Sectors

Banks face many challenges from a slower economy and tighter financial conditions, which offset benefits from rising rates and higher net interest income. It is likely that things will get worse, a sentiment supported by many banking executives. However, negative expectations have already been priced in. We will maintain our overweight for now but will fade this position after a bounce in the next bear market rally. The long-term outlook is negative. We prefer Regional Banks to Diversified Banks.

Is the BoE’s emergency intervention in its bond market a British idiosyncrasy that global investors can ignore? No, the UK’s near death experience sends three salutary warnings, with implications for all investors.

Stay defensive at least until the US midterm election is over. Gridlock is disinflationary in 2023 and hence marginally positive for US equities. But any relief rally will be short-lived as recession risks are very high.

The Fed says that to get back to 2 percent inflation, the US unemployment rate must increase by ‘just’ 0.6 percent through 2023-24. All well and good you might think, except that the Fed is forecasting something that has been unachievable for at least 75 years! Is the Fed gaslighting us? And what does it mean for investment strategy?

This week, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for Q3/2022. We also discuss the model portfolio’s expected performance over next 3-6 months after our recent moves to reduce overall duration exposure and increase the underweight to US Treasuries.

This week we present our Portfolio Allocation Summary for October 2022.

We remain bearish on equities. Inflation is a monetary phenomenon that is embedded and perpetuated by a wage-price spiral. The Fed will “keep at it until the job is done.” Economic growth is slowing, and an earnings recession as soon as the end of this year is highly likely. US equities are not cheap and rising rates and slowing earnings growth will take their toll on performance. Don’t fight the Fed!

Executive Summary For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. To reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. In the US, a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. This reiterates our ‘2022-23 = 1981-82’ template for the markets. A coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. It Now Costs Twice As Much To Buy Than To Rent A UK Home! Bottom Line: Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation. Feature Mortgage rates around the world have skyrocketed. The UK 5-year fixed mortgage rate which started the year at under 2 percent has more than doubled to over 5 percent. And the US 30-year mortgage rate, which began the year at 3 percent, now stands at an eyewatering 7 percent, its highest level since the US housing bubble burst in 2008. This raises a worrying spectre. Is the recent surge in mortgage rates about to trigger another housing crash? (Chart I-1 and Chart I-2). Chart I-1UK Mortgage Rate Has Doubled Chart I-2US Mortgage Rate Has Doubled A good way to answer the question is to compare the cashflow costs of buying versus renting a home. This is because home prices are set by the volume of homebuyers versus home-sellers. If would-be homebuyers decide to rent rather than to buy – because renting gets them ‘more house’ – then it will drag down home prices. Here’s the concern. For the first time in a decade, it is much less attractive to buy than to rent a home. In both the UK and US, the mortgage rate is now almost double the average rental yield. Put another way, whatever your monthly housing budget, you can now rent a home worth twice as much as you can buy (Chart I-3 and Chart I-4). Chart I-3It Now Costs Twice As Much To Buy Than To Rent A UK Home! Chart I-4It Now Costs Twice As Much To Buy Than To Rent A US Home! The Universal Theory Of House Prices Buying and renting a home are not the same thing, so the head-to-head comparison between the mortgage rate and rental yield is a simplification. Buying and renting are similar in that they both provide you with somewhere to live, a roof over your head or, in economic jargon, the consumption service called ‘shelter’. But there are two big differences. First, unlike renting, buying a home also provides you with an investment whose value you expect to increase in the long run. Second, unlike renting, buying a home incurs you the costs of maintaining it and keeping it up-to-date. Studies show that the annual cost averages around 2 percent of the value of the home.1 So, versus renting, buying a home provides you with an expected capital appreciation, but incurs you a ‘depreciation’ cost of around 2 percent a year. Which results in the following equilibrium between buying and renting: Mortgage rate = Rental yield + Expected house price appreciation - 2 But we can simplify this. In the long run, the price of any asset must trend in line with its income stream. Therefore, expected house price appreciation equates to expected rental growth. Also, rents move in lockstep with wages (Chart I-5). Understandably so, because rents must be paid from wages. And wage growth itself just equals consumer price inflation plus productivity growth, which averages around 1 percent (Chart I-6). Pulling all of this together, the equilibrium simplifies to: Chart I-5Rents Track Wages Chart I-6Rent Inflation = Wage Inflation = Consumer Price Inflation + 1 Mortgage rate = Rental yield + Expected consumer price inflation - 1 So, here’s our first conclusion. Assuming central banks achieve their long-term inflation target of 2 percent, the equilibrium becomes: Mortgage rate = Rental yield + 1 Under this assumption, to justify the current UK rental yield of 3 percent, the UK mortgage rate must plunge to 4 percent. But given that the government has just triggered an incipient balance of payments and currency crisis, the mortgage rate is likely to head even higher. In which case the rental yield must rise to at least 4 percent. Meaning either house prices falling 25 percent, or rents rising 33 percent. Meanwhile, to justify the current US rental yield of 3.7 percent, the US mortgage rate must plunge to 4.7 percent. Alternatively, to justify the current mortgage rate of 7 percent, the rental yield must surge to 6 percent. Meaning either house prices crashing 40 percent, or rents surging 60 percent. More likely though, all variables will correct. The equilibrium between buying and renting will be re-established by some combination of lower mortgage rates, lower house prices, and higher rents. The Housing Investment Cycle Is Turning Down The relationship between buying and renting a home raises an obvious counterargument. What if central banks cannot achieve their goal of price stability? In this case, expected inflation in the equilibrium would be considerably higher than 2 percent. This would justify a much higher mortgage rate for a given rental yield. Put differently, it would justify rental yields to stay structurally low (house prices to stay structurally high), even if mortgage rates marched higher. In an inflationary environment, houses would become the perfect foils against inflation. In an inflationary environment, houses would become the perfect foils against inflation because expected rental growth would track inflation – allowing rental yields to stay depressed versus much higher mortgage rates. This is precisely what happened in the 1970s. When the US mortgage rate peaked at 18 percent in 1981, the US rental yield barely got above 6 percent (Chart I-7). Chart I-7In The Inflationary 70s, The Rental Yield Remained Well Below The Mortgage Rate... If the market fears another such inflationary episode, would it make the housing market a good investment? In the near term, the answer is still no, for two reasons. First, even if rental yields do not track mortgage rates higher point for point, the yields do tend to move in the same direction – especially when mortgage rates surge as they did in the 1970s (Chart I-8). Some of this increase in rental yields might come from higher rents, but some of it might also come from lower house prices. Chart I-8...But Even In The 70s, The Rental Yield And Mortgage Rate Moved Directionally Together Second, based on the US, it is a bad time in the housing investment cycle. Theoretically and empirically, residential fixed investment tracks the number of households in the economy. But there are perpetual cycles of underinvestment and overinvestment – the most spectacular being the overinvestment boom that preceded the 2007-08 housing crisis. US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Therefore, contrary to the popular perception, there is not an undersupply of homes, but a marked oversupply relative to the number of households. (Chart I-9). This is important because, as the cycle turns down now – as it did in 1973, 1979, 1990, and 2007 – the preceding overinvestment always weighs down housing valuations (Chart I-10). Chart I-9The US Housing Investment Cycle Has Moved Into Overinvestment Chart I-10A Housing Investment Downcycle Always Weighs On Housing Valuations The Investment Conclusions Let’s sum up. If the market believes that economies will return to price stability, then to reset the equilibrium between buying and renting a home, either mortgage rates must come down by around 150 bps, or house prices must suffer a large double-digit correction. Or some combination, such as mortgage rates down 100 bps and house prices down 10 percent. If the market believes that economies will not return to price stability, then house prices are still near-term vulnerable to rising mortgage rates – especially in the US, as a 10-year upcycle in housing investment has resulted in overinvestment relative to the number of households.  US housing investment has just experienced a 10-year upcycle in which it has overshot its relationship with the number of households. Falling house prices coming hot on the heels of a combined stock and bond market crash will unleash a deflationary impulse in 2023, which will return economies to 2 percent inflation – even if the markets do not believe it now. This reiterates our ‘2022-23 = 1981-82’ template for the markets, as recently explained in Markets Still Echoing 1981-82, So Here’s What Happens Next. In summary, a coordinated global recession will cause bond prices to enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Meanwhile, the S&P 500 will test 3500, or even 3200, before a strong rally will lift it through 5000 later in 2023. Analysing The Pound’s Crash Through A Fractal Lens Finally, the incipient balance of payments and sterling crisis triggered by the UK government’s unfunded tax cuts has collapsed the 65-day fractal structure of the pound (Chart I-11). This would be justified if the Bank of England does not lean against the fiscal laxness with a compensating tighter monetary policy. But if, as we expect, monetary policy adjusts as a short-term counterbalance, then sterling will experience a temporary, but playable, countertrend bounce. Chart I-11The Pound Usually Turns When Its Fractal Structure Has Collapsed On this assumption, a recommended tactical trade, with a maximum holding period of 65 days, is to go long GBP/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Chart 1Hungarian Bonds Are Oversold Chart 2Copper's Tactical Rebound Maybe Over Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started Is Fragile Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 11The Strong Downtrend In The 3 Year T-Bond Is Fragile Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Fragile Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The Rate of Return on Everything, 1870–2015 (frbsf.org) Fractal Trading System Fractal Trades 6-12 Month Recommendations 6-12 MONTH RECOMMENDATIONS EXPIRE AFTER 15 MONTHS, IF NOT CLOSED EARLIER. Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Please note I will be hosting a live webcast on September 29, 2022 at 9:00 AM HKT for the APAC region. I will discuss the global/China/EM macro outlooks and financial market implications. For clients in the Americas and EMEA, we had a webcast on September 28, 2022. You can access the replay via this link. Arthur Budaghyan Executive Summary Global Semi Stock Prices: Further Downside Ahead Global semiconductor stock prices are still vulnerable to meaningful downside over the next three months. Global semi consumption will contract due to the corresponding waning demand of smartphones, personal computers, and other consumer electronics. Global semi demand in sectors of automobiles and datacenters will continue growing. However, such an increase in demand cannot offset the demand reduction in other sectors. Semiconductor consumption in China has entered a contraction phase.  Semiconductor inventories have swelled. Alongside a sharp upsurge in chip production capacity, this increase in inventories will lead to chip price deflation in the next nine months. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point for semi stocks.  Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will seek to recommend buying semiconductor stocks when a more material decline in semi companies’ profits is priced in their share prices. At the moment, we are downgrading Taiwanese stocks from neutral to underweight relative to the EM equity benchmark but are maintaining an overweight stance on the Korean bourse within an EM equity portfolio.   The global semiconductor equity index is breaking below its technical support (Chart 1). The implication is that these share prices are in an air pocket and investors should not chase a declining market. Based on previous cycles, we expect global semiconductor stocks to bottom late this year or early next year and semi sales to trough in 2023Q2. In the previous five cycles, global semi stocks always bottomed before global semi sales and lead times varied from three-to-six months. Chart 2 shows that Taiwan’s semiconductor new export orders lead global semi sales by about three months, and they continue to point to considerable downside in the global semi-industry. Chart 1Global Semi Stocks: Breaking Down Chart 2Global Semi Sales: More Downside Ahead The semiconductor industry has a history of cyclicality. Shortages have been followed by oversupply, which has led to declining prices, revenues, and profits for semi producers. This time is no exception Global Semi Sales: A Cyclical Slump Underway Global semiconductor demand began its downward trajectory in May of this year and will continue to slide in the next three-to-six months. Both the volume and value of China’s semiconductor imports are in a deep contraction and China’s imports from Taiwan have also plummeted (Chart 3). China is the world’s largest consumer of semiconductors, accounting for 35% of global demand. We expect semi sales to remain in contraction in China and to shrink in regions outside China in the next six-to-nine months (Chart 4).  Chart 3China's Semi Imports Plummeted Chart 4Semi Sales Will Contract Across Regions There are several important reasons for the retrenchment worldwide. First, the lockdowns around the world in 2020 and 2021 generated an unprecedented increase in online activities and a corresponding surge in demand for smartphones/PCs/tablets/game consoles/electronic gadgets. This was the main driving force for the boom in global semiconductor sales from 2020Q3 to 2022Q1. The excessive demand for consumer goods and electronics has run its course and global demand will sag in the next six months. As we have been contending since early this year, global exports are set to contract. Households that bought these goods in the past two years probably will not make new purchases in the near term. In addition, declining real disposable income and rising interest rates will constrain consumer spending. Smartphones, PCs, tablets, home appliances, and other household electronic goods consume about half of global semi output. In addition, rising job uncertainties resulting from China’s dynamic zero-COVID policy and slowing household income growth will curb consumption within China. Here are our takeaways for each segment: Chart 5China's Output Of Mobile Phones And PCs Has Been Shrinking Mobile phones: Mobile phones are the largest contributor to global semi sales, with a share of 31% as of 2021, based on the data from World Semiconductor Trade Statistics (WSTS). According to the International Data Corporation (IDC), global smartphone shipments are set to decline by 6.5% year-over-year in volume terms in 2022. Smartphone OEMs cut their orders drastically in 2022 because of high inventories and low demand, with no signs of an immediate recovery. China accounts for 67% of global mobile phone production and its mobile phone production has been contracting (Chart 5, top panel).   Traditional PCs and tablets: Based on data from the IDC, global traditional PC1  and tablet shipments are set to decline by 12.8% year-over-year in 2022 and by an additional 2.6% next year in volume terms. Computer production in China, which is the world’s largest computer producer and exporter, also shows massive downsizing (Chart 5, bottom panel).   Home appliances: China is also the largest producer and exporter of air conditioners (ACs), washing machines, refrigerators, and freezers. Except for a slight growth in AC output in response to heatwaves in China and Europe, China’s output of other home appliances will shrink. Globally, these industries accounted for about half of all semiconductor sales in 2021. Given the overconsumption of these goods worldwide over the past two years, we expect a material decline in these sectors in the next six-to-nine months. Second, automobiles, servers, and industrial electronics, which together account for about 30% of global semi sales, will have positive single-digit growth going forward. Yet, such an increase will not be enough to offset the lost demand from the consumer electronic goods sector in the next six-to-nine months.  Chart 6Global Auto Production Will Rise Automotive (accounts for 11% of world chip demand): The chip shortage in this sector has eased only moderately. Auto output levels in major producing countries remain well below their pre-pandemic levels (Chart 6). In light of improved foundry capacity, semiconductor producers will be able to produce automotive chips and reduce lingering shortages. However, for most chips to automakers, there are no supply shortages. Only a small number of categories of automotive chips, such as microcontrollers (MCU) and insulated-gate bipolar transistors (IGBT), are still in tight supply. Given that the total automotive sector only accounted for about 5% of total global semi sales last year, the recovery in global automobile output will contribute only limited growth to global semi sales.   Servers (account for 10% of world chip demand): The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers. Total server demand is comprised of data servers for cloud providers and private enterprises, with the former as the main driving force in recent years.  Data center expansion among cloud service providers will be driven by 5G, automotive, cloud gaming, and high-performance computing. After expanding by 10% last year, the pace of annual growth in global server shipments will likely be more moderate, to about 5%-6% in the next couple of quarters.   Chart 7Global Industrial Demand For Chips Is Set to Decelerate Industrial electronics (account for 9% of world chip demand): The growth rate in semi demand for this sector is falling. The global manufacturing new order-to-inventory ratio has plunged, and global manufacturing production is set to decline for the rest of this year and through to 2023H1 (Chart 7). Nevertheless, given structural tailwinds for industrial electronics, we expect semi demand in this sector to dip to single-digit growth in the near term rather than to contract.  Third, with semiconductor inventories having surged, new orders for chips, and hence their production, will plummet.   The length and intensity of the chip shortage, which started in 2020H2, triggered stockpiling among a broad range of customers, including manufacturers of smartphones and other consumer electronics. Moreover, the recent slowdown in smartphone/PC demand increased the inventory of silicon chips. Chart 8Semiconductor Inventory Overhang China had also stockpiled semiconductors from 2020Q2 to 2021Q4. With faltering demand, the country will continue its destocking process in the next couple of quarters. Semiconductor inventories in Taiwan and Korea have surged, corroborating the fact that the current cyclical downturn in the global semi sector will be a severe one (Chart 8). Hence, businesses in the semi supply chain will continue to draw upon their inventories rather than increase their semiconductors orders. This will reduce semiconductor demand meaningfully in the coming months. Bottom Line: The cyclical slump in worldwide semiconductor sales has further to go, with the sector’s sale volumes and prices projected to contract in the next six months. Semi producers will experience a substantial decline in their profits. Comparing Cycles Previous cycles may provide insight in the downside of the cyclical slump in global semi sales. In the previous five cycles, global semi sales experienced a contraction, ranging from 7% to 45% (Table 1). In the current cycle, global semi sales still had 7% year-over-year growth in 2022Q2 (Chart 9). Table 1Six Cyclical Downturns In Global Semiconductor Market Chart 9Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices In fact, the current downturn could be deeper than the one between 2018 and 2019 (when sales contracted by 16%) for the following reasons: Sales of both cell phones and PCs will likely dwindle further this time than they did in 2018 to 2019. The pandemic boosted demand for consumer electronics, but this also brought forward future demand. In comparison with 2018, the current cycle might have a longer replacement cycle for mobile phones and PCs. Unlike 2019, global demand for consumer goods will likely contract rather than decelerate. This has ramifications for the duration and magnitude of the semi downturn.   Economic growth, and job and income uncertainties in China are much worse now than they were between 2018 and 2019. These factors will likely lead to a bigger cut in IT spending by both consumers and businesses, resulting in a larger downturn in global semi demand in this cycle. The tech battle between the US and China is more intense than in it was from 2018 to 2019. In mid-2018, the U.S. imposed a 25% tariff on Chinese imports of semiconductor goods, including machines and flat panel displays. China retaliated by imposing its own 25% tariff on U.S. exports of semiconductor goods, such as test equipment. This month, the US imposed new restrictions on NVIDIA and AMD in relation to selling artificial intelligence chips to Chinese customers. The US also plans to curb further its shipments of chipmaking tools to China. These plans will cut China’s imports of high-end semi products, for which producers enjoy high profit margins. In addition, the shortage of these chips will stall the development and sales of many consumer products within China, which will thereby reduce demand for other types of chips needed for consumer products. Chart 10Rapid Semi Capacity Expansion Worldwide Global semi capacity expansion has recently been much stronger in current cycle than it was in the 2016-2018 cycle. This may lead to a bigger supply surplus in this cycle than in the last one. It takes about 18-24 months, on average, to build a new semiconductor fabrication plant. Thus, large capital expenditures by semi producers in 2021-22 entail considerable new supply in 2023-24. According to IC Insights, the annual wafer capacity growth rates were 6.5% in 2020, 8.5% in 2021 and 8.7% in 2022. This compares with 4%-6.5% between 2016 and 2018 (Chart 10). Rapid capacity expansion typically leads to price deflation for chips and is therefore negative for the semi producers’ profitability and their share prices. Are global semi stock prices already pricing bad news? We do not think so. Nearly all major players saw a drop in revenues in the past cycle. In sharp contrast, only Intel’s revenues have dropped so far in the current cycle (Chart 11). Global semi stock prices will continue falling as companies report shrinking sales and earnings in the next couple of quarters. In former cycles when global semi stocks bottomed, investor sentiment – as measured by the net EPS revisions – was more downbeat than it is currently (Chart 12). Chart 11More Semi Companies' Sales Are Likely To Contract Chart 12Global Semi Stock Prices: Net EPS To Drop More Bottom Line: The global semiconductor sector’s cyclical slump could be deeper than it was in the 2018-2019 cycle. Hence, shares prices will fall considerably more than they did in late 2018. Ramifications For Taiwanese And Korean Markets Taiwanese and Korean semiconductor stock prices will probably continue to fall in absolute terms. The former recently broke its three-year moving average and the latter its six-year moving average (Chart 13). Chart 13Taiwanese And Korean Semi Stock Prices Will Fall Further Chart 14TSMC: Smartphone And HPC Make 81% Of Revenue For TSMC, the smartphone sector still accounts for 38% of revenues (Chart 14). Hence, a contraction in global smartphone sales in the next six-to-nine months could hurt the company’s top and bottom lines considerably. Meanwhile, the high-performance computing (HPC) sector became the largest contributor of TSMC revenues with a 43% share. A slowdown in data center investment and a decrease in GPU demand due to falling bitcoin prices will also materially affect the company’s profitability. In addition, the US government’s AI chips export restriction policy will decrease NVIDIA and AMD AI sales to China. According to NVIDIA’s news release, approximately US$400 million in potential chip sales to China (including Hong Kong) will likely be subject to this new restriction. AI chips are manufactured by TSMC with its advanced node technology and have a high-profit margin. Hence, the new policy will negatively impact TSMC’s revenues and profits. For Samsung, the memory market is in a free-fall due to plummeting demand (Chart 15). TrendForce expects the average overall DRAM price to drop by 13-18% in 2022Q4 because of high inventories in the supply chain and stagnant demand. The semi shipment-to-inventories ratios for both Taiwan and South Korea nosedived, pointing to lower semi stock prices in these two markets (Chart 16). Chart 15Samsung: Vulnerable To Sinking Prices Of Memory Chips Chart 16Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Bottom Line: Both TSMC and Samsung stock prices have more downside over the next three months.  Equity Valuations And Investment Conclusions The global semiconductor stock index in USD terms has tumbled by 45% from its recent peak. Multiples of semiconductor stocks are near their long-term average levels (Chart 17 and 18). These multiples could undershoot as they did in 2018-2019, which means even more downside is ahead. Chart 17Multiples Of Semi Stocks Could Undershoot Chart 18Multiples Of Semi Stocks Could Undershoot Aside from the profit outlook, higher US bond yields are also causing multiple compression for global semiconductor stocks (Chart 19). As to the allocation to semi stocks within an EM equity portfolio, we recommend downgrading Taiwan from a neutral allocation to underweight and reiterate an overweight stance on the KOSPI. The US-China geopolitical confrontation will escalate in the coming years and Taiwan is at the epicenter of this. These are relative calls, that is against the EM benchmark (Chart 20). We remain negative on their absolute performance. Chart 19Higher US Bond Yields = Multiple Compression In Global Semi Stocks Chart 20Downgrade Taiwan To Underweight Relative To The EM Benchmark   Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We would recommend buying semiconductor stocks after pricing in a more material contraction in semi companies’ revenues and profits. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     Traditional PCs are comprised of desktops, notebooks and workstations.

Executive Summary The USD has appreciated by over 25% since the beginning of 2021. This is a negative for US corporate sales and profits and is a drag on US equity performance. According to BCA FX strategists, the USD is likely to roll over as it appears overbought and overvalued. However, even if the USD has peaked, the effects of its appreciation will be imprinted in the earnings of US corporates for months. Our earnings model signals an earnings recession, with earnings expected to contract to the tune of 20% into the year-end. Technology and Materials are most exposed to the dollar, while Utilities, Financials, and Real Estate are the most domestic sectors. Growth is a more international style than Value, while midcaps offer the best protection from a stronger greenback. USES Model Breakdown Bottom Line: While a strong dollar is certainly a headwind for US earnings growth and for the performance of US equities, its adverse effects are minor compared to the effects of tighter monetary policy, slowing growth at home and abroad, rising costs, falling productivity, and fading pricing power. An earnings recession is inevitable. Dollar depreciation will be a welcome development, yet the dollar should be the least of investors’ worries. Feature The USD has appreciated by over 25% since the beginning of 2021 (Chart 1), a concerning development for US equity investors. The S&P 500 companies derive roughly 40% of sales from abroad and the strong dollar is a headwind: Not only does an appreciating domestic currency diminish foreign earnings through a currency translation effect, but it also makes US goods and services more expensive and less competitive in a global marketplace. Related Report  US Equity StrategyUS Dollar Bear Market: What To Buy & What To Sell Over the past few months, a number of US multinationals have complained about the adverse effect of the strong greenback on their sales and earnings. The list is both long and diverse and includes technology giants like Microsoft, Dell, and Netflix as well as the likes of Philip Morris, Johnson and Johnson, TJX, and Costco. Investors paid attention: Since the beginning of 2021, US companies with a high share of international sales underperformed their more domestically oriented counterparts by about 20% (Chart 2). However, partially this divergence in performance may be explained by the international index heavily overrepresenting Tech, which has headwinds of its own. Chart 1The USD Has Appreciated By Over 25%​​​​​​ Chart 2US Multinationals Have Underperformed​​​​​​ In this week’s report, we will analyze the effects of the stronger dollar on US corporate earnings, zooming in on its implications for the S&P 500 sectors and styles. Sneak Preview: A strong dollar is a definite negative for US corporate sales and profits and is a drag on US equity performance. However, when compared in magnitude to the effects of tighter monetary policy, slowing growth, and rising costs – the dollar should take a backseat to the other investor worries. USD: The Best House On The Worst Street The reasons for the rapid rise of the USD are manifold. The following are just a few: The Dollar smile: The USD outperforms when global growth is strong and investors are optimistic, as well as when growth slows and investors are fearful, benefiting from its status as a reserve currency. Over the past two years, both scenarios have played out. In 2021, investor flows pushed the dollar higher as the US was ahead of the rest of the world in terms of post-pandemic recovery. This year, the USD became a safe haven for jittery investors and became one of the rare assets delivering positive returns in the “sea of misery.” Chart 3Rate Differentials Favored The US The US looks good compared to other regions: Despite its own economic maladies, such as high inflation and slowing growth, the US has been in an advantageous position compared to the rest of the world. The US appears well insulated from global shudders compared to Europe, which is in the midst of a recession and an energy crisis, China roiling from the zero-COVID policy and property market fallout, and EM countries on the verge of food and energy shortages. Interest rate differentials: The Fed is being viewed as the most credible central bank to curb inflation. As a result, US rates have risen more than in other markets (Chart 3). The USD has been strengthening as the US has been enjoying relative stability and better growth compared to the other regions. The Fed is also ahead of the curve. Will The USD Appreciation Continue? BCA FX Strategist Chester Ntonifor does not expect the dollar to continue to appreciate for the following reasons: While the Fed is ahead of the curve, other central banks are also becoming more hawkish. As such, interest rate differentials will not materially move further in favor of the dollar. Inflation is a global problem as opposed to US-centric. Thanks to the Fed’s aggressive policy stance compared to the other central banks, the inflation impulse is slowing in the US, relative to a basket of G10 countries (Chart 4). In addition, the dollar is expensive, overbought, and is a crowded consensus trade (Chart 5). Chart 4The US Inflation Impulse Has Turned​​​​​ Chart 5The Dollar Is Overvalued On A PPP Basis​​​​​​ We concur. While we will not outright bet against the dollar, to our mind, risks are skewed to the downside. The dollar must be close to its peak, and we are neutral on a tactical basis. Effects Of USD Moves On S&P 500 Sales And Earnings Growth It Takes Time While US dollar appreciation may have come to an end, its toll will be imprinted on US earnings growth for a while. There is a lag between currency appreciation and its effects on company sales and earnings: It takes companies three to six months to change contracts, adjust prices and record revenue (Table 1). Stronger Dollar: Lower Sales And Lower Costs It is foreign sales that are most affected by the variation in the purchasing power of foreign currencies relative to the dollar (Chart 6). And while US multinationals hate the strengthening dollar, they also get a hand from it on the cost side of the equation, especially if they outsource a sizeable part of production abroad. Thus, the net effect on profits depends on the cost structure and the type of business. That explains why changes in the dollar are never one-to-one to changes in earnings growth. Table 1Sensitivity Of EPS YoY% To USD YoY% Over Time Modeling Effects Of A Stronger Dollar In the “Is An Earnings Recession In The Cards?” report published this past June, we introduced our EPS Growth Forecast Model (Table 2). The model has five intuitive factors: Chart 6The USD Primarily Affects Sales​​​​​​ Table 2EPS Growth Forecast Model ISM PMI is a gauge of US economic growth and a proxy for top-line growth. PPI stands for the change in costs. Pricing Power is a BCA proprietary indicator and captures companies’ ability to pass costs onto their customers. HY Spreads indicate costs of borrowing and also the state of the economy (spreads tend to shoot up in a slowing economy). USD represents the ability of US multinationals to sell goods abroad. These five factors explain 65% of the variation in earnings growth,1 and all factors are statistically significant. Earnings Recession Is Still In The Cards Back in June, we predicted an earnings recession later this year. After all, economic growth is slowing at home and abroad, and demand is rolling over while costs are rising, especially wages. Making things worse, productivity is falling, and Unit Labor Costs (ULC) hit nearly 10% in August. At the same time, consumers are reeling from rising prices, while companies are coming to realize that their ability to pass on costs to customers is pushing the limit. We have updated the model with three more months of data and expect earnings to start contracting in the third quarter, falling as much as 20% in the fourth quarter (Chart 7). None of this is surprising. S&P 500 margins have fallen by 2% in the second quarter, and earnings growth ex Energy came in at -2% on a nominal basis. Analysts expect six out of 11 S&P 500 sectors to deliver negative EPS Growth in Q3-2022. And while a 20% earnings drawdown sounds terrible, it is fairly mild compared to recent recessions – at the worst point in 2008, nominal earnings went to 0, printing a -100% contraction (Table 3). Chart 7The BCA Earnings Model Predicts A Earnings Recession Later This Year​​​​​​ Table 3The S&P 500 Earnings Drawdowns Here, we would like to emphasize that financial econometrics is not an exact science, and earnings growth point estimates are rarely precise. However, it is abundantly clear that earnings growth will trend well past the zero mark. Costs And Pricing Power Are Key Drivers Of S&P 500 Earnings In 2022 Breaking down the negative earnings growth forecast into contributions from different factors (Chart 8), we observe that the outcome is mostly driven by the interplay between PPI and Pricing Power – costs are rising and companies’ ability to pass them on further defines their profitability. And while commodity prices have fallen, these changes will take a while to flow into earnings. In addition, tighter monetary policy and slowing growth are the new speed bumps (HY Spreads and ISM PMI). Chart 8Interplay Of PPI And Pricing Power Drives The Direction Of Earnings Chart 9The USD Contribution Is Negative… USD Is Less Important So what about the dollar? According to our model, 1% of dollar appreciation is shaving off roughly 50bps from earnings growth. However, we need to keep this number in context. While the dollar has appreciated more than 25% since the beginning of 2021, only the last three to six months matter on a rolling basis. And over the past three months, USD has appreciated by about 8%, which will detract 4% from earnings in Q4-2022 (Chart 9). The importance of the USD for earnings growth is fairly minor compared to the other factors, such as pricing power, PPI, HY spreads, and ISM PMI (Chart 10). Chart 10... But Is Minor Compared To The Other Factors Bottom Line: A strong dollar is a headwind for earnings growth. However, its effects are dwarfed by other factors. Sectors Most Affected By The Strong Currency And Weakening Global Growth Table 4The S&P 500: % Of Foreign Sales By Sector While the overall negative effect of a strong dollar on the S&P 500 earnings is relatively minor, some sectors in the index are more exposed than others (Table 4). While the S&P 500 derives about 40% of sales from abroad, the Technology and Materials sectors have about 60% of foreign sales, and for the companies in these sectors, a strong currency is a serious concern. Utilities, Financials, and Real Estate are the most domestic in the index. It is important to note, that, at present, US multinationals are dealing not only with the effects of a stronger currency but also with global growth slowdown. Effects Of Strong Dollar On US Equity Performance While over the long term, a link between earnings growth and equities performance is irrefutable, in the short run, there may be significant variations. In this section, we will look at the relationship between equity returns and the USD. We will also isolate sectors and styles that are best positioned to withstand the current environment. And when the dollar swoons, we will also know which parts of the equity market are most likely to bounce back. USD Dollar Regimes To better understand the relationship between equity returns and the USD, we demarcate two distinct USD regimes, defined rather simplistically as “USD Rising” and “USD Falling” (Chart 11). Then we compile median monthly returns in each regime and keep track of how many months the S&P 500 was positive in each. Chart 11The USD Regimes Chart 12The USD Is A Headwind For The Performance Of Equities We found that when the USD is appreciating, median monthly returns are only 0.5% and are positive only 37% of the time. However, when the dollar is depreciating, median monthly returns are 1.4% and are positive 63% of the time (Chart 12). This relationship is significant at a 10% confidence level. Sector Performance Under Different USD Regimes When the USD rises, more defensive sectors, such as Utilities, Healthcare, and Consumer Staples tend to outperform. Energy has made the list thanks to the recent rally – normally Energy does not benefit from dollar strength (Chart 13). Chart 13Materials And Comm Services Will Outperform If The USD Turns The weakening dollar supports Materials as it stimulates demand, as well as the Communications sector, as it is home to multinational media and entertainment companies like Netflix, Facebook, and Google. Style Performance Under Different USD Regimes Growth Vs Value: Growth is more exposed to the USD than Value thanks to the index composition (Chart 14). Growth is home to Tech as well as Media & Entertainment, and “growthy” Consumer Discretionary, all of which have a higher share of earnings from abroad than the index. Value is dominated by Financials, Industrials, and Utilities, which are fairly domestic. Thus, while over time, exposure to the dollar fluctuates, over the long term, Growth is clearly more sensitive than Value (Chart 15). Chart 14Growth Is Dominated By Multinationals​​​​​​ Chart 15Growth Is More Exposed To The USD Than Value​​​​​​ Chart 16Mid Is A More Domestic Asset Class Than Small Small Vs Mid: According to a popular belief, small caps are insulated from currency moves as they don’t have reach and scale and earn very little outside of the US. However, small caps are often part of the ecosystem and supply chain of multinationals, and when the profitability of those is under pressure, they also start to feel the heat. Small caps have little leverage with their large clients and their profitability changes with the ebbs and flows of their larger brethren. Hence, they are quite sensitive to currency moves. Arguably, it is midcaps that are the most domestic asset class, as their exposure to the USD is less and more stable compared to the S&P 500 and small caps (Chart 16). Midcaps are usually not big enough to have much international reach but are big enough to have bargaining power with their multinational customers to guard their profitability. Investment Implications The S&P 500 derives roughly 40% of sales from abroad, which makes its earnings quite sensitive to dollar moves and global growth. The recent dollar bull market and slowing growth abroad have challenged US corporates and have detracted from their profit growth. However, slower growth, rising costs, and diminished pricing power by far dwarf the effects of the dollar. Overall, challenges at home and abroad are likely to trigger an earnings recession, which in all likelihood, has already started this summer, and is about to get worse. The dollar may be close to its peak, and our colleagues from the FX team expect dollar devaluation over the long term. A turn in the dollar will offer some respite for the performance of US equities despite the domestic backdrop of slowing growth and rising rates. It will also trigger a change in leadership, with sectors such as Materials and Communications rebounding from their lows. In terms of styles, a strong dollar lends support to Value, thanks to its sector composition. Once the dollar starts to depreciate, Growth will get another tailwind towards recovery. And lastly, midcap is one area in the US equity market somewhat more insulated from currency moves. Bottom Line While a strong dollar is certainly a headwind for US earnings growth and for the performance of US equities, its adverse effects are minor compared to the effects of tighter monetary policy, slowing growth at home and abroad, rising costs, falling productivity, and companies, diminished ability to pass on costs to customers—who are already strapped by rising prices. In short, dollar depreciation will be a welcome development, yet the dollar is the least of investors’ worries.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Footnotes 1      The model’s adjusted R-squared is 0.65. Recommended Allocation