe change in profit marginsThe impact of changes in capital structure and index compositionThe change in the trailing P/E ratioThe income return from dividendsThe impact of changes in foreign exchangeThe sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth October 2021 October 2021  Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends.Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects.Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar October 2021 October 2021  Box II-1Proxying The Impact Of Changes In Shares OutstandingWe proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects.However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It October 2021 October 2021  Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period.What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based October 2021 October 2021  The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services.Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion.Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks October 2021 October 2021  Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension… There Has Been A Strong Style Dimension... There Has Been A Strong Style Dimension...   Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition ...To The Impact Of Changes In Capital Structure And Index Composition ...To The Impact Of Changes In Capital Structure And Index Composition   Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally  The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally.The Relative Secular Return Outlook For US StocksWe present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis.Profit MarginsChart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks  Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real October 2021 October 2021  Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.1 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation.But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.”On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors.Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems.In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive).Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models October 2021 October 2021  Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize.Capital Structure And Index CompositionAs noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US.In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments.However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates.Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks? Can The US Continue To Accrete EPS Through Stock Buybacks? Can The US Continue To Accrete EPS Through Stock Buybacks?   Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers US Growth Companies Are No Longer Generating More Cash Than Their Global Peers US Growth Companies Are No Longer Generating More Cash Than Their Global Peers   Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years.Equity MultiplesThere are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade  Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity US Multiples Are Not Justified By Higher Return On Equity US Multiples Are Not Justified By Higher Return On Equity  Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close.Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The US Stock Market Is Now Extremely Concentrated The US Stock Market Is Now Extremely Concentrated  The Foreign Exchange EffectAs a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance.The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance... The US Dollar Has Helped US Common Currency Performance... The US Dollar Has Helped US Common Currency Performance...   Chart II-18…And Is Now Expensive October 2021 October 2021   The Absolute Secular Return Outlook For US StocksOver a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall.For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade  Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… October 2021 October 2021  Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%.One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship ...But That Depends Heavily On The Tech Bubble / GFC Relationship ...But That Depends Heavily On The Tech Bubble / GFC Relationship  Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium.In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The US ERP Seems Normal Based On A Very Long Term History... The US ERP Seems Normal Based On A Very Long Term History...  The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields.This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades ...And Based On The Forward Earnings Yield Over The Past Four Decades ...And Based On The Forward Earnings Yield Over The Past Four Decades   Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time   We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.2In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade October 2021 October 2021  Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Future Returns From US Stocks Will Greatly Disappoint Investors Future Returns From US Stocks Will Greatly Disappoint Investors  Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over The Coming Year, Favor Value And Global Ex-US Stocks Over The Coming Year, Favor Value And Global Ex-US Stocks  Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US.Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era.Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements.Jonathan LaBerge, CFAVice PresidentThe Bank Credit AnalystFootnotes1  Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com2  Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com

Highlights The global fight against the Delta variant of COVID-19 continued to show progress in the month of September, but not without cost. Growth in services activity slowed meaningfully, which has likely delayed the return to potential output in the US until March of next year (at the earliest). However, even with this revised timeline, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. In this regard, the Fed’s likely decision at its next meeting to taper the rate of its asset purchases makes sense and is consistent with a first rate hike in the second half of 2022. The rise in long-maturity bond yields following this month’s Fed meeting is consistent with the view that 10-year Treasurys are overvalued and that yields will trend higher over the coming year. Fixed-income investors should stay short duration. The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. In our view, a detailed examination of shipping prices over the past 18 months points to a future pace of inflation that is not dangerously above-target, but does meet the Fed’s liftoff criteria. A mix-shift in consumer spending, away from goods and toward services, is not a threat to economic activity or S&P 500 earnings – so long as the decline in the former is not outsized relative to the rise in the latter. It will, however, disproportionately impact China, and could be the trigger for meaningful further easing by Chinese policymakers. In the interim, a catalyst for EM stocks may remain elusive. We continue to recommend an overweight stance toward value versus growth stocks and global ex-US versus the US, particularly in favor of developed markets ex-US. Investors should remain cyclically overweight stocks versus bonds, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months in response to higher long-maturity bond yields. Still, we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Feature The global fight against the Delta variant of COVID-19 continued to show progress in the month of September. Chart I-1 highlights that an estimate of the reproduction rate of the disease in developed economies has fallen below one, and the weekly change in hospitalizations in both the US and UK – the two countries at the epicenter of the Delta wave that have not reintroduced widespread COVID-19 control measures – have fallen back into negative territory. In addition, we estimate that approximately 6% of the world’s population received vaccines against COVID-19 in September, with now 45% of the globe having received a first dose and 33% now fully vaccinated. Pfizer’s announcement last week that it has found a “favorable safety profile and robust neutralizing antibody responses” from its vaccine trial in children five to eleven years of age suggests that the FDA may grant emergency use authorization within weeks, which would likely raise the vaccination rate in the US (and ultimately other advanced economies) by at least 5 percentage points in fairly short order. This would also further reduce the impact of school/classroom closures on the labor market, via both an increased participation rate and increased hiring in the education sector. This fight, however, has not been without cost. US jobs growth slowed significantly in August, manufacturing and services PMIs continued to slow in September, and, as Chart I-2 highlights, the normalization in transportation use that was well underway in the first half of the year has clearly inflected in both the US and UK in response to the spread of Delta. Consensus market expectations for Q3 growth have been cut in the US, and to a lesser extent in the euro area, and the Fed reduced its forecast for 2021 real GDP growth from 7% to 5.9% following the September FOMC meeting. Chart I-1The Delta Wave Continues To Abate... The Delta Wave Continues To Abate... The Delta Wave Continues To Abate... Chart I-2...But At A Cost To Economic Activity ...But At A Cost To Economic Activity ...But At A Cost To Economic Activity   The Path Toward Eventually Tighter Monetary Policy It has been surprising to some investors that the Fed has moved forward with their plans to taper the rate of its asset purchases against this backdrop of slowing near-term growth – an event that now seems likely to occur at its next meeting barring a disastrous September payroll report. In our view, this is not especially surprising, given that the Fed has expressed a desire for net purchases to reach zero before they raise interest rates for the first time. Chair Powell noted during last week’s press conference that FOMC participants felt a “gradual tapering process that concludes around the middle of next year is likely to be appropriate”, underscoring that the Fed wants the flexibility to raise interest rates in the second half of next year. The timing of the first Fed rate hike is entirely subject to the evolution of the economic data over the next year, and is not, in any way, calendar-based. But we presented in last month's Special Report why the Fed’s maximum employment criteria may be met as early as next summer,1 and the Fed’s projections for the pace of tapering are consistent with our analysis. Chart I-3Maximum Employment Remains A Very Possible Outcome By Next Summer Maximum Employment Remains A Very Possible Outcome By Next Summer Maximum Employment Remains A Very Possible Outcome By Next Summer The Fed’s most recent Summary of Economic Projections (“SEP”) also seemingly confirmed Fed Vice Chair Richard Clarida’s view that a 3.8% unemployment rate is consistent with maximum employment, barring any issues with the “breadth and inclusivity” of the labor market recovery. We noted in last month’s report that these issues are unlikely in a scenario where jobs growth is sufficiently high to bring down the unemployment rate below 4%. Chart I-3 highlights that both the Fed’s forecast and Bloomberg consensus expectations imply a closed output gap by March, even after factoring in the near-term impact of the Delta variant. Consequently, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. Long-maturity bond yields rose following the Fed meeting, which is also not especially surprising given how low yields have fallen relative to the fair value implied by the Fed’s SEP forecasts even assuming a December 2022 initial rate hike. Chart I-4 highlights that the fair value of the 10-year Treasury yield today is roughly 2% using this approach, rising to 2.15% by next summer. Ironically, the September SEP update modestly lowered the fair value shown in Chart I-4 relative to what would otherwise have been the case, as it implied that the Fed is expecting to raise interest rates at a pace of approximately three hikes per year – rather than the four that prevailed prior to the pandemic. Investors should also note that the fair value for the 10-year yield is nontrivially lower based on market participant and primary dealer estimates of the terminal Fed funds rate (also shown in Chart I-4), although they still imply that long-maturity yields should trend higher over the coming year. Global Trade, Inflation, And The Fed A return to maximum employment will likely signal the onset of monetary policy tightening, as long as the Fed's inflation criteria for liftoff have been met. For now, inflation is signaling a green light for hikes next year, even after excluding the prices of COVID-impacted services and cars (Chart I-5). In fact, more recently, CPI ex-direct COVID effects has been pointing in the “non-transitory” direction, which continues to prompt questions from investors about whether the Fed will be forced to hike earlier than it currently expects for reasons other than a return to maximum employment. Chart I-4US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year Chart I-5For Now, Inflation Is Signaling A Green Light For Hikes Next Year For Now, Inflation Is Signaling A Green Light For Hikes Next Year For Now, Inflation Is Signaling A Green Light For Hikes Next Year   At least some portion of the current pace of increase in consumer goods prices is tied to surging import costs, which have run well in-excess of what would be predicted by the relationship with the US dollar (Chart I-6). This, in turn, is being driven by an explosion in shipping costs that has occurred since the onset of the pandemic, which is being driven both by demand and supply-side factors (Chart I-7). Chart I-6US CPI Is Being Affected By Surging Import Prices... US CPI Is Being Affected By Surging Import Prices... US CPI Is Being Affected By Surging Import Prices... Chart I-7...Which Are Being Driven By An Explosion In Shipping Costs ...Which Are Being Driven By An Explosion In Shipping Costs ...Which Are Being Driven By An Explosion In Shipping Costs   The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. To the extent that demand side factors are mostly responsible, investors should have higher confidence that the recent surge in consumer prices is transitory, because a shift away from above-trend goods spending and toward below-trend services spending is likely over the coming year. If supply-side factors are mostly responsible, then it is conceivable that the global supply chain impact on consumer goods prices will persist for longer than would otherwise be the case, potentially raising the odds of a larger or more sustained rise in inflation expectations. In our view, a detailed examination of shipping prices over the past 18 months points to a mix of both demand and supply effects, even since the beginning of 2021. However, as we highlight below, several facts point toward the view that supply-side factors will be the dominant driver over the coming year, and that they are more likely to exert a disinflationary/deflationary rather than inflationary effect: Chart I-8 breaks down the cumulative change in the overall Freightos Baltic Index by route since December 2019. The chart makes it clear that shipping costs from China/East Asia to the West Coast of the US have risen far more than any other route, underscoring that US demand for goods has been an important part of the rise in shipping costs. Chart I-8US Demand For Goods Is An Important Part Of The Shipping Cost Story October 2021 October 2021 Chart I-9US Goods Spending Has Clearly Been Boosted By US Fiscal Policy US Goods Spending Has Clearly Been Boosted By US Fiscal Policy US Goods Spending Has Clearly Been Boosted By US Fiscal Policy Chart I-9 shows the level of real US personal consumption expenditures on goods relative to its pre-pandemic trendline, underscoring both that goods spending is currently well-above trend, and that there have been two distinct phases of rising goods spending: from May to October 2020 following the passage of the CARES act, and from January to March 2021 following the December 2020 extension of UI benefits and in anticipation of the passage of the American Rescue Plan. Since March, US real goods spending has trended lower, a pattern that we expect will continue over the coming year. Chart I-10 highlights that while the global supply chain struggled heavily last year in response to surging demand and the lagging effects of labor shortages and factory shutdowns during the earliest phase of the pandemic, there were some signs of supply-side normalization in the first half of 2021. The chart highlights that the number of ships at anchor at the Los Angeles and Long Beach ports declined meaningfully from February to June, and global shipping schedule reliability tentatively improved in March. The chart also shows that shipping costs from China/East Asia to the West Coast of the US continued to rise in Q2 seemingly as a lagged response to the Jan-Mar rise in goods spending, but they were still low at the end of June compared to today’s levels. Chart I-10Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs In Q3, circumstances drastically changed. Shipping costs between China/East Asia to the West Coast of the US rapidly doubled, and the number of ships at anchor at the LA/LB ports exploded well past its peak in early February. This rise in China/US shipping costs since late-June has accounted for nearly 60% of the cumulative rise since the pandemic began, and cannot be attributed to increased demand. Instead, the increase in prices and the surge in port congestion in Q3 appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Yantian is the fourth largest port in the world and exports a sizeable majority of global electronics given its close proximity to Shenzhen, underscoring the impact that its closure likely had on an already bottlenecked logistical system. There are two key points emanating from our analysis of global shipping costs. First, demand has been an important effect driving costs higher, but it does not appear to have driven most of the increase in shipping costs this year. Still, over the coming year, goods demand in advanced economies is likely to wane as consumer spending shifts from goods to services spending, which will help ease clogged global trade channels and lower shipping costs. Second, the (brief) evidence of supply-side normalization in the first half of 2021, when consumer demand was actually strengthening, suggests that the supply-side of the global trade system will turn disinflationary over the coming year if further COVID-related labor market shocks can be avoided. What does this mean for the Fed and the prospect of monetary policy tightening next year? In our view, the combination of a positive output gap, stable but normalized inflation expectations, and disinflation (or outright deflation) in COVID-related goods and services (including import prices) is likely to lead to a pace of inflation that meets the Fed’s liftoff criteria. Chart I-11 highlights that important longer-term inflation expectations measures have recently been well-behaved, despite a surge in actual inflation and shorter-term expectations for inflation. Aided by disinflation/deflation in certain high-profile COVID-related goods and services prices, this argues against meaningful upside risks to inflation. However, the current level of long-term expectations and the fact that the output gap is set to turn positive in the first half of next year argues against the notion that inflation will fall below target outside of COVID-related effects. As such, we continue to expect that the Fed will raise interest rates next year, potentially as early as next summer, driven by the progress towards maximum employment. Spending Shifts And The Equity Market We noted above, and in previous reports, that consumer spending in advanced economies is likely to continue to shift away from goods and toward services over the coming year. This raises the question of whether a contraction in goods spending will weigh disproportionately on the economy and equity earnings, given the close historical correlation between manufacturing activity and the business cycle. Chart I-12 illustrates this risk: in a hypothetical scenario in which real goods spending were to return to the trendline shown in Chart I-9 by March of next year, it would contract on the order of 10% on a year-over-year basis, on par with what occurred last year and vastly in excess of what even normally occurs during a recession. Chart I-11Longer-Term Inflation Expectations Remain Well-Behaved Longer-Term Inflation Expectations Remain Well-Behaved Longer-Term Inflation Expectations Remain Well-Behaved Chart I-12A Contraction In Goods Spending Is Likely Over The Coming Year A Contraction In Goods Spending Is Likely Over The Coming Year A Contraction In Goods Spending Is Likely Over The Coming Year   Chart I-12 is a hypothetical scenario and not a forecast, as there is some evidence that consumers are currently deferring durable goods purchases on the expectation that prices will become more favorable. In addition, a positive output gap next year implies that goods spending may settle above its pre-pandemic trendline. Nevertheless, the prospect of a potentially significant slowdown in goods spending has unnerved some investors, even given the prospect of improved services spending. Chart I-13highlights that this fear is understandable given how the US economy normally behaves. The top panel of the chart shows the year-over-year contribution to real GDP growth from real goods and services spending, and the bottom panel shows these contributions in absolute terms to better illustrate their relative magnitudes. The chart makes it clear that goods spending is normally a more forceful driver of economic activity than is the case for services spending, which ostensibly supports concerns that a significant slowdown in the former may be destabilizing for overall activity. Chart I-13Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. However, Chart I-13 also highlights that the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-WWII economic environment. This is not surprising given the nature of the COVID-19 pandemic, but it is important because it underscores that investors should not rely excessively on typical rules of thumb about how modern economies tend to function over the course of the business cycle. In terms of the impact on overall economic activity, investors should focus on the net impact of goods plus services spending. It is certainly possible that the former will slow at a pace that is not fully compensated by the latter, but our sense is that this is not likely to occur barring a further extension of the pandemic in advanced economies. Chart I-14Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Chart I-14 presents a similar conclusion for the US equity market. The chart highlights the historical five-year correlation between the quarterly growth of nominal spending and S&P 500 sales per share. The chart shows that S&P 500 revenue was more sensitive to goods versus services spending prior to the 1990s, when the US was more manufacturing-oriented and goods were more likely to be produced domestically than is the case today. Another gap in the correlation emerged following the global financial crisis when the US household sector underwent several years of deleveraging. But over the past five years, Chart I-14 highlights that S&P 500 revenue growth has actually been more strongly correlated with US services spending than goods spending. Some of this increased correlation might reflect technology-related services spending which could suffer in a post-pandemic environment, but the bottom line from Chart I-14 is that there is not much empirical support for the view that US equity fundamentals will be disproportionately impacted by a slowdown in goods spending, so long as services spending rises in lockstep. China: Exacerbating An Underlying Trend Chart I-15China Will Be Disproportionately Affected By Slowing DM Goods Spending China Will Be Disproportionately Affected By Slowing DM Goods Spending China Will Be Disproportionately Affected By Slowing DM Goods Spending China, on the other hand, will be disproportionately affected by slower goods spending in advanced economies, because its exports have disproportionately benefited from the surge in spending on goods over the past year. Chart I-15 highlights that Chinese export volume growth has exploded this year, and that current export growth is running at a pace of 10% in volume terms – significantly higher than has been the case on average over the past decade. Several problems in China have been in the headlines over the past few months: a regulatory crackdown by Chinese authorities on new economy companies, the situation with Evergrande and, more recently, power shortages that have forced factories in several key manufacturing hubs to curtail production as a result of China’s ban on coal imports from Australia (Chart I-16). However, the key point for investors is that these are not truly new risks to China’s growth outlook; rather, they are developments that have the potential to magnify the impact of an already established trend: the ongoing slowdown in China’s economy that has clearly been caused by a decline in its credit impulse (Chart I-17). In turn, China’s decelerating credit impulse has been caused by tighter regulatory and monetary policy. Chart I-16Power Outages: The Latest Negative Headline From China Power Outages: The Latest Negative Headline From China Power Outages: The Latest Negative Headline From China Chart I-17China Is Slowing Because Policymakers Have Tightened China Is Slowing Because Policymakers Have Tightened China Is Slowing Because Policymakers Have Tightened   BCA’s China Investment Strategy service has provided a detailed analysis of the ongoing Evergrande saga.2 In short, our view is that the government will likely restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. As such, Beijing may rescue the stakeholders of Evergrande, but likely not its shareholders. However, in terms of stimulating the broader economy, it is still not clear that Chinese policymakers are willing to engage in more than gradual or piecemeal stimulus, given a higher pain threshold for a slower economy and a lower appetite for leverage. This may change once Chinese export growth slows in response to a shift in DM spending from goods to services, as policymakers will no longer be able to rely on the external sector for support. This potentially offsetting nature of eventual Chinese stimulus and global goods spending underscores both the importance of a normalization in DM services spending as an impulse for global growth, as well as the fact that a catalyst for EM stocks may remain elusive over the tactical horizon. Investment Conclusions In Section 2 of this month’s report, we explain why the performance of US stocks may be flat versus their global peers over a structural time horizon. We also highlighted that US stocks are likely to earn low annualized total returns over the coming 10 years (between 1.8 - 4.7%), which would fall well short of the absolute return goals of many investors. Chart I-18Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Over the coming 6-12 month time horizon, we continue to recommend an overweight stance towards value vs. growth stocks and global ex-US vs. US, particularly in favor of developed markets ex-US. The relative performance of value vs. growth stocks is likely to benefit from the transition to a post-pandemic state and a rise in long-maturity bond yields, as monetary policy shifts towards the point of tightening. Regional equity trends have been closely correlated with style over the past two years, and the underperformance of growth strongly implies US equity underperformance. From an asset allocation perspective, investors should remain overweight stocks versus bonds over the coming year, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months. Chart I-18 highlights that outside of the context of recessions, months with negative returns from both stocks and long-maturity bonds are quite rare, but they tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). Fundamentally, we do not see a rise in bond yields to any of the levels shown in Chart I-4 as being threatening to economic growth or necessarily implying lower equity market multiples. But the speed of adjustment in bond yields could unnerve equity investors, and there are open questions as to how far the equity risk premium can fall before T.I.N.A. – “There Is No Alternative” – becomes a less persuasive argument. As such, we would not rule out a brief correction in stocks at some point over the coming several months, but we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst September 30, 2021 Next Report: October 28, 2021 II. The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms Since 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance. There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon. In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples. Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US. The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities. In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar. We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. A Deep Examination Of US Outperformance Since 2008 Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are: Total revenue growth for each equity market, in local currency terms The change in profit margins The impact of changes in capital structure and index composition The change in the trailing P/E ratio The income return from dividends The impact of changes in foreign exchange The sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth October 2021 October 2021 Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends. Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects. Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar October 2021 October 2021 Box II-1 Proxying The Impact Of Changes In Shares Outstanding We proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects. However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It October 2021 October 2021 Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period. What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based October 2021 October 2021 The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services. Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion. Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks October 2021 October 2021 Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension… There Has Been A Strong Style Dimension... There Has Been A Strong Style Dimension... Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition ...To The Impact Of Changes In Capital Structure And Index Composition ...To The Impact Of Changes In Capital Structure And Index Composition Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally. The Relative Secular Return Outlook For US Stocks We present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis. Profit Margins Chart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real October 2021 October 2021 Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.3 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation. But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.” On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors. Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems. In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive). Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models October 2021 October 2021 Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize. Capital Structure And Index Composition As noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments. However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates. Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks? Can The US Continue To Accrete EPS Through Stock Buybacks? Can The US Continue To Accrete EPS Through Stock Buybacks? Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers US Growth Companies Are No Longer Generating More Cash Than Their Global Peers US Growth Companies Are No Longer Generating More Cash Than Their Global Peers   Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years. Equity Multiples There are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity US Multiples Are Not Justified By Higher Return On Equity US Multiples Are Not Justified By Higher Return On Equity Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close. Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The US Stock Market Is Now Extremely Concentrated The US Stock Market Is Now Extremely Concentrated The Foreign Exchange Effect As a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance. The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance... The US Dollar Has Helped US Common Currency Performance... The US Dollar Has Helped US Common Currency Performance... Chart II-18…And Is Now Expensive October 2021 October 2021   The Absolute Secular Return Outlook For US Stocks Over a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall. For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… October 2021 October 2021 Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%. One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship ...But That Depends Heavily On The Tech Bubble / GFC Relationship ...But That Depends Heavily On The Tech Bubble / GFC Relationship Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium. In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The US ERP Seems Normal Based On A Very Long Term History... The US ERP Seems Normal Based On A Very Long Term History... The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields. This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades ...And Based On The Forward Earnings Yield Over The Past Four Decades ...And Based On The Forward Earnings Yield Over The Past Four Decades Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time   We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.4 In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade October 2021 October 2021 Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Future Returns From US Stocks Will Greatly Disappoint Investors Future Returns From US Stocks Will Greatly Disappoint Investors Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over The Coming Year, Favor Value And Global Ex-US Stocks Over The Coming Year, Favor Value And Global Ex-US Stocks Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US. Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era. Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum as net revisions and positive earnings surprises remain near record highs. Bottom-up analyst earning expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury yield has broken above its 200-day moving average, beginning its recovery after falling sharply since mid-March. After a decline initially caused by waning growth momentum and the impact of the Delta variant of SARS-COV-2, long-maturity bond yields appear to be responding to the interest rate guidance that the Fed has been providing. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that 10-Year Yields are set to trend higher over the coming year. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the pace of advance in industrial metals prices has eased. Global shipping costs have exploded due to supply-side constraints, but are likely to ease over the coming year if further COVID-related labor market shocks can be avoided. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. 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-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth 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   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 2  Please see China Investment Strategy "A Quick Take On Embattled Evergrande," dated September 21, 2021, and China Investment Strategy "The Evergrande Saga Continues," dated September 29, 2021, available at cis.bcaresearch.com 3 Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com 4     Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com

Highlights Evergrande has not only crossed regulatory gridlines but also regulators’ bottom lines; the government will use the example of Evergrande to impose discipline on real estate developers. The policy response will likely prioritize domestic homebuyers and suppliers to minimize systemic risks and damage to the real economy. However, a bigger risk stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a significant spillover to other segments in the economy. The existing policy restrictions on China’s housing sector will not be reversed; the sector is on a structural downshift and will face risks of further consolidation and profit growth compression. Feature China Evergrande Group continues to stir up the global markets. Last Thursday the company missed a deadline to pay USD $83.5m in bond interest. The firm has now entered a 30-day grace period; it will default if that deadline also passes without payment. Chart 1Roller-Coaster Ride Continues... Roller-Coaster Ride Continues... Roller-Coaster Ride Continues... Evergrande has not remarked on the potential default nor have China’s authorities or state media offered any clues about a potential rescue package. Meanwhile, the PBoC injected large amounts of liquidity into the banking system of late, a clear sign of support for the markets. Evergrande share prices continued their roller-coaster ride (Chart 1). Evergrande’s tumult is indicative of an industry-wide problem.  Real estate developers have expanded their businesses and profits through high-debt growth models. China’s policymakers have been trying to crack down on this business practice since 2017 and their clampdown has significantly intensified since August 2020. In this report, we follow up on last week’s Special Alert and share our thoughts on the potential market implications and policy response to the evolving Evergrande situation. The “Three Red Lines” Versus The “Bottom Lines” Evergrande has not only crossed the “three red lines” – three debt metrics China’s authorities laid out a year ago to reduce the housing sector’s leverage – but it has also crossed the bottom lines of policymakers. Therefore, we do not expect the government to lend a financial hand to bail out the corporation and its shareholders. Meanwhile, as discussed in our Special Alert, we expect that there will be some kind of a rescue plan to help onshore homebuyers and suppliers recover their losses. The authorities’ silence in the past three months as investors’ concerns about Evergrande’s debt situation escalated speaks volumes about plans for the overleveraged company. The Evergrande episode is not idiosyncratic; it represents an industry-wide problem linked to the sector’s high-debt growth model.  However, Evergrande has become China’s and the world’s most indebted property developer; the “three red lines” policy last year has pushed the company into a severe liquidity crunch.  Evergrande not only borrowed heavily to pursue an aggressive expansion strategy (“disorderly expansion of capitals”), but did so as President Xi Jinping famously remarked “houses are for living, not for speculation” in late 2016. Between 2016 and 2020, Evergrande’s total liabilities almost doubled and its stock prices jumped by 460%. Evergrande’s founder was ranked the richest man in China in 2017, building his company’s fortune on excessive leverage. The way that the company accumulated wealth conflicts with the government’s new mantra of building “common prosperity”, a policy shift to reduce income and wealth inequality. Furthermore, Evergrande paid its offshore investors in June this year while it continued to borrow from onshore banks and offload its onshore assets. This move did not bode well for China’s domestic stake- and shareholders, along with policymakers. Chart 2Housing Price Inflation Has Been Subdued Outside Of Top-Tier Cities Housing Price Inflation Has Been Subdued Outside Of Top-Tier Cities Housing Price Inflation Has Been Subdued Outside Of Top-Tier Cities In contrast with policymakers’ silence about the future of Evergrande and its shareholders, the authorities have reportedly urged the company to finish and deliver its housing projects.  Evergrande’s projects are mostly in tier-three cities where post-pandemic home price inflation has been subdued compared with top-tier cities (Chart 2). As such, policymakers will be less concerned about fueling home prices in these cities and more willing to work out a plan to finish and deliver those housing projects. Bottom Line: Beijing may rescue the stakeholders of Evergrande rather than its shareholders. Contagion Risks We discussed our baseline scenario for Evergrande’s bankruptcy and restructuring in last week’s Special Alert. Our message has been that the well-telegraphed Evergrande default might not create an imminent systemic crisis or crash in China’s financial markets. However, it will likely reinforce the credit tightening that has been underway in China over the past 12 months.  This will delay and weaken the transmission of liquidity easing into the real economy. So far things are not bad enough for policymakers to reflate the economy in any meaningful way. Since the contagion risks from Evergrande’s debt crisis to China’s onshore financial markets seem to be contained, policy easing in the coming months will likely be gradual. Regulators have shown no sign of reversing the existing policy restrictions. Therefore, a bigger risk to China’s financial markets stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a spillover to other segments in the economy. Real estate activity and investment in China are set to slow structurally (discussed in the section below). If policymakers allow a disruptive deceleration in the sector's growth while being reluctant to ramp up support in other industries, China’s economic growth could downshift much more than policymakers would like to see. A rapid deceleration in the real economic activity and jitters in the financial markets could reinforce each other and spiral out of control. The facts below explain why risks of an imminent systemic crisis in China’s and global financial markets are limited (Table 1): The exposure of China’s banks to real estate developers is small relative to the banks’ total lending.  Although about 40% of total bank loans are property-related, only 6% are in loans to real estate developers. The majority of the 40% is in mortgage loans, construction loans and other loans collateralized by land and property. Evergrande’s outstanding bank debt accounts for less than 0.1% of China’s total onshore loan balances. The company owes about 1% of China’s existing trust loans and 0.04% of domestic bonds. The company has quality assets, as we discussed in last week’s report, that could cover most of its onshore outstanding debt. Widespread mortgage loan defaults are unlikely to happen, even if Evergrande does not strike a debt restructuring deal with the government. Strict housing and home-sale regulations cap the upside and limit the downside in home prices. Moreover, conservative loan-to-value ratio requirements have contributed to China’s low default rates on mortgage loans.1 Evergrande’s overseas liabilities are more significant, with its USD $20 billion bonds accounting for about 10% of China's corporate USD bonds issued by real estate developers. On the other hand, major US financial institutions have minimal direct exposure to China and Hong Kong SAR. Table 1Evergrande Debt, An Overview* The Evergrande Saga Continues The Evergrande Saga Continues Despite limited systemic risks to the financial markets, a lack of government intervention could result in a disruptive bankruptcy of the company, risking substantial ripple effects on other parts of the economy. Evergrande’s accounts payable and bills amount to nearly RMB 700 billion, owed to companies in the upstream and downstream industry supply chains.  In addition, Evergrande’s contract liabilities are as high as RMB 170 billion and are associated with the pre-sold but unfinished residential units in more than 200 cities. We think policymakers and Evergrande will ultimately agree on a debt restructuring plan. Evergrande could transfer some of its hard assets to state-owned banks or enterprises and the banks could either extend or restructure Evergrande’s existing loans to help finish and deliver the company’s housing projects. Regardless of how the debt is restructured, a government-led rescue will likely prioritize domestic homebuyers and suppliers. Evergrande shareholders and investors in offshore, USD-denominated corporate bonds will suffer large losses. Bottom Line: Our base case scenario is that the government will restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. Will Policymakers Reverse Restrictive Housing Policies? Even though China’s monetary and fiscal policies have eased at margin, policy restrictions on the property market remain in place. The bar for regulators to significantly ease or to reverse policy tightening in the real estate industry is much higher than in past cycles. Furthermore, the government’s efforts to contain the sector’s leverage and home price inflation are structural rather than cyclical. Our view is based on the following observations: Chart 3China's Housing Demand Is On A Structural Downshift China's Housing Demand Is On A Structural Downshift China's Housing Demand Is On A Structural Downshift China’s housing demand is on a structural downshift due to China’s falling birthrate and working-age population.  The decline in demand will likely accelerate in the next four to five years (Chart 3). Therefore, it is unreasonable to expect that the growth in real estate investment in the coming years will continue growing at the same rate as in the past cycles.  The government is determined to improve housing affordability by capping home prices in the coming years while increasing lower-income household wage growth. Previous “big bang” stimulus and soaring home prices have widened rather than narrowed income and wealth inequality. Beijing’s current primary focus is “common prosperity,” which aims to reduce inequality. This overarching policy initiative will prevent policymakers from backtracking on reforms in the property sector. Things are not bad enough for a major shift in policy direction. Demand for housing is down, but from a very elevated level (Chart 4). The growth of home sales is now reverting to its pre-pandemic rate. In a previous report we pointed out that the current policy backdrop resembles that of 2H2018 and 2019, when the stimulus was very measured despite a slowing economy and an escalating trade war with the US. Demand for housing in the first eight months of this year is stronger than in 2018/19, thus policymakers may not feel pressure to loosen restrictions in the housing sector.  Chart 4Post-Pandemic Housing Demand Stronger Than 2018/19 Post-Pandemic Housing Demand Stronger Than 2018/19 Post-Pandemic Housing Demand Stronger Than 2018/19 Chart 5Real Estate Investment Relatively Steady Despite Contracting Housing Starts Real Estate Investment Relatively Steady Despite Contracting Housing Starts Real Estate Investment Relatively Steady Despite Contracting Housing Starts Growth in real estate investment has been steady despite contracting housing starts (Chart 5).  The government’s deleveraging pressure on the sector since August last year has forced developers to hurry and finish their existing projects (Chart 5, bottom panel). This has helped to reduce developers’ project inventories and discourage them from hoarding land reserves, and the policy intention is unlikely to change (Chart 6). Additionally, the government has prioritized home price stability by capping prices and fine-tuning the supply of land (Chart 7). In other words, housing starts have become less market-driven and weaker readings may reflect regulators’ policy intentions to rein in land supplies.2 Local governments may increase the supply of land when real estate investment softens too fast, but home sales and project completions will have to decelerate more significantly. Chart 6Developers Have Been Rushing To Finish Existing Projects Developers Have Been Rushing To Finish Existing Projects Developers Have Been Rushing To Finish Existing Projects Chart 7Government Prioritizes Home Price Stability By Capping Prices And Fine-Tuning Land Supply Government Prioritizes Home Price Stability By Capping Prices And Fine-Tuning Land Supply Government Prioritizes Home Price Stability By Capping Prices And Fine-Tuning Land Supply Funding constraints will not be removed soon and restrictive policies apply to both developers and banks. Banks need to meet the “two red lines” while developers must bring their leverage ratios below the “three red lines” by end-2023. The “two red lines”, which the PBoC unveiled in January this year, set the upper limit on the portion of household mortgages and real estate loans in banks’ total lending.  Despite aggressively scaling back lending to the housing sector, the lending ratio in many banks – including China’s six large banks and various medium-sized banks – still exceeded the upper limit. These banks will have to continue to reduce their property-related lending while the other banks will maintain a lower percentage of loans to the housing sector than in the past. Consequently, binding constraints on developers and banks will continue to weigh on the housing market in the coming years, suggesting that the property market downturn will last longer than in previous cycles. Chinese policymakers are unlikely to have much appetite for more robust construction activity in the current environment with supply-side constraints for both raw materials and energy. More than 10 provinces in China are currently under power rationing and have cut factory production amid electricity supply issues and a push to enforce environmental regulations. We expect supply shortages and production decreases to continue through the winter, limiting the upside potential of the country’s economic activity. Bottom Line: China’s reforms in the property sector are structural and the leadership is much less likely to use housing as counter-cyclical policy support to the economy than in previous cycles. Investment Implications China’s growth and its ever-important property market activity have slowed. Given the policymakers’ higher pain threshold for a slower economy and lower appetite for leverage, policy easing will likely be gradual and piecemeal in the near term. The current monetary, fiscal, and industry policy backdrops resemble China’s response in H2 2018 and early 2019. Chinese stock prices rose briefly in early 2019 on the expectation of a sizable stimulus, but the rally was short-lived (Chart 8). Furthermore, we do not rule out the possibility that policymakers will be overconfident in their capability to stabilize the economy as they balance structural reforms against growth volatility. They may choose to wait until there are signs of a significant spillover to other segments in the economy before backtracking the deleveraging campaign in the property sector and lending more support to the market/economy. In this scenario, the near-term response in the equity market will likely be very negative. China-related asset prices will not stabilize until policymakers decisively and significantly dial-up their reflationary response. Property sector stocks in China’s on- and offshore markets have been beaten down by policy tightening and lately the Evergrande saga (Chart 9). We maintain our view that these stocks have not reached their bottom. The property downturn in China is a structural change and authorities are unlikely to reverse current restrictions on the sector to support the economy. Chart 8Chinese Stock Price Rally In 2019 Was Short-Lived Chinese Stock Price Rally In 2019 Was Short-Lived Chinese Stock Price Rally In 2019 Was Short-Lived Chart 9Chinese Real Estate Stocks Have Not Reached Their Bottom Chinese Real Estate Stocks Have Not Reached Their Bottom Chinese Real Estate Stocks Have Not Reached Their Bottom The real estate sector’s contribution to China’s economic growth is expected to gradually decline in the medium to long term. The industry will be further reformed and consolidated, and more developers will be forced to abandon their high-leverage, high-growth business expansion model. The outlook for the real estate industry’s profit growth will become less certain.  Investors will require higher risk premiums for real estate sector stocks, which means that these stocks’ valuations will be further compressed.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Chinese homeowners’ down payment ratios on a first property is 30% and 50% on a second property. 2Land auctions were delayed in July and August due to overwhelming demand from developers in the first half of the year. Market/Sector Recommendations Cyclical Investment Stance

Highlights Investment Grade: Investment grade corporate bond total returns will be close to zero or negative during the next 12 months. The bonds are also likely to outperform duration-matched Treasuries during that period, but excess returns are probably capped at 85 bps. High-Yield: High-yield total returns will fall between -0.29% and +1.80% during the next 12 months, but with a much higher likelihood of being positive than investment grade corporates. Junk will outperform duration-matched Treasuries by between 0.94% and 1.84%, besting the excess returns earned in investment grade. Inflation & The Fed: The Fed will announce asset purchase tapering before the end of this year, and tapering will proceed at a pace that opens the door to a potential rate hike before the end of 2022. Ultimately, whether the Fed lifts rates in 2022 will depend on trends in core CPI excluding COVID-impacted services and autos, along with wage growth and inflation expectations. Feature Chart 1Valuations Are Stretched Valuations Are Stretched Valuations Are Stretched There are two broad factors that must be considered when deciding whether to favor corporate bonds over Treasuries in a US bond portfolio: (i) The cyclical macroeconomic environment and (ii) valuation. The problem is that, as it stands today, these two factors are sending contrasting signals. The cyclical macroeconomic environment is consistent with strong positive excess returns for spread product versus Treasuries. However, corporate bond spreads and yields are extremely low relative to history (Chart 1). We view the slope of the yield curve as the single best indicator of the cyclical macro environment and have shown in prior research that corporate bonds tend to deliver positive excess returns versus Treasuries when the 3-year/10-year Treasury slope is above 50 bps, even when corporate spreads are tight.1 At present, the 3-year/10-year slope sits at 90 bps and our bias will be toward an overweight allocation to corporates until the slope breaks below 50 bps. A flatter yield curve is negative for corporate bond performance because it suggests that monetary conditions are less accommodative. It also makes it more likely that an unforeseen shock will lead to yield curve inversion, a highly reliable recession indicator. While the macro environment is consistent with continued corporate bond outperformance versus Treasuries, valuation suggests that we should anticipate lower returns than usual from corporate bonds. Table 1 shows annualized corporate bond excess returns during each of the past six cycles. Additionally, it splits each cycle into three phases based on the slope of the 3-year/10-year Treasury curve. Phase 1 of the cycle lasts from the end of the prior recession until the slope breaks below 50 bps. Phase 2 encompasses the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Table 1Corporate Bond Excess Returns In Different Phases Of The Cycle Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds The first conclusion to draw from Table 1 is that excess returns tend to be lower in Phase 2 than in Phase 1 and lower in Phase 3 than in Phase 2. Second, we see that investment grade corporates have returned an annualized 7.55% in excess of duration-matched Treasuries so far this cycle and high-yield corporates have delivered 15.15% of outperformance. These figures are well above even those seen in prior Phase 1 periods. Based on this, an expectation for lower – but still positive – excess corporate bond returns seems like a reasonable base case for the next 6-12 months. Table 2 is identical to Table 1 except that it shows total returns instead of excess returns. We observe that, so far this cycle, junk bond total returns have outpaced prior Phase 1 periods. Investment grade total returns have been slightly lower given the greater exposure to interest rate risk of those securities. Table 2Corporate Bond Total Returns In Different Phases Of The Cycle Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds As noted above, our expectation is that corporate bonds will outperform Treasuries during the next 6-12 months, but that both excess returns and total returns will take a step down. The next section of this report presents a scenario analysis that puts some more specific numbers on the sorts of excess and total corporate bond returns investors might expect to earn during the next year. Corporate Bond Returns: Scenario Analysis Methodology To run our scenario analysis for investment grade corporate bond returns we use the following equations: Excess Return = OAS0  – D0 (dOAS) Total Return = OAS0+ TSY0 – D0 (dOAS+dTSY) Where: Excess Return = The expected corporate index excess return versus duration-matched Treasuries during the next 12 months Total Return = The expected corporate index total return during the next 12 months OAS0 = Today’s average index option-adjusted spread D0 = Today’s average index duration TSY0 = Today’s Treasury yield that matches the duration of the corporate index dOAS = The expected change in the index option-adjusted spread during the next 12 months dTSY = The expected change in the duration-matched Treasury yield during the next 12 months These equations are obviously simplifications. For example, the impact of convexity is ignored. However, Chart 2 shows that our proxies track actual index returns very closely over time, assuming the estimated yield and spread changes are accurate. Chart 2Estimating IG Returns Estimating IG Returns Estimating IG Returns We use similar equations for assessing high-yield corporate returns, with the additional complication that we must include an assumption for default losses. Excess Return= OAS0 – (DR × (1 - RR)) –D0(dOAS) Total Return= OAS0 + TSY0 – (DR × (1 – RR)) –D0 (dOAS + dTSY) In these equations: DR = The expected issuer-weighted default rate for the next 12 months RR = The expected average recovery rate on defaulted debt for the next 12 months Once again, though these equations are relatively simple, they do a good job of capturing actual returns over time (Chart 3). Chart 3Estimating HY Returns Estimating HY Returns Estimating HY Returns Scenarios With the above equations in hand, we can easily make some educated guesses about future yields, spreads and default losses and translate those assumptions into expected return forecasts. Specifically, we test three different scenarios (bullish, neutral and bearish) for corporate spreads, Treasury yields and default losses. For corporate index spreads, both investment grade and high-yield, our bullish scenario assumes that spreads reach the all-time tight levels seen in the mid-1990s. For investment grade bonds this spread level is 58 bps, 27 bps below the current level. For high-yield bonds this spread level is 233 bps, 41 bps below the current level. Our neutral scenario assumes that index spreads remain at their current levels (85 bps for investment grade and 274 bps for junk). Finally, our bearish scenario assumes that spreads widen back to the average levels seen during the 2017-2019 period (112 bps for investment grade and 369 bps for junk), this implies 27 bps of widening for investment grade and 95 bps of widening for junk. Given our view that bond yields will rise as we approach the next Fed tightening cycle, none of our scenarios assume that Treasury yields will fall during the next 12 months. Our bullish Treasury yield scenario assumes that yields stay flat at current levels. Our neutral Treasury yield scenario assumes that yields follow the path implied by current forward rates, and our bearish Treasury yield scenario assumes that yields rise to levels consistent with fair value estimates assuming the market prices-in a December 2022 Fed liftoff followed by 100 bps of rate hikes per year until the fed funds rate levels-off at 2.08%.2 We use the 7-year and 6-year Treasury yields as our inputs for the investment grade and high-yield scenarios, respectively, as those yields most closely match the interest rate component embedded in the corporate indexes. For default losses, our bullish scenario assumes a 1.8% default rate – consistent with the rate at which defaults are tracking so far this year – and a recovery rate of 50%. Our neutral scenario assumes a 3% default rate and a 40% recovery rate. Our bearish scenario assumes a 4% default rate and 30% recovery rate. Investment Grade Results Table 3 shows the results of our scenario analysis for investment grade corporate bond returns. Table 3Investment Grade Corporate Bond Expected Return Scenarios Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Starting with excess returns, we think it is most likely that spreads remain near current levels, or perhaps widen a bit, during the next 12 months. We think it’s extremely unlikely that spreads will tighten to the levels seen in the mid-1990s because the average duration of the index is much higher today than it was back then. All else equal, it’s generally true that securities with higher duration also have higher OAS. This means we expect investment grade corporate bond excess returns to be between -153 bps and +85 bps during the next 12 months, probably closer to +85 bps. Obviously, this represents a significant step down from the +550 bps earned during the past year. In fact, even the most bullish scenario where spreads tighten back to all-time lows only implies an excess return of +323 bps, well below the recent rate of outperformance. As for total returns, we estimate that a neutral scenario where the index spread holds steady and Treasury yields follow the forward curve will lead to total returns being close to zero during the next 12 months. In fact, our results suggest that it’s highly likely that investment grade corporate bonds will deliver negative total returns during the next 12 months. Yes, the index is expected to deliver a total return of 1.98% if both the index spread and duration-matched Treasury yield remain at their current levels, but an environment where growth is slow enough to keep Treasury yields flat is much more likely to coincide with spread widening than with steady corporate spreads. For some additional historical perspective, the columns labeled “Historical Percentile Rank” show how the returns in each scenario would rank relative to actual returns earned during the past 31 calendar years. For example, even the most bullish total return scenario of 4.36% ranks at the 27th percentile relative to history. This means that it would only be better than 27% of historical 12-month return observations for that index. High-Yield Results Tables 4A, 4B and 4C summarize the results of our high-yield scenario analysis. Table 4A assumes the bullish scenario for default losses, Table 4B assumes the neutral scenario for default losses and Table 4C assumes the bearish scenario for default losses. Table 4AHigh-Yield Corporate Bond Expected Return Scenarios: Bullish Default Loss Scenario* Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Table 4BHigh-Yield Corporate Bond Expected Return Scenarios: Neutral Default Loss Scenario* Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Table 4CHigh-Yield Corporate Bond Expected Return Scenarios: Bearish Default Loss Scenario* Expected Returns In Corporate Bonds Expected Returns In Corporate Bonds Looking at excess returns, the first result that jumps out is that even the most bullish scenario leads to an expected 12-month excess return of +3.43%, this would be equivalent to the median return earned during the past 31 calendar years. In our view, it’s more likely that excess returns will be in the +0.94% to +1.84% range during the next 12 months. This is consistent with flat spreads and a range for default losses between our neutral and bullish scenarios. Our sense is that junk bonds are less likely to deliver negative total returns than investment grade bonds. Though even the most bullish scenario puts expected junk total returns at +4.54%, consistent with the 39th percentile relative to history. Investment Implications To summarize, our expectation is that investment grade corporate bond total returns will be close to zero or negative during the next 12 months. The bonds are also likely to outperform duration-matched Treasuries during that period, but excess returns are probably capped at 85 bps. Our best guess places high-yield total returns at between -0.29% and +1.80%, but with a much higher likelihood of earning positive total returns than a position in investment grade. We estimate that excess junk returns will fall between +0.94% and +1.84%, above returns earned in investment grade. In general, the message is that investors should remain overweight corporate bonds versus Treasuries, but should retain a preference for high-yield over investment grade and should expect to earn far lower returns than were earned during the past year. Given low expected returns, investors should also seek out creative ways of adding additional spread to a bond portfolio. We offered some suggestions in a recent report.3 CPI Update And FOMC Preview This week’s FOMC meeting could be significant for bond markets. First off, there is a possibility that the Fed will announce a timeline for tapering its asset purchases. Our sense is that last month’s weak employment report probably delays this announcement, but we still expect it to come before the end of the year. We expect that the actual tapering of purchases will start in January 2022 and that net Fed purchases will reach zero by Q3 of next year. More broadly, we continue to think that the market is already priced for a tapering announcement in 2021. In other words, any information about asset purchases probably won’t move bond yields that much. What will move bond yields is any hint about when the Fed thinks it may want to start lifting rates. Such news could come in the form of revisions to the Fed’s interest rate forecasts, or in any information that the Fed provides about the pace of asset purchase tapering. Because the Fed has indicated a strong preference for having net purchases at zero prior to liftoff, any pace of tapering that gets net purchases to zero by the middle of next year opens the door to a possible rate hike before the end of 2022. Of course, the economic data between now and the end of 2022 will have a lot to say about whether the Fed actually starts to hike. In particular, last week’s report made the case that next year’s inflation data will determine when rate hikes begin.4 With that in mind, last week’s CPI release showed a significant deceleration in core inflation, driven by the COVID-impacted service and auto sectors that had previously caused inflation to spike (Chart 4). Interestingly, core inflation excluding COVID-impacted services and autos jumped on the month (Chart 4, bottom panel). From the Fed’s perspective, it ignored the transitory rise of COVID-impacted service and auto inflation on the way up, it will also be inclined to ignore its descent. What will ultimately matter for monetary policy is whether underlying inflationary pressures start to build throughout 2022. It is therefore much more important for us to focus on trends in core inflation excluding the COVID-impacted services and autos, along with wage growth and inflation expectations. Our view is that underlying inflationary pressures will be strong enough for the Fed to lift rates before the end of 2022. This will, in large part, be due to an acceleration of shelter inflation (Chart 5). Owner’s Equivalent Rent and Rent of Primary Residence inflation have already jumped, and leading indicators of shelter inflation like the unemployment rate (Chart 5, panel 3) and the Apartment Market Tightness Index (Chart 5, bottom panel) are consistent with further acceleration. Chart 4Looking For Underlying Inflation Looking For Underlying Inflation Looking For Underlying Inflation Chart 5Shelter Inflation Will Keep Rising Shelter Inflation Will Keep Rising Shelter Inflation Will Keep Rising Bottom Line: The Fed will announce asset purchase tapering before the end of this year, and tapering will proceed at a pace that opens the door to a potential rate hike before the end of 2022. Ultimately, whether the Fed lifts rates in 2022 will depend on trends in core CPI excluding COVID-impacted services and autos, along with wage growth and inflation expectations.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 Last week’s report provides more detail on this fair value analysis. Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 3 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 4 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Stocks tend to perform worse when unemployment is low. Since 1950, the S&P 500 has risen at an annualized pace of 12% when the unemployment rate was above its historic average compared to 6% when the unemployment rate was below its average. Three reasons help explain this relationship: 1) The unemployment rate has historically been mean-reverting; 2) Low unemployment often leads to monetary tightening; and 3) Valuations are usually more stretched when unemployment is low. In the spring of 2020, stocks benefited from what turned out to be a very auspicious environment: A steady decline in the unemployment rate from very high levels, assisted by a massive dose of monetary and fiscal stimulus. Today, the situation is less clear-cut. The labor market has improved dramatically, while both monetary and fiscal policy are turning less accommodative. Nevertheless, the Fed is unlikely to hike rates for at least 12 months, and it will take much longer than that for monetary policy to turn restrictive. This suggests that we are still in the middle-to-late stages of a business cycle expansion that began following the Great Recession (and was only briefly interrupted by the pandemic). Historically, cyclical stocks have done well during this phase of the business cycle. To the extent that cyclicals are overrepresented in overseas indices, investors should favor non-US stock markets. Non-US stocks also trade at a substantial valuation discount to their US peers. A Surprising Relationship One of the best pieces of advice I received when I was starting my research career was to get to the punchline as soon as possible. As a strategist, you are not writing a detective novel where the answers are shrouded in mystery until the very end. You are providing conclusions to readers with supporting evidence. Chart 1Stocks Do Best When Unemployment Is High Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? With that in mind, let me answer the question posed in the title of this report: Is low unemployment good or bad for stocks? As Chart 1 shows, the answer is bad. The interesting issues are why it is bad and what this may mean for investors today. There are three key reasons why low unemployment has typically corresponded with paltry equity returns: The unemployment rate has historically been mean-reverting: Low unemployment is often followed by high unemployment. And, when the unemployment rate starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession occurring (Chart 2). Chart 2When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising Low unemployment often leads to monetary tightening: An economy can only grow at an above-trend pace if there is labor market slack. Once the slack runs out, growth is liable to weaken as supply-side constraints kick in. Worse yet, labor market overheating has historically prompted central banks to raise rates (Chart 3). Higher rates in the context of slowing growth is toxic for stocks. Valuations are usually more stretched when unemployment is low: During the post-war period, the S&P 500 has traded at an average Shiller P/E ratio of 22.5 when the unemployment rate was below its historic average compared to 16.3 when the unemployment rate was above its average. Implications For The Present Day Stocks fare best when unemployment is high but falling. In contrast, stocks fare the worst when unemployment is low and rising (Chart 4). My colleague Doug Peta, BCA’s Chief US Investment Strategist, reached a similar conclusion in his August report entitled Level Or Direction? Chart 3Low Unemployment Often Leads To Monetary Tightening Low Unemployment Often Leads To Monetary Tightening Low Unemployment Often Leads To Monetary Tightening Chart 4Stocks Do Best When Unemployment Is Falling From High Levels Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks?   In the spring of 2020, stocks benefited from what turned out to be a very auspicious environment: A steady decline in the unemployment rate from very high levels, assisted by a massive dose of monetary and fiscal stimulus. Controversially at the time, this led us to argue that the pandemic could lead to much higher stock prices. Chart 5There Is Still Slack There Is Still Slack There Is Still Slack Today, the situation is less clear-cut. On the one hand, the unemployment rate has fallen dramatically, while monetary and fiscal policy are turning less accommodative. This week, the ECB reduced the pace of net asset purchases under the PEPP. The Fed will start paring back asset purchases by the end of this year. Governments are also withdrawing fiscal policy support. In the US, emergency federal unemployment benefits expired, somewhat ironically, on Labor Day. On the other hand, the unemployment rate in most economies is still above pre-pandemic levels. In the US, the unemployment rate for prime-age workers is 1.7 percentage points higher than in February 2020, while the employment-to-population ratio is 2.4 points lower (Chart 5). The presence of labor market slack ensures that policy support will be withdrawn only gradually.   Granted, core CPI inflation in the US is running above 4%. Standard Taylor Rule equations suggest that the Fed funds rate should be well above zero (Chart 6). That said, these equations use realized inflation, which may be misleading given that both market participants and Fed officials expect inflation to fall rapidly (Chart 7). Indeed, the widely followed 5-year/5-year forward TIPS breakeven rate is below the Fed’s comfort zone (Chart 8).1 With long-term inflation expectations still subdued, there is no urgency for the Fed to sound more hawkish. Chart 6What Rate Does The Taylor Rule Prescribe? Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Chart 7Investors Expect Inflation To Fall Rapidly From Current Levels Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Chart 8Long-Term Inflation Expectations Are Muted Long-Term Inflation Expectations Are Muted Long-Term Inflation Expectations Are Muted Cyclical Stocks Usually Do Best In The Latter Innings Of The Business Cycle Expansion Monetary policy is unlikely to become restrictive in any major economy during the next 18 months, which should allow global growth to remain at an above-trend pace. Hence, it is too early to turn bearish on stocks. Nevertheless, given that the unemployment rate in most countries is closer to a trough than to a peak, it is reasonable to conclude that we are somewhere in the middle-to-late stages of a business cycle expansion that began following the Great Recession (and was only briefly interrupted by the pandemic). As Chart 9 shows, cyclical equity sectors, such as industrials, energy, and materials, typically do best in the latter innings of business cycle expansions. Such was the environment that prevailed in 2005-08, and such will be the environment that prevails over the coming quarters as the unemployment rate falls further, capital spending increases, and commodity prices rise further. Chart 9The Business Cycle And Equity Sectors Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Increased government infrastructure spending should help cyclical sectors. The US Congress is set to pass a 10-year $500 billion package. The EU’s €750 billion Next Generation fund is finally up and running. Chinese local government infrastructure spending is poised to accelerate over the remainder of the year.   Chart 10The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 11Past Another Covid Wave Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? A weaker US dollar should also buoy cyclical stocks (Chart 10). As a countercyclical currency, the greenback usually weakens when global growth is strong. A cresting in the Delta variant wave should help jumpstart global growth over the coming months (Chart 11). Meanwhile, interest rate differentials have moved sharply against the US dollar, while the US trade deficit has widened noticeably (Charts 12A & B).   Chart 12AInterest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Interest Rate Differentials Have Moved Against The Dollar Chart 12BThe US Trade Deficit Has Widened Noticeably The US Trade Deficit Has Widened Noticeably The US Trade Deficit Has Widened Noticeably Cyclical sectors are overrepresented outside the US (Table 1). Although not a classically cyclical sector, financials are also overrepresented in overseas indices. BCA’s global fixed-income strategists recommend a moderately underweight duration stance. As bond yields rise, bank shares should outperform (Chart 13). In contrast, tech stocks often lag in a rising yield environment. Table 1Cyclicals Are Overrepresented Outside The US Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Chart 13Higher Rates: A Boon For Banks And A Bane For Tech Higher Rates: A Boon For Banks And A Bane For Tech Higher Rates: A Boon For Banks And A Bane For Tech How Expensive Are Stocks? A high Shiller P/E predicts low future returns (Chart 14). Today, the Shiller P/E stands at 37 in the US. This is consistent with an expected 10-year total real return of close to zero for the S&P 500. Thus, the long-term outlook for US stocks is poor. We stress the words “long term.” As the bottom panel of Chart 14 shows, no matter what the starting point of valuations is, the average return over short-term horizons is very low relative to realized volatility. This is another way of saying that valuations provide a great deal of information about the long-term outlook for stocks, but little information about their near-term direction. Over horizons of about 12 months, the business cycle drives the stock market, as a simple comparison between purchasing manager indices and stock returns illustrates (Chart 15).   Chart 14Valuation Is The Single Best Predictor Of Long-Term Equity Returns Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Chart 15AThe Business Cycle Drives Cyclical Swings In Stocks The Business Cycle Drives Cyclical Swings In Stocks The Business Cycle Drives Cyclical Swings In Stocks Chart 15BThe Business Cycle Drives Cyclical Swings In Stocks The Business Cycle Drives Cyclical Swings In Stocks The Business Cycle Drives Cyclical Swings In Stocks Outside the US, the Shiller P/E stands at 20. In emerging markets, it is only 16 (Chart 16). This is significantly below US levels, implying that the long-term prospect for equities is much more attractive abroad. Thus, both medium-term cyclical factors and long-term valuation considerations favor non-US stocks.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 16US Stocks Are Pricey US Stocks Are Pricey US Stocks Are Pricey Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Special Trade Recommendations Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks? Current MacroQuant Model Scores Is Low Unemployment Good Or Bad For Stocks? Is Low Unemployment Good Or Bad For Stocks?

Highlights The equity risk premium has turned negative for the first time since 2002. It follows that any significant rise in bond yields will cause risk-asset prices to collapse, quickly flipping any incipient inflationary shock into a deflationary shock. Shorting bonds yielding 2 percent is a ‘widow maker’ trade, as anybody who has tried this with a long list of government bonds has learned to their cost, the most recent being UK gilts. Hence, the next on the list for the ‘widow maker’ is shorting the US 30-year T-bond which is now yielding 2 percent. In fact, the US 30-year T-bond is a must-own structural investment. Fractal analysis: Medical equipment versus healthcare services. Feature Chart of the WeekThe Equity Risk Premium Turns Negative For The First Time Since 2002 The Equity Risk Premium Turns Negative For The First Time Since 2002 The Equity Risk Premium Turns Negative For The First Time Since 2002 Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. For example, the US 10-year Treasury Inflation Protected Security (TIPS) and the UK 10-year index linked gilt are yielding -1.3 percent and -2.8 percent respectively. Meaning that anybody who buys and holds these bonds to redemption is guaranteed a deeply negative 10-year real return. Meanwhile, in nominal yield space, 10-year government bonds yield -0.35 percent in Germany and Switzerland, 0.7 percent in the UK, and 1.3 percent in the US. What about equities? Unlike a bond’s redemption yield, equities do not offer a guaranteed long-term return for buy-and-hold investors. So, some analysts assume that the equity market’s earnings yield is the proxy for this long-term return. According to these analysts, the US equity market’s earnings yield of 4.4 percent means that it will deliver a prospective long-term real return of 4.4 percent per annum. Compared to the 10-year TIPS real yield of -1.3 percent, they argue that this offers an excess return or ‘equity risk premium’ of a comfortable +5.7 percent. Therefore, claim these analysts, equities are reasonably valued, relative to bonds, and in absolute terms.  But as we will now demonstrate, this analysis is deeply flawed. The Equity Risk Premium Has Turned Negative The equity market’s earnings yield is a valuation metric, so clearly there is some connection between it and the prospective return delivered by the equity market. Nevertheless, the crucial point to grasp is that: The equity market’s earnings yield does not equal its prospective return. Charts I-2 - I-3 should make this point crystal clear. As you can see, the earnings yield rarely equals the delivered prospective 10-year return, either real or nominal. When the earnings yield is elevated, the prospective return turns out higher. Conversely, when the earnings yield is depressed, as now, the prospective return turns out to be much lower. Chart I-2The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... Chart I-3...Or In Nominal ##br##Terms ...Or In Nominal Terms ...Or In Nominal Terms Therefore, to take the current earnings yield of 4.4 percent and subtract the real bond yield of -1.3 percent to derive an equity risk premium of +5.7 percent is analytically flawed, just as it is analytically flawed to subtract apples from oranges. To derive the equity risk premium, the correct approach is first to translate the earnings yield into a prospective 10-year return based on the established mathematical relationship between these variables. Chart I-4 does this and shows that, based on a very tight mathematical relationship through the past thirty five years, an earnings yield of 4.4 percent translates into a prospective 10-year nominal return of just 1 percent. Chart I-4We Must Mathematically Map The Earnings Yield Into A Prospective Return... We Must Mathematically Map The Earnings Yield Into A Prospective Return... We Must Mathematically Map The Earnings Yield Into A Prospective Return... Having translated the earnings yield into a prospective 10-year nominal return of 1 percent, we can now make an apples-for-apples comparison with the 10-year T-bond yield of 1.3 percent (Chart I-5). Chart I-5...And Only Then Subtract The Bond Yield ...And Only Then Subtract The Bond Yield ...And Only Then Subtract The Bond Yield Derived correctly therefore, the equity risk premium has turned negative for the first time since 2002 (Chart of the Week). We deduce that the equity market is very richly valued both in absolute terms and relative to bonds. And crucially, that this rich valuation is contingent on bond yields remaining ultra-low, or going even lower. Shorting Bonds Yielding 2 Percent Is A ‘Widow Maker’ All of which brings us to one of the most pressing questions we get from clients. When a bond is offering a feeble yield, what is the point in owning it? Maybe the best people to answer are the casualties of the now infamous ‘widow maker’ trades. The original widow maker trade was the idea that the yield on the Japanese Government Bond (JGB), at 2 percent, was so feeble that there was no point in owning it. Furthermore, with massive Japanese fiscal stimulus coming down the pike, the ‘no-brainer’ investment strategy was not just to disown the JGBs, but to take an outright short position, as it seemed that the only direction that JGB yields could go was up. In fact, JGB yields did not go up, they continued to trend down. As feeble yields became even feebler, the owners of the short positions got carried out of their careers, feet first. Meanwhile, those investors who owned 30-year JGBs yielding a ‘feeble’ 2 percent in 2013 reaped returns of 75 percent, and even now, are sitting on handsome profits of 55 percent. Some people protest that Japan is an exceptional and isolated case, rather than a template for economies which will not repeat their putative policy-errors. Such protests have always struck us as factually wrong, blinkered, and even prejudiced. Nevertheless, let’s indulge these prejudices with a simple rejoinder – forget Japan, what about Switzerland, or the UK? (Chart I-6) Chart I-6Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Meanwhile, those investors who owned 30-year UK gilts yielding a ‘feeble’ 2 percent in 2018 reaped returns of 40 percent, and even now are sitting on tidy profits of 30 percent. Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Bear in mind that a 30-year bond yielding a feeble 2 percent will deliver a cumulative return of more than 80 percent to redemption. And that if the feeble yield becomes even feebler, this return will get front-end loaded, creating widow makers for the short positions and spectacular gains for the long positions, as witnessed in JGBs and UK gilts. The 30-Year T-Bond Is A Must-Own Structural Investment The next candidate for the widow maker is shorting the US 30-year T-bond, which is yielding, you guessed it, 2 percent. Remember that while Japan may not be a great template for the US, the UK certainly is – because the US and UK have very similar economic, financial, political, social, and cultural structures. Until recently therefore, bond yields in the US and UK were moving in near-perfect lockstep (Chart I-7). Chart I-7The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock So, what happened? The one word answer is: Brexit. The recent difference between US and UK bond yields is simply that the UK has had one more deflationary shock than the US. Put the other way around, the US is just one deflationary shock away from a UK level of bond yields – meaning the 30-year yield not at 2 percent, but at 1 percent. But why can’t the next shock be an inflationary shock resulting in much higher yields? The simple answer is that the equity risk premium has turned negative for the first time since 2002. Moreover, as we pointed out in The Road To Inflation Ends At Deflation the extremely rich valuation of $300 trillion of global real estate is also highly contingent on ultra-low bond yields. It follows that any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. In a $90 trillion global economy, this will quickly flip any incipient inflationary shock into a deflationary shock. Any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. We conclude that the US 30-year T-bond is a must-own structural investment. Fractal Analysis Update As hospitals have rushed to clear their backlog of non-pandemic treatments and procedures, medical equipment stock prices have surged. This is particularly true for US medical equipment (ticker IHI) which, since June, is up by 25 percent versus US healthcare services (Iqvia, Veeva, or loosely proxied by ticker XHS). Given that the backlog of treatments will eventually clear, and that the intense rally is now extremely fragile on its 65-day fractal structure (Chart I-8), a recommended countertrend trade is to short US medical equipment versus healthcare services. Set the profit target and symmetrical stop-loss at 8.5 percent.  Chart I-8The Intense Rally In Medical Equipment Stocks Has Become Fragile The Intense Rally In Medical Equipment Stocks Has Become Fragile The Intense Rally In Medical Equipment Stocks Has Become Fragile   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations