Technology

Dear client, Next week instead of our regular Strategy Report we will be sending you a Special Report from BCA’s Equity Analyzer service on Inflation and Factor investing penned by my colleague Lucas Laskey, Senior Quantitative Analyst. Finally, on February 22 we will be hosting our quarterly webcast one at 10am EST for North American and EMEA clients and one at 8pm EST for Asia Pacific, Australian and New Zealand clients “From Alpha To Omega With Anastasios”. Mathieu Savary, who heads our Daily Insights service, will be our special guest in the morning webcast. On March 1 we will resume our regular publication schedule. Kind Regards, Anastasios Highlights Portfolio Strategy China’s engineered economic deceleration, the knee jerk US dollar bounce along with signs of soft US capital expenditures entice us to protect our deep cyclicals versus defensives portfolio gains and institute a 2.5% rolling stop to this share price ratio. Rising relative capital outlays, firming software pricing power and an M&A frenzy more than offset the negative relative profit signal from our models that sell side analysts already anticipate. Continue to overweight the S&P software index.  Recent Changes Last Tuesday we closed out our VIX futures hedge for a gain of 19% since the December 7, 2020 inception. Last Wednesday we re-initiated our long “Back-To-Work”/short “COVID-19 Winners” pair trade. Feature Equity volatility settled down last week following a ferocious ten-day SPX oscillation that sent the VIX soaring to roughly 38 near the peak at the end of January, courtesy of the GME/Wallstreetbets (WSB) saga before collapsing back down near 21 last week. Chart 1 shows that this was likely an equity-only event: both risk off currencies – the yen and the franc – actually fell versus the USD, junk bond spreads barely budged and the vol curve violently inverted, a move that more often than not signals that complacency has morphed into panic. Importantly, when the Fed embarks on active QE the SPX drawdown maxes out at 10% based on empirical evidence, including the recent September/October 10% drawdown. Using the ES futures low hit two Sundays ago, the S&P 500 experienced a 5.3% peak-to-trough pullback well within the range of previous Fed active QE iterations. As a reminder, the 2010 and 2011, 17% and 20% respective drawdowns took root after the Fed had concluded QE1 and QE2 operations. The implication is that for a more significant drawdown to materialize, likely the Fed has to end the current QE operation and reinject some volatility in the bond markets (bottom panel, Chart 1).  Isolating the true signal from all this noise, convinced us to book handsome gains to the tune of 19% in our VIX June futures hedge (conservatively assuming that no leverage was used), reinitiate the long “Back-To-Work”/short “COVID-19 Winners” pair trade and put the small cap size bias on our upgrade watch list. As volatility has slowly died down, investors can start to refocus on profit fundamentals. Similar to the steep fall in EPS that the SPX 35% drawdown predicted in March of 2020, in recent research we showed that were we to hold the SPX at current levels, its 12-month rate-of-change would surpass the 61% mark next month and forecast that profit growth would rise by a similar amount. Indeed, sell side analysts’ bottom up earnings estimates corroborate this analysis as quarterly EPS will peter out roughly at a 48% year-over-year (YOY) growth rate next quarter and vault to all-time highs in quarterly level terms in Q3 following a three-year hiatus (Chart 2). Chart 1Equity-only Event Equity-only Event Equity-only Event Chart 2Joined At The Hip Joined At The Hip Joined At The Hip Importantly, the tech sector no longer commands an earnings weight similar to its market cap weight likely because it’s run ahead of itself and also because the rest of the sectors are playing catch up this year as the US economy is slated to reopen on the back of the herculean inoculation efforts (profit weight and mkt cap weight columns, Table 1). Table 1Sector EPS And Market Cap Weights Re-grossing? Re-grossing? This is most evident on the sector contribution to this year's SPX earnings growth. Historically, the tech sector commanded the lion’s share of profit explanation for the SPX, but not in 2021. In fact, the S&P IT sector is ranked 4th in terms of contribution to overall SPX profits, behind industrials, financials and consumer discretionary (Chart 3).   Delving deeper into 12-month forward earnings growth figures is instructive. Table 2 shows our universe of coverage ranked first by GICS1 sector growth rates and then re-ranked per sub-group. As an aside the energy sector’s EPS is slated to contract in calendar 2020 and thus any YOY growth rate figures are rendered useless for the broad sector and the energy sub-industries. Chart 3Sector Contribution To 2021 SPX EPS Growth Re-grossing? Re-grossing? Table 2Identifying S&P 500 Sector EPS Growth Leaders And Laggards Re-grossing? Re-grossing? Our portfolio positioning is well aligned with the sector ranking of EPS growth for the coming year. Put differently, given the havoc that COVID-19 wreaked to the US industrial and service bases it is normal that deep cyclical sectors along with financials and the decimated services-heavy parts of the consumer discretionary sector to occupy the top ranks. In contrast, defensives sectors that were largely COVID-19 beneficiaries (especially health care and consumer staples) are near the bottom of the pit. The sole misalignment is the bombed out real estate sector that we remain overweight (Table 2). Netting it all out, our sense is that the market has successfully navigated a tumultuous two-week period and we reiterate our long-held sanguine 9-12 month cyclical view on the prospects of the S&P 500. This week, we update a defensive tech sub-group and put a tight stop in the cyclicals/defensives portfolio bent in order to protect profits. Risks To The Cyclicals Over Defensives Portfolio Bent Last December we highlighted that China’s four year cycle will peter out in the back half of 2021 and could cause some equity market consternation, with stocks likely sniffing out any trouble likely by the end of Q1/2021. It appears that investors have been sleeping at the wheel and largely distracted by the GME/WSB saga. Not only did they neglect the robust SPX profit season, but they also ignored that something is amiss in China as we first showed last week (please refer to Chart 12 here). Importantly, what worries us most is the transition from China being the primary locomotive of global growth to the US taking the reins in coming quarters. Clearly such a handoff is tumultuous, especially given the recent added risk of a reflex rebound in the greenback that we first warned about on January 12 when we set the cyclicals/defensives ratio on downgrade alert. Subsequently, we upgraded the S&P utilities sector to neutral locking in gains of 15% for the portfolio, and today we decide to institute a 2.5% rolling stop in the cyclicals/defensives portfolio bent, in order to participate on further upside but also protect 16% gains for the portfolio since the July 27, 2020 inception in case of a market relapse. Practically, when the rolling stop gets triggered we will move the cyclicals/defensives bent down to neutral via executing the downgrade alert we have in the S&P materials sector. In more detail, China’s slamming on the brakes is the key risk to cyclicals/defensives. Not only are the Chinese authorities trying to engineer a slowdown with the recent reverse repo operations, but also BCA’s China Monetary Indicator, the selloff in the Chinese sovereign bond market and the cresting in the PBOC’s balance sheet are all corroborating the economic deceleration signal (Chart 4). Chinese total social financing has peaked, the 6-month credit impulse is plunging, and the nosedive in Goldman Sachs’ Chinese current activity indicator (CAI) are all firing warning shots that the economy is slated to slowdown (Chart 5).  Chart 4Everywhere… Everywhere… Everywhere… Chart 5…One Looks… …One Looks… …One Looks… Already both the Chinese manufacturing and services PMIs have hooked down with the manufacturing new orders-to-inventories (NOI) in free fall and export orders in outright contraction. Tack on the reversal in the Citi economic surprise index (ESI) for China and the outlook dims further for US cyclicals/defensives (Chart 6). No wonder Chinese demand for loans has turned the corner, infrastructure spending has topped out and railway freight volumes have ticked down as a direct response to the tightening in Chinese monetary conditions (Chart 7). Chart 6…China… …China… …China… Chart 7…Is Slowing… …Is Slowing… …Is Slowing… Chinese imports flirting with the zero line best capture all this softening in Chinese data and also warns that the US cyclicals/defensives ratio is nearing a zenith (Chart 8). Beyond the dual risk of a counter trend rally in the USD and China’s undeniable deceleration, returning to US shores reveals another source of potential trouble for cyclicals/defensives. Chart 8…Down …Down …Down The US Citi ESI has come back down to earth, and the ISM manufacturing PMI cooled off last month with the NOI ratio flashing red (Chart 9). Importantly, Goldman Sachs’ US CAI is sinking like a stone corroborating that, at the margin, US economic data is softening (Chart 10). Moreover, US capex is in the doldrums courtesy of the collapse in EPS last year that dealt a blow to CEO confidence. Worrisomely, the rollover in the latest capex intentions from regional Fed surveys along with the downbeat NFIB survey’s capital outlays in 6-months component underscore that CEOs remain reluctant to invest (Chart 9). Chart 9Even US Trouble… Even US Trouble… Even US Trouble… Finally, relative valuations have surged to all-time highs leaving no cushion in case of a mishap, while relative technicals are in extreme overbought territory near a level that has marked the commencement of prior relative share price drawdowns (Chart 11). Chart 10…Is Brewing …Is Brewing …Is Brewing Netting it all out, China’s engineered economic deceleration, the knee jerk US dollar bounce along with signs of soft US capital expenditures entice us to protect our deep cyclicals versus defensives portfolio gains and institute a 2.5% rolling stop to this share price ratio. Bottom Line: Prepare to move the cyclicals/defensives portfolio bent back down to neutral from currently overweight. Today we recommend investors establish a 2.5% rolling stop to the cyclicals/defensives relative share price ratio as a risk management tool in order to protect profits. Chart 11Overstretched And Pricey Overstretched And Pricey Overstretched And Pricey Software On The Ascend While we remain on the sidelines with regard to the broad S&P technology sector we continue to recommend a barbell portfolio approach preferring defensive software and services stocks to aggressive hardware and equipment equities. In that light, we reiterate our overweight stance in the key S&P software sub-industry that still commands the highest market cap weight in the tech sector just shy of 33%. While overall capex is sluggish as we highlighted above, software capital outlays have recovered smartly and according to national accounts are growing at a 10%/annum pace. Stock market-reported capex confirms that software capital expenditures are on an absolute tear and remain a key pillar of our secular preference for this defensive tech group (Chart 12). On the sales front, COVID-19 accelerated the push to the cloud and 2020 has been a bumper year for industry sales. True there is an element of stealing revenues from the future, but as long-time readers of our publication know we do not believe that SaaS is a fad and the adoption of cloud services remains in the early innings. Impressively, while relative forward top line growth expectations have rolled over, the attempt of the software price deflator to exit deflation suggests that software stocks will easily surpass this lowered revenue bar in coming quarters (Chart 13). Chart 12Primary Capex Beneficiary Primary Capex Beneficiary Primary Capex Beneficiary Amidst the IPO frenzy that has captured investors’ imagination especially given the spectacular increases in both SNOW and PLTR (neither of which is in the SPX yet), software M&A fever remains as high as ever. This constant reduction of software stock supply, coupled with the insatiable appetite of software executives to aggressively retire equity, signals that software equity prices will remain well bid (Chart 14). Chart 13Software Tries To Exit Deflation Software Tries To Exit Deflation Software Tries To Exit Deflation Chart 14Positive Share Price Dynamics Positive Share Price Dynamics Positive Share Price Dynamics Nevertheless, our relative EPS growth models are waving a yellow flag. The SPX is slated to grow profits north of 25% this year, but according to our profit models software will only manage to grow in the single digits, thus trailing the broad market by a wide margin. Encouragingly, this grim relative profit growth backdrop is already reflected in depressed sell side analysts’ forecasts (Chart 15). Finally, while relative valuations are still lofty they recently have corrected back to one standard deviation above the historical mean. Similarly, relative technicals have worked off overbought conditions and have settled down near the recent historical average (Chart 16). Chart 15Risks… Risks… Risks… In sum, rising relative capital outlays, firming software pricing power and an M&A frenzy more than offset the negative relative profit signal from our models that sell side analysts already anticipate. Bottom Line: Continue to overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. Chart 16…To Monitor …To Monitor …To Monitor   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views January 12, 2021  Stay neutral small over large caps July 27, 2020 Overweight cyclicals over defensives (2.5% rolling stop) June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth

Dear Client, I am writing as the US Capitol goes under lockdown to tell you about a new development at BCA Research. Since you are a subscriber of Geopolitical Strategy, we wanted you to be the first to know. This month we are launching a new sister service, US Political Strategy, which will expand and deepen our coverage of investment-relevant US domestic political risks and opportunities. Over the past decade, we at Geopolitical Strategy have worked hard to craft an analytical framework that incorporates policy insights into the investment process in a systematic and data-dependent way. We have learned a lot from your input and have refined our method, while also building new quantitative models and indicators to supplement our qualitative, theme-based coverage. While our method served us well in 2020, the frantic US election cycle often caused clients to lament that US politics had begun to crowd out our traditional focus on truly global themes and trends. We concurred. Therefore we have decided to expand our team and deepen our coverage. With a series of new hires, we are now better positioned to provide greater depth on US markets in US Political Strategy while redoubling our traditional global sweep in the pages of Geopolitical Strategy. Going forward, US Political Strategy will cover executive orders, Capitol Hill, federal agencies, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. It will be BCA Research’s newest premium investment strategy service and will include the full gamut of weekly reports, special reports, webcasts, and client conferences. Meanwhile Geopolitical Strategy will return to its core competency of geopolitics writ large – including the US in its global impacts, but diving deeper into the politics and markets of China, Europe, India, Japan, Russia, the Middle East, and select emerging markets.  Both strategies will utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes (i.e. comparing constraints versus preferences). As you know best, we are agnostic about political parties, transparent about conviction levels and scenario probabilities, and solely focused on getting the market calls right. To this end, we offer you a complimentary trial subscription of US Political Strategy. We aim to become an integral part of your work flow – separating the wheat from the chaff in the political and geopolitical sphere so that you can focus on honing your investment process. We know you will be pleased to see Geopolitical Strategy return to its roots – and we hope you will consider diving deeper with us into US politics and markets. We look forward to hearing from you. Happy New Year! All very best, Matt Gertken, Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Table 1What EPS Hit To Expect? Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 2Democrats Won Georgia Seats, US Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 3B… In Georgia Runoffs Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 13Energy And Financials Turned Around With Vaccine Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.  

Mind The Cataract Mind The Cataract Since late summer we have published a number of reports arguing for a rotation out of expensive tech titan stocks and into beaten down late-cyclicals. Taking a closer look at the Nasdaq 100/S&P energy ratio is instructive. In just 7 trading days, the share price ratio has collapsed 20% from its November 6th high, once again highlighting the violent ongoing rotation within the US equity universe. Vaccine announcements were undoubtedly the catalyst that accentuated this rotation, but once the news of what appears to be peaking US COVID-19 cases hit the wire, this healthy rotation will likely reaccelerate (see chart). Bottom Line: We continue to recommend investors remain exposed to the economic reopening trade that news of effective vaccines has brought to the forefront.

The global semiconductor industry has been experiencing a record amount of IPOs and M&A deals in recent months. A flurry of IPOs and M&As in any industry often serves as a sign of a top in share prices (Chart 1). Chat 1Will Booming Semiconductor IPOs And M&As Mark A Peak In Share Prices? Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan The basis is that IPO and M&A booms usually occur when investor sentiment on that industry is super optimistic, which often coincides with a top in share prices. Does this mean that semiconductor stocks in general, and the ones in Taiwan and Korea in particular, are at their zenith? Our broad judgement is that semi stocks have not reached a secular peak. First, as we argued in a recent Special Report, the semiconductor industry is in a structural uptrend due to the continuing rollout of 5G networks and phones, a wider adoption of data centers, further technological advancements in artificial intelligence, cloud computing, edge computing and smaller nodes for chip manufacturing. Second, it is critical to differentiate a macro call on semiconductors from a bottom-up call on individual stocks. Not all semi companies have rallied in recent years, i.e., there has been great divergence among global semi stocks as shown in Chart 2. Chat 2The Performance Of Semiconductor Stocks Has Varied Greatly Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan Several semiconductor companies – like TSMC, Nvidia and AMD – have achieved technological breakthroughs, putting them in a position to enjoy high order volumes and charge higher prices. Not surprisingly, revenues of these companies have outpaced the industry average by a wide margin (Chart 3). Chat 3Semiconductor Companies' Revenues Have Diverged Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan Others – like Intel and Analog Devices - have posted inferior revenue gains because they have fallen behind technologically or because they are specializing in certain types of semiconductors for which demand and pricing have been lackluster. Chat 4One-Off Surge In Demand For Semis Might Be Over Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan Finally, if the global reflation trade resumes and global stocks continue advancing, as the first post-US election day suggests, there is little reason for global semiconductor stocks to falter at this moment. From the macro perspective, lower interest rates in the long run will support not-so-cheap semiconductor stock valuations. In addition, companies with access to unique technological capabilities will be able to raise their product prices benefiting their profits.    That said, there are also several signs that the global semi demand cycle might have entered a period of indigestion: The one-off demand surge for personal computers and gadgets and one-off ramp up of global server shipments due to the pandemic might be drawing to a close (Chart 4, top panel). Digitimes Research has reported that global server shipments are estimated to have slipped 6% sequentially in Q3 from Q2 and are projected to drop another 12% in Q4 (Chart 4, bottom panel). Unlike those in March-April, renewed lockdowns are unlikely to produce another surge in demand for digital equipment and, hence, for semis. Many people and companies have already settled into working from home. In short, as the effect of the one-off demand surge for digital hardware fades, global semi demand will moderate.  Semiconductor companies in general, and the ones in Korea and Taiwan in particular, have greatly benefited from China having stockpiled semiconductors in 2019 and 2020 in preparation for US sanctions on Huawei that went into effect on September 15, 2020 (Chart 5). The US supply ban on semiconductors to China for 5G technology will remain in place regardless of the outcome of the US presidential elections. Restrictions on semi sales to China will weigh on certain semi producers. In addition, smartphone sales in China generally, including 5G smartphone sales, have plunged as of late (Chart 6). Chat 5China Has Been Accumulating Semis Inventories Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan Chat 6China: Smartphone Shipments, Including 5G, Are Weak Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan   Finally, the PMI new orders sub-index for Taiwan’s electronic industry has rolled over, signaling a slowdown in its growth rate (Chart 7).   Similarly, the memory chip revenue indicator has recently rolled over, signaling a potential risk to memory stocks such as Samsung and Hynix which make up the Korean technology index (Chart 8). Chat 7A Moderation In The Taiwanese Semis Industry? Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan Chat 8Proxy for Value Of Memory Chips And Korean Tech Stocks Asian Semi Stocks: Upgrade Korea But Not Taiwan Asian Semi Stocks: Upgrade Korea But Not Taiwan   We have been advocating a neutral allocation to both the Korean and Taiwanese stock markets within the EM equity universe. One of our arguments for this strategy has been a potential escalation in the US-China confrontation going into the US elections. However, this risk has not materialized. We are upgrading the Korean bourse to overweight. As to Taiwan, a contested US election and the resulting vacuum of power in the next couple of months might lead to a rise in all types of geopolitical risks around the world. Taiwan could be one of these. We maintain a neutral allocation to the Taiwanese bourse within an EM equity portfolio. Bottom Line: In absolute terms, Korean and Taiwanese equity performance depends on the direction of global stocks. We will discuss the outlook for global and EM stocks in a Strategy Report to be published early next week when there is more clarity on the outcome of the US presidential elections. Within an EM equity universe, we are upgrading Korean stocks from neutral to overweight but keeping Taiwan’s allocation at neutral. Arthur Budaghyan Chief Emerging Markets Strategist arthur@bcaresearch.com Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes

Buenos Aires Consensus Buenos Aires Consensus The Fed remains a key player enabling the transition from Washington to fiscally loose Buenos Aires consensus as we outlined in this Monday’s Weekly Report. As fiscal valves open and debt piles rise, the bond market will be the only regulatory mechanism. The implication is that the interplay between future fed funds rate (FFR) expectations and the 10-year US Treasury yield becomes a key variable to monitor. The most recent, and similar to today, period was during the GFC, when the Fed held the FFR near zero from December 2008 until December 2015. In this seven-year period, the interplay between the FFR change expectations and the 10-year US Treasury yield reveals that the sensitivity of interest rates to FFR change expectations stood near 2-to-1; i.e. a 50bps increase in the FFR change expectations would push the 10-year yield 100bps higher and vice versa. Year-to-date, the 10-year US Treasury yield’s sensitivity to FFR change expectations has ranged between 1-to-1 and 2-to-1. Looking ahead post the election, the odds are rising of a mammoth fiscal package, especially if there is a “Blue Sweep” but also potentially in a renewed Trump administration. Under such a backdrop the 10-year US Treasury yield would spike and so will FFR hike expectations. Bottom Line: Any selloff in the bond market will serve as a catalyst for a rotation out of fully valued tech stocks and into deeply undervalued financials (see chart).  ​​​​​​​

A Complete Circuit A Complete Circuit Neutral Today, we are removing our downgrade alert from the S&P semiconductors index on the back of an improving macro backdrop. First and foremost, the semi sales cycle is tied to global rates that tend to lead by approximately 18 months. As Central Banks across the globe are committed to remain on the easening path, global semi sales will likely rebound further (middle panel). A revival of chip M&A activity which effectively reduces the supply of stocks does not show any signs of abating, and will continue to underpin semi stocks as premia paid remain elevated (bottom panel). Bottom Line: We remain neutral the S&P semiconductors index, but are removing our downgrade alert. On a related note, our underweight stance in the sister chip equipment index remains intact. Stay tuned.      

Continue To Avoid Semi Cap Names Continue To Avoid Semi Cap Names Underweight We are currently underweight the S&P semi equipment index in line with our broader strategy of preferring defensive software & services tech stocks at the expense of the more aggressive hardware & equipment tech stocks. Recent news of the Trump administration’s potential tightening of the noose on Chinese chip company SMIC (the country’s largest foundry) was a net negative for US semi cap names. It also was a wake up call for investors with regard to the sector’s vulnerability to a flare up in the US/China trade tensions, especially given the sell-side’s extremely optimistic sales and earnings projections (see chart).   Bottom Line: Stay underweight the S&P semiconductor equipment index. For more details, please refer to this Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG S5SEEQ – AMAT, KLAC, LRCX. ​​​​​​​

Highlights Portfolio Strategy We opt to stay patient and refrain from deploying fresh capital especially in the tech sector in the near-term; a better entry point will likely materialize between now and the end of the year. The softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and the risk of a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. A balanced outlook keeps us on the sidelines in the S&P home improvement retail (HIR) index. Recent Changes There are no changes to the portfolio this week. Table 1 Churning Churning Feature Equities tried to regain their footing last week, but risks still lingering on the (geo)political front should sustain the tug of war between bulls and bears and rekindle volatility. While monetary and fiscal policies will remain loose, the intensity of easing is waning as both the Fed’s impulse (i.e. second derivative) of asset purchases has ground to a halt and Congress has hit a stalemate over the next round of stimulus. Crudely put, the thrust of monetary and fiscal policies is at heightened risk of shifting from stimulative to contractive (Chart 1). As a result, we remain patient with fresh capital and will wait to deploy it when the dust settles hopefully by the end of the year. Turning to equity market internals and other high frequency financial market data is instructive in order to get a clearer picture of the direction of the broad equity market. The value line arithmetic and geometric indexes and small cap stocks that led the March 23 SPX trough are emitting a distress signal (Chart 2). Chart 1Running Out Of Thrust Running Out Of Thrust Running Out Of Thrust Chart 2Market Internals... Market Internals... Market Internals... Drilling deeper on a sector basis, hypersensitive chip stocks, energy shares, and discretionary versus staples equities will likely weigh on the prospects of the broad equity market (Chart 3). The VIX index, the vol curve and the yield curve, all excellent leading indicators of the S&P 500, have crested and warn that the shakeout phase has yet to run its course (VIX shown inverted ,Chart 4). Chart 3...Say It Is Prudent... ...Say It Is Prudent... ...Say It Is Prudent... Chart 4...To Remain On The Sidelines ...To Remain On The Sidelines ...To Remain On The Sidelines Trying to quantify the SPX drawdown, we turn to CBOE’s equity put/call (EPC) ratio. The EPC ratio is nowhere near recent extreme readings. SPX pullbacks since the early-2018 “Volmageddon” have corresponded to significantly higher EPC ratio readings. In the past 10 such iterations, the median EPC ratio has been 0.86, the mean 0.93, with a range of 0.77 to 1.28 (Table 2). Currently, the EPC ratio is hovering near 0.58 suggesting that downside risks persist (EPC ratio shown inverted, Chart 5). Chart 5Downside Risks Persist Downside Risks Persist Downside Risks Persist Table 2Equity Put/Call (EPC) Ratio During Pullbacks Since 2018 Churning Churning Finally, the commodity complex is also firing warnings shots. Lumber has collapsed nearly $300/tbf from the recent peak, oil is trailing gold bullion and silver is also cresting versus the yellow metal, iron ore is petering out and the Baltic dry index is wobbling. True, copper and materials stocks are holding their own, but overwhelmingly commodity market internals are waving a yellow flag (Chart 6). Chart 6Commodity Yellow Flags Commodity Yellow Flags Commodity Yellow Flags Netting it all out, we opt to stay patient and refrain from deploying fresh capital especially in the tech space in the near-term; a better entry point will likely materialize between now and the end of the year. This week we reiterate our underweight stance in a niche technology index and shed more light on our recent downgrade to neutral of a key consumer discretionary subgroup. Chip Equipment Update: Tangled Up In The Trade War We remain committed to our intra-tech strategy of preferring defensive software and services tech names to aggressive hardware and equipment tech stocks. In that light, we reiterate our underweight stance in the niche S&P semi equipment index. Recent news of the Trump administration’s potential tightening of the noose on Chinese chip company SMIC (the country’s largest foundry) was a net negative for US semi cap names, similar to export restrictions of American technology to Huawei was a net negative for US semi cap names. As a reminder, these manufacturers count China as one of their largest export market alongside Taiwan and South Korea. Thus, this flare up in the US/Sino trade war bodes ill for semi cap companies’ future sales and profit growth projections (Chart 7). There are high odds that relative share prices have plateaued earlier this month and a fresh down cycle has commenced. Under such a backdrop, this hyper-sensitive manufacturing group will likely overshoot to the down side as is evident in the historical tight correlation with the ISM manufacturing survey: these violent oscillations are warning that a cooling off in the ISM will be severely felt in this niche manufacturing intense index (Chart 8). Chart 7Lofty Expectations Lofty Expectations Lofty Expectations Chart 8Violent Oscillations Violent Oscillations Violent Oscillations On the global demand front, there is an element that COVID-19 is stealing sales from the future and bringing demand forward. Already global semi sales are rolling over, and a couple of industry pricing power proxies are deflating at an accelerating pace: Asian DRAM prices are topping out in the contraction zone and Taiwanese export prices are sinking like a stone, warning that a deficient demand down cycle will squeeze semi cap profit margins (Chart 9). Importantly, Taiwanese tech capex, which TSMC dominates, has crested, warning that all the euphoria behind 5G deployment and uptake is likely baked in the relative share price ratio. The implication is that semi cap names remain vulnerable to any global 5G-related hiccups (top panel, Chart 10). Chart 9Waning Selling Price Backdrop Waning Selling Price Backdrop Waning Selling Price Backdrop Chart 10Cresting Cresting Cresting Finally, the tight positive correlation between Bitcoin prices and the relative share price ratio remains intact. Were a knee-jerk rebound in the US dollar to knock down Bitcoin, at least temporarily, it would serve as a catalyst to shed chip equipment stocks (bottom panel, Chart 10). Moreover, 90% of the industry’s sales originate abroad, thus a rise in the greenback would eat into their P&L via FX translation losses. Adding it all up, a softening demand backdrop that is weighing on selling prices, the rekindling of the US/China tech-related trade war and a reflex rebound in the US dollar, all warn to shy away from semi cap stocks. Bottom Line: Stay underweight the S&P semiconductor equipment index. The ticker symbols for the stocks in this index are: BLBG S5SEEQ – AMAT, KLAC, LRCX. Home Improvement Retailers: Stay On The Sidelines Two weeks ago our trailing stop was triggered in the S&P home improvement retail index (HIR) and we monetized gains of 15% since the mid-April inception and moved to the sidelines. Today we reiterate our benchmark allocation in this consumer discretionary sub group. Clearly, HIR was a major beneficiary of the lockdown as the US and Canadian governments deemed these retailers “essential” and allowed them to stay open during the peak of the pandemic. These Big Box retailers saw their sales soar as the fiscal easing package replenished consumers’ wallets, and coupled with the lockdown, caused a surge in DIY remodeling activity. Our portfolio also greatly benefited from the stellar performance of the S&P HIR index, as existing home sales staged a significant comeback and inventories of homes for sale receded substantially thus further tightening the residential real estate market (top & middle panels, Chart 11). As reminder, historically a vibrant housing market is synonymous with handsome returns in relative share prices and vice versa. But now a number of stiff headwinds, which our HIR model encapsulates, signal that a lateral digestive move is in store in the coming months (Chart 12). Chart 11Unsustainable Front Running Unsustainable Front Running Unsustainable Front Running Chart 12Stiff Headwinds Stiff Headwinds Stiff Headwinds First, a repeat of the spike in demand for home improvement projects is highly unlikely, especially given that demand was brought forward. Also during the autumn and winter months there is a natural slowdown in the take-up of remodeling projects until the spring home selling season arrives. Second, the industry’s sales-to-inventories (S/I) ratio is literally off the charts (bottom panel, Chart 11). An inventory build-up and easing in demand will bring back the S/I ratio back to a more reasonable level. Lastly, lumber prices have taken a beating of late collapsing from over $900/tbf to below $600/tbf. This drubbing of this economically hypersensitive commodity directly cuts into HIR earnings. These Big Box retailers make a set margin on lumber sales so as prices fall they take a big bite out of profits (bottom panel, Chart 13). Nevertheless, a few offsets prevent us from turning outright bearish in this early cyclical retailers. Namely, the industry’s profit growth bar is on a par with the broad market and thus does not pose a large hurdle to overcome. Importantly, given that HIR earnings have kept pace with the massive run-up in stock prices (second panel, Chart 14), they have kept relative valuations at bay. While, the S&P HIR 12-month forward P/E trades at a market multiple, the relative forward P/E changes hands at a 20% discount to the historical mean. Thus, HIR enjoy a significant valuation cushion (bottom panel, Chart 14). Chart 13Timber! Timber! Timber! Chart 14But There Are Powerful Offsets But There Are Powerful Offsets But There Are Powerful Offsets Finally, the Fed just explicitly committed to stay on the zero interest rate line until 2023! This easy monetary policy as far as the eye can see is a powerful tonic to early cyclical and interest rate-sensitive home improvement retailers (fed funds rate shown inverted, top panel, Chart 14). Netting it all out, a balanced outlook keeps us on the sidelines in the S&P HIR index.  Bottom Line: Stick with a benchmark allocation in the S&P home improvement retail index. The ticker symbols for the stocks in this index are: BLBG S5HOMI – HD, LOW.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Languishing Buybacks Languishing Buybacks This summer we have been highlighting unsustainable trends in the US equity market and today we turn our attention to buybacks. As we first pointed out in the late-2019 Weekly Report, share buybacks have been a key pillar underpinning stocks since the GFC averaging roughly $500bn/annum since 2010, and reaching nearly the $1tn/annum mark in 2018 on the back of President Trump’s massive fiscal easing package. Clearly, such breakneck pace was unsustainable and a renormalization was overdue.  Fast forward to Q2, and even our conservative quarterly $125bn equity retirement estimate proved overly optimistic. From the recent peak to just below $90bn/qrt, SPX buybacks have fallen by a whopping 67%. Such a corporate buyer’s strike is negative for the near term prospects of the S&P 500 (top panel). Drilling deeper beneath the surface is revealing. When we disaggregate the headline buybacks number into GICS1 sectors, we observe that once again the tech titans (comprising the S&P technology and the S&P communication services indexes) are doing all the heavy lifting accounting for 70% of the overall number (bottom panel). Q2 was the first time in recent memory that a cross has occurred where tech accounts for more buybacks that all the other sectors put together! Bottom Line: We continue to recommend investors keep some powder dry and refrain from deploying capital at the current juncture. A better entry point in the broad equity market will likely materialize in late Q4.

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs More Stimulus Needed More Stimulus Needed Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators High-Frequency Bond Indicators High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers More Stimulus Needed More Stimulus Needed This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings Three Scenarios For Income And Savings Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC More Stimulus Needed More Stimulus Needed Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One More Scenario One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed More Stimulus Needed More Stimulus Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot Inflation Coming In Hot Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories More Stimulus Needed More Stimulus Needed The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success.   Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities More Stimulus Needed More Stimulus Needed Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification