Developed Countries

Executive Summary US biotech is trading at its greatest discount to the market. Ever. Much of biotech’s underperformance is due to transient factors: specifically, the sell-off in long-duration bonds; the focus on delivering a Covid vaccine; regulatory concerns; a drought in M&A; and a flood of IPOs. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. If, as we expect, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. Fractal trading watchlist: We focus on biotech, and add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Bottom Line: Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. Feature Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. But before we go into the specifics of biotech, let’s quickly discuss the recent action in the broader market. The Past Year Has Been All About ‘Duration’ A good way to think of any investment is to compress all its cashflows into one future ‘lump-sum payment.’ The length of time to this lump-sum payment is the investment’s ‘duration.’ And the present value of the investment is just the discounted value of this lump-sum payment, where the discount factor will depend on the required return on the investment combined with its duration.1 It follows that, all else being equal, the present value of a long-duration stock must rise and fall in line with the present value of an equally long-duration bond – because their discount factors move in lockstep. And, as we have been banging on in recent weeks, this simple observation is all you need to explain market action over the past year. For the 30-year T-bond, 2.4-2.5 percent is an important resistance level. Given that long-duration indexes such as the Nasdaq, S&P 500 and MSCI Growth have the same duration as the 30-year T-bond, they have been tracking the 30-year T-bond price one-for-one (Chart I-1 and Chart I-2). Hence, when the long-duration bond rallied, these stock markets outperformed shorter-duration indexes such as the FTSE100 and MSCI Value; and when the long-duration bond sold off, they underperformed. Chart I-1The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One Chart I-2MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One The Russian invasion of Ukraine has catalysed a retreat in the 30-year T-bond yield from a ‘line in the sand’ at 2.4-2.5 percent, which we have previously highlighted as an important resistance level. If, as we argued in A Massive Economic Imbalance, Staring Us In The Face, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Over the longer term, the bigger driver of the stock price will not be the discount factor on the future lump-sum payment; the bigger driver will be the size of the lump-sum payment itself. For any company, industry, or stock market, this expected lump-sum payment will evolve in line with current profits multiplied by a ‘structural growth multiple.’ It turns out that while current profits are updated every quarter, the structural growth multiple does not change much from quarter to quarter, year to year, or even decade to decade. Yet occasionally, it can phase-shift violently downwards when an event, or realisation, shatters the market’s lofty hopes for structural growth. Occasionally, an event or realisation shatters the market’s lofty hopes for structural growth. For example, after the dot com bubble burst it became clear that the sky-high hopes for non-US tech companies were just pie in the sky. The result was that their structural growth multiple halved, which weighed down non-US tech stocks for the subsequent 10 years (Chart I-3). Chart I-3After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed More recently, the realisation that Facebook – or Meta Platforms as it is now known – is losing subscribers was the gestalt moment that shattered hopes for its structural growth. Note that while its 2022 profits are down slightly, the Meta share price has collapsed, indicating a big hit to the structural growth multiple (Chart I-4). Chart I-4Facebook's Structural Growth Multiple Has Collapsed Conversely, there are rare occasions when a phase-shift down in a structural growth multiple is unwarranted or has gone too far. Right now, a case in point is the biotech sector, especially the US biotech sector. Relative to the relationship of the 2010s decade, US biotech’s structural growth multiple has halved (Chart I-5). The result is that US biotech is trading at the greatest valuation discount to the market (-20 percent). Ever. It is also trading at its greatest valuation discount to the broader tech sector (-35 percent). Ever (Chart I-6 and Chart I-7). Chart I-5US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? Chart I-6US Biotech Is Trading At Its Greatest Ever Discount To The Market... Chart I-7...And Its Greatest Ever Discount To Big-Tech Another way of putting it is that in the post-pandemic era, while the structural growth multiple for the broader tech sector is largely unchanged, the structural growth multiple for biotech has collapsed by 40 percent (Charts I-8, I-11). Begging the question, is such a massive structural de-rating justified? Chart I-8US Tech's Structural Growth Multiple ##br##Is Unchanged... Chart I-9...But US Biotech's Structural Growth Multiple Has Collapsed Chart I-10Global Tech's Structural Growth Multiple##br## Is Unchanged... Chart I-11...But Global Biotech's Structural Growth Multiple Has Collapsed Much Of Biotech’s Underperformance Is Due To Transient Factors We have identified five culprits for biotech’s recent underperformance, but they are largely transient: The sell-off in long-duration bonds: Ironically, though the market has downgraded biotech’s structural growth, it has still behaved like a long-duration sector that has tracked the sell-off in the 30-year T-bond. Hence, if the long-duration bond rallies, it will boost biotech stocks. The focus on delivering a Covid vaccine: While biotech was developing a Covid vaccine, investors became enamoured with the sector, but once the vaccine was delivered, investors fell out of love with the sector. Yet there is more to biotech than a provider of vaccines, and as we show in the final section, the sell-off has gone too far. Regulatory concerns: In the US there has been some concern about the dilution of a biotech company’s intellectual property (IP) rights – known as March-In-Rights – if government funding or research has contributed to an innovation. In practice though, the sophistication of most innovations means that IP would remain with the innovator. There has also been concern about drug pricing reform, but as is normal in any negotiation, the opening extreme position is likely to get watered down. A drought in M&A: The focus on Covid, plus the uncertainty around regulation, has led to a drought in the M&A activity that is usually the mechanism to crystallize value. Still, for long-term investors, value is value, whether it is crystallized or not. Furthermore, the drought in M&A cannot last forever. A flood of IPOs: The more than 100 biotech IPOs in 2021 was double the usual rate, creating an oversupply and indigestion for specialist investors in the sector. But given the poor performance of the sector, the IPO flood is likely to recede through 2022-23 in a self-correction. So, we come back to the question: is it right to price a structural growth outlook for biotech worse than the overall market and much worse than for big-tech? If anything, it is big-tech that faces the much greater existential risk in the form of Web 3.0 – which will remove big-tech’s current ownership of the internet, thereby wiping out its very lucrative business model. Look out for our upcoming Special Report on this major theme. To repeat, the market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market, when most of the headwinds it faces are transient. All of which leads to two investment conclusions. The market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. Fractal Trading Watchlist This week’s analysis focusses on our main theme, biotech, and we add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. Reinforcing the arguments in the preceding sections, US biotech is deeply oversold versus broader tech, reaching a point of fractal fragility that signalled several significant turning-points through the past two decades (Chart I-12). Accordingly, this week’s recommended trade is to go long US biotech versus US tech, setting the profit target and symmetrical stop-loss at 17.5 percent. Chart I-12US Biotech Is Deeply Oversold Versus Broader Tech   US Banks Are At Risk Of Reversal Norway's Outperformance Could End Greece's Snapback At A Resistance Point BRL/NZD At A Resistance Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined fully, the duration of an investment is the weighted-average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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

Executive Summary US Policy Uncertainty Rises With ERP The US is witnessing a rolling political crisis that will escalate again in the 2022-24 election cycle and presents a tail-risk of constitutional fracture. However, fundamental economic, constitutional, and geopolitical factors are structurally positive. US domestic political risk is not greater than foreign geopolitical risk affecting other major markets like Europe. The US faces challenges to maintain its competitive and technological edge. But the combination of a vibrant private sector and increasingly proactive fiscal policy give reason for optimism. The 2022-24 macroeconomic and political cycles will likely cause an increase in policy uncertainty and hence the equity risk premium – but foreign markets face even greater risks. Recommendation (Tactical) Inception Level Initiation Date Stop Loss Long DXY   Feb 23/2022   Bottom Line: Go tactically long US dollar (DXY) on the anticipation that US and especially global policy uncertainty and political risk premiums will rise. Feature With President Joe Biden’s approval rating falling to a new net low of -13%, investors are starting to ask about the future of American politics once again. It is highly likely that Democrats will lose control of Congress this fall, setting up a tumultuous 2024 election cycle. With political polarization at historic highs, it is worth asking whether US policy uncertainty will inject a risk premium into US equities. Our answer is yes, uncertainty and the risk premium will rise. But the US also contains fundamental strengths, especially relative to other major markets. With geopolitical risk rising for Europe as Russia engages in new military adventures, the US market will remain attractive over the long run. Natural Advantages Any fundamental assessment of US capability should begin with its people. The US working-age population continues to grow, while that of Europe and China has started to plateau or decline (Chart 1). China’s working population is four times bigger than that of the US, so if China can manage its transition to a higher-wage economy (i.e. if it can maintain productivity growth) then it can compete for global investment capital. But the US’s continued labor force growth, despite social change and political instability, suggests that the US will not follow Japan and Europe into sluggish trend growth, unless sharp curbs on immigration are put into place. The maxim that “the people are the riches of a nation” is only true if economic opportunity and job creation are sufficient. People need access to capital to become more productive. Europe has the largest capital stock in the world, at $100,000 per capita, compared to the US’s $71,000 and China’s $33,000. But Europe’s capital stock has been flat-to-down since the Great Recession. China’s capital stock is rising rapidly and has a lot further to go given its low level. But the country also faces a difficult transition to a new economic model and a debt-deleveraging process that may slow down the pace of capital deepening in the coming years, forcing the government to step in and promote capital projects (Chart 2). Meanwhile the US’s capital stock continues to grow steadily.  Chart 1The People Are The Riches Of A Nation... Chart 2...As Long As The People Are Not Starved Of Capital Since the shale boom the US has become nearly energy self-sufficient and now produces 20% of global oil and fuel. This development is a blessing from an economic and national security perspective. But it also poses the risk of a kind of resource curse, in which the US could lack the motivation to pioneer renewable energy technology. Currently the US only produces 4% of the world’s renewable energy, a share that has been declining. Europe and China are both energy import-dependent, which is a national security vulnerability, and they will continue to invest in renewable solutions to improve their energy security (Chart 3). Russian aggression will motivate Europe to go down this path, whereas China will go down this path for fear of American strategic containment. For now, however, the US is energy self-sufficient while technologically capable of advancing in renewable energy. The US has a range of structural problems: rising income inequality, extreme political polarization, and a policy turn away from globalization over the past 20 years. However, these problems have not weighed on GDP per capita growth. Of course, the greatest strides in GDP per capita are occurring in the developing world: China and India show the most promise. But the US’s GDP per capita is still growing at an annual average rate of 3%, putting it alongside Germany and ahead of the much less developed Brazil (Chart 4). Germany did not see anywhere near as big of increases in inequality and polarization and is still generally committed to globalization, yet its GDP per capita growth is about the same as the US’s, despite faster US population growth. Chart 3North America's Natural Resource Blessing Chart 4Does Political Instability Harm Productivity? Partisanship Means Big Government None of the above benefits have been reversed by the US’s historic increase in political polarization and partisanship over the past three decades. Make no mistake, the latter trends are harmful and could weigh on US stability and productivity in coming years, primarily through deteriorating fiscal management. But so far their bad effects have been contained. The two US political parties have won control of the White House, the Senate, and the House of Representatives a roughly equal number of times. While Republicans have a larger regional presence, across the 50 states, and tend to perform better in the Electoral College and the Senate, this advantage is very slight judging by the number of electoral victories. Meanwhile Democrats have a larger popular presence and perform better in the House of Representatives but this advantage is also slight (Chart 5). The two parties are evenly balanced, which is one explanation for why they compete so viciously for marginal victories. But it also prevents either party from achieving absolute power and distorting or corrupting American bureaucracy and corporate structures to perpetuate single-party rule. Chart 5An Even Balance Of Power Between The Parties The size of the federal government fluctuates within a fairly low and narrow range. Federal government receipts hovered around 16% of GDP in the 1950s-60s, peaked at 20.4% in 2000, and today stand right in the middle of this post-war range at 18.5%. Major increases in revenue follow the business cycle and it is rare that Democrats manage to raise taxes enough to have a substantial impact. This point is clear from looking at periods when Democrats controlled both the House of Representatives and the White House (shaded areas in Chart 6): the large increases in tax take mostly coincide with economic growth spurts. It is conceivable that the Biden administration will raise a minimum corporate tax this year via the budget reconciliation process, but the odds of that have been falling and it will not change the pattern in this chart, which shows rising revenue relative to GDP as the economy recovers but is not likely to match what was seen in the late 1990s. From the perspective of federal government spending, the growth in the size of government is clearer, rising from the post-war 15% of GDP to today’s 25% of GDP, with a pronounced structural uptrend. Republicans rarely control both the White House and the House of Representatives and only in the 1950s did they reduce spending outright. The past two Republican administrations presided over large increases in spending, while also capping revenue via tax cuts (Chart 7). Chart 6US Federal Revenue Does Not Change Much Over Time Chart 7US Federal Spending Does Not Change Much Over Time Thus in America’s highly polarized and populist political scene, Republicans fail to cut spending while Democrats fail to increase taxes. The takeaway is that budget deficits will remain structurally large. The political outlook reinforces this point as it promises a return to congressional gridlock. Historically speaking, Biden’s net negative approval rating implies that Democrats will lose 40 seats in the House of Representatives and 4 seats in the Senate this fall. It is unlikely that Democratic fortunes will improve much between now and this November given that midterm elections almost always punish the ruling party and midterm voters tend to make up their minds early in the year. Moreover the ruling party’s ailments are not easily reversed: headline inflation is running at 7.5%, crime and immigration are growing at historic rates, while foreign policy challenges will likely feed the narrative that the Biden administration is weak on the global stage. The likelihood of congressional gridlock from 2022-24 (and maybe beyond) entails that future increases in fiscal spending will be automatic, through lack of entitlement reform, rather than through grandiose new spending programs, which will not pass into law. As such, “Big Government” is back but it is still “limited government” in the US tradition – i.e. limited big government. Neither party has a blank check or dominates for long. And if anything a period of fiscal normalization (or pseudo-normalization) is on the horizon. Constitutional And Geopolitical Advantages The balance of the parties is not accidental but essential to the American constitutional system. This system is based on the tradition of “mixed” or “balanced” constitutionalism, which developed in ancient Greece and Rome and came to the Americas via the United Kingdom. The system can be discussed in philosophical or ideological terms but it is rooted in real, physical, institutional power. The tradition begins with great philosophers like Plato and Aristotle but is perhaps best illustrated by the Greek historian Polybius. Polybius observed a violent historical cycle that ceaselessly shifted from despotism to oligarchy to the tyranny of the masses to anarchy and finally back to despotism. He argued that the Roman constitution, by mingling the different social classes (the leaders, the elite, and the masses), could produce a durable constitutional order that would prolong the time period until the state decayed and collapsed. We call this the “Polybius Solution” (Diagram 1). Diagram 1The Polybius Solution The US constitution is successful because, like several of the oldest European constitutions, it mixes the different social classes and sources of power so that the leaders, elites, and masses each have a share in the political system and no single group can predominate and overwhelm the others. It is an extra benefit that the US constitution is one of the longest continually operating constitutions in the world, since the long fortification of the system in practice helps provide sociopolitical and economic stability, whereas the ideas themselves are not well taught or understood (Table 1). The fact that the constitution is written in a single document is useful but not decisive, as the British constitution similarly provides stability over long periods of change and upheaval both at home and abroad. Table 1The Balanced Constitution Investors should not mistake this constitutional system merely for a set of preferential ideas. Opinions change very easily. But it is physically difficult for ruling classes to take away rights and privileges that the masses of people have been given. Thus the mixture of constitutional powers is based in political realism, not idealism. The US constitution operates not because Americans are more well-meaning, educated, civic-minded, altruistic, or enlightened than others. It operates because the oligarchy is not powerful enough to disenfranchise the democracy, while the democracy is not powerful enough to purge the oligarchy. The government leaders themselves (the president, the lawmakers, the career bureaucrats, etc) are not powerful enough to suspend term limits and stay in power forever. Nor have they been able to ally with either the oligarchy or the democracy closely enough to permanently exclude the other one from its share of power within the system. There is a clear and present danger that the constitutional system could come under too much strain and fracture amid recent power struggles among the American social classes. The struggles between the classes have intensified since the fall of the Soviet Union (which deprived America of a common enemy) and especially the Great Recession (which provoked populist democratic movements). Some fear that a president could turn into an autocrat and refuse to yield power, others fear that the oligarchic faction could steal elections or manipulate the legal system, others fear that the democratic faction could steal elections or ride roughshod over legal procedures. Of these risks, the risk of autocracy is the lowest, while the risk of institutional corruption or electoral manipulation or majoritarian rule-breaking are the highest. Certainly political risk and policy uncertainty will rise from current levels over the 2022-24 election cycle, which promises to be extremely disruptive. However, there are three reasons to hold the baseline view that the US political structure will remain stable enough to sustain economic productivity over the coming years, despite enormous upheaval on the cyclical level of politics. The US remains secure from invasion, while provoked to meet rising geopolitical challenges. Neither Canada nor Mexico poses a fundamental threat to US national security – the US is capable of militarizing the borders, however undesirable – and the US is inaccessible to more distant enemies due to the tyranny of distance across the Atlantic and Pacific oceans. Yet the resurgence of Russia and the rise of China are likely to present common external rivals around which America’s elites will attempt to galvanize public opinion to maintain national security and keep themselves in office. Because elections still tend to swing on historically critical regions, such as the Midwestern heartland, politicians will need to pursue some degree of economic nationalism to stay in power (Map 1). Map 1USA: Splendid Isolation? The US continues to benefit from a “brain drain” of talented foreign immigrants and will keep that door open if and when it curbs immigration more broadly. Immigration flows into the US are typically robust according to various indicators, including the numbers of newly naturalized citizens, which is itself an indicator of the US’s abiding advantages (Chart 8). The global pandemic caused a decline that is quickly rebounding. Immigration is one of the major outstanding sources of power struggle between the US political factions. It will become a centerpiece of the 2022-24 election cycle. The outcome is unclear. But general American attitudes toward immigration are not hostile, while elite attitudes favor immigration. Therefore whatever government policy finally emerges, it will likely preserve the US’s national interest of continuing to import global talent . Chart 8People Voting With Their Feet The US’s chronic trade imbalance generated a new policy consensus in favor of strengthening American competitiveness. The US pursued a policy of globalization and de-industrialization for decades but it became untenable in the wake of the Great Recession, which spawned a populist backlash. The Biden administration has largely coopted the Trump administration’s hawkish approach to trade. While US trade and current account deficits will remain very large for the foreseeable future, reflecting a fundamental imbalance of savings relative to investment (Chart 9), nevertheless the US will undertake targeted policies to improve supply chain resilience and domestic high-tech competitive edge. The Congress’s likely passage of the American Competes Act of 2022 exemplifies the new bipartisan consensus around the need to invest in American industrial and technological capabilities so as to better compete with great powers overseas (Table 2). Chart 9US Competitiveness Waning? Table 2US Bipartisan Consensus On Restoring Competitiveness By contrast, other regions face greater geopolitical threats to their homelands and greater difficulties coping with hypo-globalization. Europe’s strategic vulnerability to Russia will dampen investment sentiment and risk appetite. Russia’s economic trajectory has suffered since 2014 and its ongoing conflict with the West will result in isolation and lower productivity. China will see rising tensions with its neighbors due to its economic transition, emerging protectionism, and its need to become more assertive for the sake of supply security. By contrast the US is relatively insulated. Investment Takeaways The US’s economic, constitutional, and geopolitical advantages are structural positives. Rising domestic policy uncertainty over the 2022-24 election cycle might overshadow these positives temporarily, but they are likely to persist over the long run. Increasing geopolitical risks abroad suggest that domestic American policy uncertainty is likely to be overrated. Great power competition – stemming from geopolitical risks – will fuel capital spending among the major nations as well as research and development investments. In this respect the United States faces challenges to maintain its competitive edge. But it is still the leader and the combination of a vibrant private sector and an increasingly proactive public sector are positive (Chart 10). Are the US’s structural advantages already priced? To a great extent, yes. The US equity risk premium today stands at 300 basis points, compared to 660 in Europe and 570 in China. And yet global geopolitical risk, highlighted by Russia’s escalating conflict with the West, suggest that this divergence can get worse before it gets better. We expect the 2022-24 election cycle to cause an increase in policy uncertainty and the political risk premium. But as things stand the increase in uncertainty and risk premiums abroad will be even greater (Chart 11). Chart 10US Investing In The Future? Chart 11US Stocks Priced The Good News?       Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes