Health Care
Executive Summary Structural Tailwinds For The Franc Volatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007.Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades (Feature Chart). Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and are vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence, the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now.Bottom Line: Favor the franc over the short term against other pro-cyclical currencies, with a view to downgrade CHF when it becomes evident that economic growth is bottoming. Any further bout of Swiss equity outperformance, prompted by global risk aversion, offers an attractive selling opportunity versus Eurozone stocks.Feature Chart 1The SNB Has Capitulated To Rising Inflation Volatility in FX markets is likely to remain elevated. This week, the Fed delivered its first 75 bps interest rate hike since 1994. It also increased its expected year-end level for the Fed Funds rate to 3.4% from 1.9%, and to 3.8% from 3.4% at the end of 2023. The FX market had been warming up to a hawkish surprise, but the dollar surged on the news, hitting a fresh two-decade high of 105.5, before later reversing gains.Meanwhile, the European Central Bank (ECB) held an emergency meeting on Wednesday, to try to mitigate the rise in Italian yields, which hit as high as 4.2% on Tuesday, or 243 bps over German 10-year yields. The subsequent statement released by the Governing Council offered no concrete details. Yes, the reinvestments of the proceeds from maturing debt in the Pandemic Emergency Purchase Program (PEPP) will flow mostly to peripheral markets, but investors want clarity on the nature of the long-awaited policy plan to tackle fragmentation risk in the Euro Area. As a result, peripheral bond markets will remain fragile until a bold program comes to fruition.To cement currency volatility this week, SNB Governor Thomas Jordan surprised markets by raising interest rates by 50 bps in Switzerland, to -0.25%, the first hike since the Global Financial Crisis (Chart 1). The negative interest rate threshold for sight deposits was also lowered, a move encouraging banks to pack reserves at the SNB. The Bank of England also raised interest rates in line with market expectations. The move initially disappointed GBP bulls, but sterling is holding above our 1.20 floor.An environment of monetary policy uncertainty, rising recession risks in response to high inflation, and the potential for central bank policy mistakes bodes well for safe-haven assets. In Europe, the market with the strongest defensive profile is Switzerland. In this report, we address whether investors should bet on continued appreciation of the franc and an outperformance of Swiss stocks, especially now that the SNB has turned hawkish.Switzerland Versus The WorldGlobal economic growth is slowing and a small/open economy like Switzerland’s has not been spared. The KOF economic barometer, a key leading indicator for Swiss GDP growth, has collapsed over the past twelve months from 144 to 97 as global industrial activity decelerated (Chart 2). Despite softening growth, global inflation refuses to decline, forcing central banks worldwide to lean into the slowdown. This threatens to cut the post-pandemic business cycle expansion short. Chart 2The SNB Is Tightening Into A Slowing Economy Surprisingly, the Swiss economy is generally performing better than the rest of Europe. Historically, Swiss economic performance is procyclical due to the large share of exports within its GDP. Hence, a slowdown in global manufacturing often creates a large threat to Swiss growth. Going forward, can the Swiss economy diverge from that of the rest of the world (Chart 3)? Such a divergence is not probable, but a few factors will protect the Swiss economy:Switzerland still has one of the lowest policy rates in the G10, even after today’s 50bps interest rate increase. This has tremendously helped ease monetary conditions. Our monetary gauge is at its most accommodative level in over two decades (Chart 4). Chart 3The Swiss Economy Is Procyclical Chart 4Swiss Monetary Conditions Are Still Accommodative Swiss inflation remains the lowest in the G10 outside Japan. In Switzerland, the main driver of price increases has been goods, while services inflation remains subdued. Consequently, the SNB has been tolerating an appreciating franc to temper imported inflation (Chart 5), while keeping domestic borrowing costs at very accommodative levels. In its updated forecasts, the SNB now expects a -0.25% interest rate to allow Swiss inflation to moderate to 1.9% in 2023 and 1.6% in 2024. Chart 5Swiss Inflation Is Surprising To The Upside Part of the reason Switzerland has low inflation has been the tremendous productivity gains, especially relative to its trading partners (Chart 6). Swiss income-per-capita is elevated, but wage growth has lagged output gains, which limits the risk of a wage-inflation spiral. It is notable that part-time employment continues to dominate job gains, implying that the need for precautionary savings will remain high in Switzerland. Chart 6A Productivity Profile For Switzerland Higher productivity growth and the elevated national savings leave their footprint on the trade data. The Swiss trade balance is hitting fresh highs, unlike Europe or Japan (Chart 7). This could potentially create a problem for the Swiss economy as it puts upward pressure on the CHF at a time when global manufacturing output is slowing. However, Switzerland specializes in high value-added exports with an elevated degree of complexity, that stand early in global supply chains. These type of goods are likely to remain in high demand in a global environment marked by supply-chain bottlenecks and high-capacity utilization. Chart 7Structural Tailwinds For The Franc Finally, Switzerland does not import energy to fulfill its electricity production. Hydropower accounts for roughly 61.4% of electricity generation, followed by nuclear power at 28.5%. This has partially insulated Switzerland from the energy shock hurting economic activity and trade balances in the EU. For example, German electricity generation is 28.8% coal and 14.7% natural gas.Bottom Line: The Swiss economy is reopening and is relatively insulated from the Russia-Ukraine conflict. This limits to some degree how closely Switzerland will track the global and European economic slowdown. It creates a departure from the traditional pro-cyclicality of the Swiss economy.The SNB, The SARON Curve, And The Swiss FrancIf the Swiss economy surprises to the upside, the case for the SNB to tolerate a rising franc becomes even stronger. The pace of foreign exchange reserve accumulation is already decelerating (Chart 8). Governor Thomas Jordan has been very clear: as global prices rise, the fair value of the franc is also rising, which implies a willingness to tolerate currency strength. In a purchasing power parity framework, higher external inflation makes Swiss goods relatively cheaper. This allows foreigners to bid up the currency.Even with today’s updated pricing, the SNB is still expected to remain among the most dovish central banks in the G10 (Chart 9). If inflationary pressures prove sticky, the SNB will step up its hawkish rhetoric. If inflationary fears subside, then global rates will fall as well, which has usually been a boon for the franc. More specifically, this would be negative for the EUR/CHF cross (Chart 10). Chart 8Less Intervention By The SNB Chart 9The SARON Curve Has Adjusted Higher Chart 10EUR/CHF And Bund Yields Can Continue To Diverge The Swiss economy can tolerate an appreciating CHF, but can it withstand higher interest rates? We believe so. Switzerland is a net creditor nation, but its domestic non-financial debt is also extremely elevated. Thus, the Swiss economy is vulnerable to higher rates, especially the housing market (Chart 11). Nonetheless, internal adjustments will soften the blow and increase affordability. Of note, property speculation in Switzerland has decreased in response to macroprudential measures. Growth in rental housing prices, which usually constitute the bulk of investment homes, has collapsed, but the price of owner-occupied homes has proven more robust (Chart 12). A cap on the percentage of secondary homes in any Canton as well as tighter lending standards have also helped. In a renewed update to its Financial Stability Report, Fritz Zurbrügg, Vice Chairman of the Governing Board, suggests that Swiss banks are well capitalized, especially given the recent reactivation of the countercyclical capital buffer. Chart 11Higher Rates Are A Risk For Swiss Real Estate Chart 12Some Adjustment Already In Investment Home Prices In the very near term, demographics might also be a tailwind. The pandemic limited immigration to Switzerland, but the working-age population is rebounding anew (Chart 13), which will create a cushion under housing and support domestic demand. Chart 13A Small Demographic Tailwind For Home Prices Stronger aggregate demand in an inflationary world will justify the need for less monetary accommodation. In a nutshell, the SNB is likely to continue walking the path of “least regrets” like most central banks, by tightening monetary policy to meet its 2% inflation mandate, but pausing if economic conditions warrant.The currency has historically been used as a key tool for calibrating financial conditions. From a fundamental perspective, our PPP models suggest the franc is quite cheap versus the dollar but at fair value versus the euro and sterling. This is echoed by Governor Jordan, who no longer views the franc as expensive. Our models adjusts the consumption basket in Switzerland for an apples-to-apples comparison across both the UK and the eurozone (Chart 14). Chart 14AA CHF Is At Fair Value Versus The EUR And GBP Chart 14BA CHF Is At Fair Value Versus The EUR And GBP Finally, hedging costs for shorting the franc against the dollar have risen substantially (Chart 15). As such, any short bets on the franc are likely being placed naked. If the Fed ends up tempering its pace of rate hikes next year in response to weaker US activity, short-covering activity is likely to accentuate any pre-existing strength in the CHF. Chart 15Hedging Costs For USD/CHF Carry Trades Have Risen Hedging Costs Are Prohibitive Bottom Line: The franc is undervalued against the dollar, and a good hedge against a rise in volatility versus other procyclical currencies. This places the franc in a good “heads I win, tails I don’t loose too much” bet. Swiss interest rates are also likely to climb higher. However, because the franc will do the bulk of the monetary tightening, the SNB is likely to lag the expectations now embedded in the SARON curve.What About Swiss Equities?Despite the cyclical nature of the Swiss economy, Swiss equities are extremely defensive. Swiss stocks have little to do with the domestic economy and are mostly a collection of large multinationals, dominated by the healthcare and consumer staples sectors, which together account for roughly 60% of the Swiss MSCI benchmark.This defensive attribute has created its own problem for Swiss equities. Relative to the Eurozone, the Swiss market has moved massively ahead of profitability, and it is now more expensive than at the apex of the European debt crisis in 2012 (Chart 16). Moreover, the jump in German yields is becoming increasingly problematic for Swiss stocks that historically perform poorly when global interest rates are rising (Chart 17). Chart 16Swiss Stocks Are Expensive Chart 17A Lost Tailwind In the near term, Swiss equities will only be able to defy the gravitational pull created by demanding valuations and higher yields if global risk aversion remains elevated. However, once global stocks find a floor and Italian spreads begin to narrow, Swiss stocks are likely to underperform massively (Chart 18). It could take a few more weeks before the BTP/Bund spreads narrow as the recent ECB announcement was rather tepid. However, the ECB holding an emergency meeting and issuing a formal statement addressing the problem facing peripheral bond markets suggests that a formal program designed to manage fragmentation risk will emerge before the end of the summer.Beyond their defensive attributes, Swiss stocks also correlate to the Quality Factor. The robust performance of this factor since the turn of the millennium, in Europe and globally, has allowed the Swiss market to greatly outperform Eurozone equities (Chart 19). However, the Quality Factor has begun to underperform, which indicates that the Swiss market is losing another of its underpinnings. Chart 18Near-term, Follow Risk Aversion Chart 19Swiss Stocks Are About Quality These observations imply that over the next 12 to 18 months, Swiss equities will underperform their Euro Area counterparts. Materials and consumer staples stand out as the two sectors with the most extended valuations relative to their Euro Area competitors, especially since their relative performances have become dissociated from relative profits (Chart 20). They should carry maximum underweights relative to their European counterparts. The healthcare sector is Switzerland’s largest market weight. It is not as expensive relative to the Eurozone as the materials and consumer staples sectors, but it carries enough of a premium that investors should still underweight this sector relative to its eurozone competitor (Chart 21). Chart 20Dangerous Setup For Swiss Materials and Staples Chart 21The Swiss Heavyweight Is Becoming Pricey Bottom Line: The defensive nature of the Swiss market has allowed for a large outperformance over European equities. However, the Swiss market is now very expensive on a relative basis, and it is vulnerable to higher interest rates. While global risk aversion can still buoy the Swiss market in the near term, conditions are falling into place for Swiss stocks to underperform their Eurozone counterpart over a 12-to-18 month window. Materials and consumer staples are the sectors mostly likely to experience a large underperformance relative to their Euro Area competitors, followed by the healthcare sector. Investment ConclusionsVolatility in FX markets is likely to remain elevated, as witnessed by the reaction of a full circle of central bank meetings this week.Policy convergence remains a good bet for interest rate curves and currency pairs. The SNB surprised markets by raising interest rates by 50 bps, to -0.25%, the first hike since 2007 (Chart 1).Higher volatility will continue to buoy the Swiss franc in the short run.Structural appreciation in the franc is also likely over the coming decades.Swiss stocks often perform well during economic downturns, but they are not particularly cheap, and vulnerable to higher interest rates. Investors should only overweight Swiss stocks if they expect more significant downside to global stocks.Valuation favors the franc versus the dollar. However, EUR/CHF and GBP/CHF are closer to fair value. CHF/JPY is expensive; hence the yen is a better hedge for downside economic surprises. Go short CHF/JPY as a trade.BCA’s Foreign Exchange Strategy was short CHF/SEK at 10.2 with stop loss at 10.5. That stop was hit overnight, triggering a loss of -3.3%. Stand aside for now. Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comMathieu Savary Chief European StrategistMathieu@bcaresearch.com
Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Chart I-3...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined as 12-month forward earnings per share. Fractal Trading System 6-Month Recommendations 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
Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com 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 - 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
Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7). Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-5Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Indicators 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
Executive Summary To understand the economy and the market we must think of them as non-linear systems which experience sudden phase-shifts. The pandemic introduced phase-shifts in our lives, which led to phase-shifts in our goods demand, which led to phase-shifts in monthly core inflation. As our lives phase-shift back to normality, goods demand will phase-shift back to low growth, and monthly core inflation prints will phase-shift from ‘high phase’ to ‘low phase’. With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, justifying a cyclical overweight position in T-bonds. Go overweight healthcare and biotech versus resources and financials. The leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Fractal trading watchlist additions: JPY/CHF, non-life insurance versus homebuilders, US homebuilders (XHB), cotton versus platinum, healthcare versus resources, and biotech versus resources. Bottom Line: With the 12-month core US inflation rate likely to peak by June at the latest, the long bond yield is likely to peak at some point in April/May, and the leadership of the equity market will flip back to long-duration sectors such as healthcare and biotech. Feature Inflation is a non-linear system, meaning that you cannot just dial it up or down gradually like the volume on your music system. Instead of gradual changes, non-linear systems suddenly phase-shift from quiet to loud, from cold to hot, from solid to liquid, or from stability to instability (Box I-1). Box 1: A Classic Non-Linear System – A Brick On An Elastic Band To experience the sudden phase-shift in a non-linear system, attach an elastic band to a brick and try pulling it across a table. As you start to pull, the brick doesn’t move because of the friction with the table. But as you increase your pull there comes a tipping point, at which the brick does move and the friction simultaneously decreases, self-reinforcing the brick’s acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability – the brick doesn’t move – to instability – the brick hits you in the face! Try as hard as you might, it is impossible to pull the brick across the table smoothly. In this non-linear system, the choice is either stability or instability. Back in 2017, in Mission Impossible: 2% Inflation – An Update, I posed a crucial question: “Given that price stability could phase-shift to instability, when should we worry about it?” I answered that “the risk remains low until the next severe downturn – when policymakers may be forced into desperate measures for a desperate situation.” The words proved prescient. Three years later, the desperate situation was a global pandemic, and the desperate measures were economic shutdowns combined with fiscal stimuluses of unprecedented scope and size. A Phase-Shift In Our Lives Produced A Phase-Shift In Inflation Developed economy inflation has just experienced a stark non-linearity. Since 2007, the US core month-on-month inflation rate remained consistently below 3.5 percent.1 Then came the pandemic’s shutdowns combined with policymakers’ massive response, and month-on-month inflation didn’t just rise to above 3.5 percent, it phase-shifted to well over 6 percent. Developed economy inflation has just experienced a stark non-linearity. The remarkable fact is that since 2007, there have been over a hundred monthly core inflation prints below 4 percent, and nine prints above 6 percent, but just one solitary print between 4 and 6 percent! In other words, monthly core inflation shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-1). Chart I-1Monthly Core Inflation Shows The Classic Hallmark Of A Non-Linear System So, what caused the phase-shift in core inflation? The simple answer is a phase-shift in durable goods spending, which itself was caused by the pandemic’s shutdown of services combined with massive fiscal stimulus. Again, this is supported by a remarkable fact. Since 2007, the monthly increase in US (real) spending on durables remained consistently below 3.5 percent. Then came the pandemic’s shutdowns and stimulus checks, and the growth in durables demand didn’t just rise to above 3.5 percent, it phase-shifted to well over 8 percent. In other words, the growth in durable goods demand also shows the classic hallmark of a non-linear system. It can be cold or hot, but not warm (Chart I-2). Chart I-2Goods Demand Shows The Classic Hallmark Of A Non-Linear System The connection between the phase-shifts in goods demand and the phase-shifts in core inflation is staring us in the face – because the three separate phase-shifts in inflation have each been associated with a preceding or contemporaneous phase-shift in goods demand, which themselves have been associated with the separate waves of the pandemic (Chart I-3). Chart I-3Phase-Shifts In Core Inflation Have Been Associated With Phase-Shifts In Goods Demand Pulling all of this together, the pandemic introduced phase-shifts in our lives – lockdown or freedom. Which led to phase-shifts in our goods demand – above 8 percent or below 3.5 percent. Which led to phase-shifts in monthly core inflation – above 6 percent or below 4 percent. The key question is, what happens next? Bond Yields Are Close To A Peak As we learn to live with the pandemic, and assuming no imminent ‘super variant’ of the virus, our lives are phase-shifting back to a semblance of normality. Which means that our spending on goods is phase-shifting back to low growth. If anything, the recent overspend on goods implies an imminent corrective underspend. At the same time, it will be difficult to compensate a phase-shift down on goods spending with a phase-shift up on services spending. This is because the consumption of services is constrained by time and biology. There is a limit to how often you can eat out, go to the theatre, or even go on vacation. The upshot is that monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’ – even if the monthly headline inflation prints are kept up longer by the commodity price spikes that result from the Ukraine crisis. Monthly core inflation prints are likely to phase-shift from ‘high phase’ to ‘low phase’. Meanwhile central banks and markets focus on the 12-month core inflation rate – which, as an arithmetic identity, is the sum of the last twelve month-on-month inflation rates.2 To establish the 12-month core inflation rate, the crucial question is: how many of the last twelve month-on-month inflation prints will be high phase versus low phase? As just discussed, the new month-on-month core inflation prints are likely to phase-shift to low phase. At the same time, the historic high phase prints will disappear from the last twelve month window. Specifically, by June 2022, the three high phase prints of April, May, and June 2021 – 10 percent, 9 percent, and 10 percent respectively – will no longer be included in the 12-month core inflation rate, with the arithmetic impact of pulling it down sharply (Chart I-4). Chart I-4The High Phase Monthly Inflation Prints Of April, May, And June 2021 Will Disappear From The 12-Month Core US Inflation Rate, Thereby Pulling It Down. Clearly, the bond market anticipates some of this ‘base effect’ on 12-month inflation. This explains why turning points in the bond yield have led by 2-3 months the turning points in the 12-month core inflation rate (Chart I-5). With the 12-month core inflation rate likely to peak by June at the latest, this suggests that – absent some new shock – the long bond yield is likely to peak at some point in April/May. Reinforcing our cyclical overweight position in T-bonds. Chart I-5The Bond Yield Turns About 2-3 Months Before Core Inflation This also carries important implications for equity investors. Rising bond yields favour short-duration equity sectors such as resources and financials versus long-duration equity sectors such as healthcare and biotech. And vice-versa. Indeed, the recent performance of resources versus healthcare and financials versus healthcare is indistinguishable from the bond yield (Chart I-6 and Chart I-7). Chart I-6The Performance of Resources Versus Healthcare Is Indistinguishable From The Bond Yield Chart I-7The Performance of Financials Versus Healthcare Is Indistinguishable From The Bond Yield With bond yields likely to peak soon, the leadership of the equity market will once more flip from short-duration sectors to long-duration sectors. Go overweight healthcare and biotech versus resources and financials. Fractal Trading Watchlist Reinforcing the fundamental analysis in the previous section, the 130-day outperformance of resources versus healthcare and biotech has reached the point of fractal fragility that has marked previous trend exhaustions, suggesting that the recent outperformance of resources is nearing an end. Also new on our watchlist is a commodity pair, cotton versus platinum, whose strong outperformance is vulnerable to reversal. And US homebuilders (XHB), whose recent underperformance is at a potential turning point. There are two new trade recommendations. First, the massive outperformance of world non-life insurance versus homebuilders is at the point of fractal fragility that has consistently marked previous turning points (Chart I-8). Hence, go short non-life insurance versus homebuilders, setting a profit target and symmetrical stop-loss at 14 percent. Second, the strong underperformance of the Japanese yen is also at the point of fractal fragility that has marked several previous turning points (Chart I-9). Accordingly, go long JPY/CHF, setting a profit target and symmetrical stop-loss at 4 percent. Please note that our full watchlist of 19 investments that are experiencing or approaching turning points is now available on our website: cpt.bcaresearch.com Chart I-8The Massive Outperformance Of Non-Life Insurance Is Vulnerable To Reversal Chart I-9Go Long JPY/CHF The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Cotton’s Outperformance Is Vulnerable To Reversal US Homebuilders’ Underperformance Is At A Potential Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Annualized month-on-month inflation rate. 2 Strictly speaking, the 12-month inflation rate is the geometric product of the last 12 month-on-month inflation rates. Chart I-1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-2The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-3AUD/KRW Is Vulnerable To Reversal Chart I-4Canada Versus Japan Is Vulnerable To Reversal Chart I-5Canada's TSX-60's Outperformance Might Be Over Chart I-6US Healthcare Providers Vs. Software Approaching A Reversal Chart I-7The Euro's Underperformance Could Be Approaching a Resistance Level Chart I-8A Potential Switching Point From Tobacco Into Cannabis Chart I-9Bitcoin's 65-Day Fractal Support Is Holding For Now Chart I-10Biotech Approaching A Major Buy Chart I-11CAD/SEK Reversal Has Started Chart I-12Financials Versus Industrials Is Reversing Chart I-13Norway's Outperformance Could End Chart I-14Greece's Brief Outperformance Has Ended Chart I-15BRL/NZD At A Resistance Point Chart I-16The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart I-17The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart I-18Cotton's Outperformance Is Vulnerable To Reversal Chart I-19US Homebuilders' Underperformance Is At A Potential Turning Point 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 - 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
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
Executive Summary Macroeconomic Backdrop Favors Defensive Consumer Staples Markets now expect five-to-six rate hikes in 2022 The rate of change in rates as opposed to their level has triggered the fast and furious repricing of long-duration assets. However, rising rates are a temporary headwind to equities The repricing of the equity market came through the P/E as opposed to the “E” Demand is clearly shifting from goods to services. Supply disruptions are clearing Earnings were strong, but investors expected more We are upgrading Consumer Staples, which is a “deep” defensive sector that offers downside protection in an environment of heightened volatility and slowing economic growth Bottom Line: While it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility. Feature Performance Hit Undo 2021 January had a nasty shock in store for equity investors: At the lowest point, the S&P 500 was down 12% from its peak, and NASDAQ was down 20%, officially entering correction territory. January market moves were a partial reversal of the 2021 gains (Chart 1A), with some of the hottest investment themes, such as clean energy, fintech, and Cathie Wood's innovation ETFs hit the hardest (Chart 1B). Investors were rushing to monetize their super-charged gains before the Fed starts draining liquidity off the market. Chart 1APerformance: Sectors And Styles Chart 1BPerformance: Investment Themes Post-Mortem A post-mortem of the sell-off shows that the stocks that have pulled back most, were trading at extended valuations and had long duration, i.e., companies that are not very profitable now but expect to grow earnings at a robust pace far into the future. These companies are akin to lottery tickets – a small payment now may result in a low-probability event of a high gain in the future. Small-cap growth stocks are down 30% from their peak. Over time, the sell-off of small-cap growth has spread to other areas of the market and has hit all sectors but Energy, almost indiscriminately. Overall, the S&P 500's multiple has contracted by over 10% (Chart 1C). Chart 1CJanuary Correction Was Down To Multiple Contraction Valuations And Technicals Pullbacks are responsible for equity market hygiene, cleansing the market of overextended valuations, taking the froth off the names that got ahead of themselves, and offering a reset for a new leg of upward moves, fueled by inflows into oversold names and cash deployed by new market entrants. Forward multiples of the S&P 500 have come down from 21.7x to a more reasonable 19.5x (Chart 2A). Now, 8 out of the 11 sectors have a forward PE below 20x (Chart 2B). Chart 2AMultiples Have Come Down A lot From The Peak Chart 2BValuations Moderated Across All Sectors But Energy By many technical metrics, such as the bull/bear ratio (Chart 2C), market breadth, and RSI, the market appears oversold. Many investors may consider this a good entry point. Chart 2CRetail Investors Have Capitulated Macroeconomic Backdrop Six Is The New Four This correction was triggered by a market surprised by the grave tone of Fed officials, acknowledging their concern about the intransigent, as opposed to transient, inflation. While monetary tightening has been on the cards for a while now, what a difference a month makes! In December, the market was pricing in three rate hikes in 2022, while currently, the probability of five rate hikes stands at over 90%, and of six rate hikes at over 80% (Chart 3A). The 10-year Treasury yield moved from 1.5% at the end of December to 1.87% at its January peak. It is important to note that monetary policy is still easy and it was the rate of change in rates as opposed to their level that triggered the fast and furious repricing of long-duration assets. Chart 3AInvestors Expect Five-To-Six Hikes In 2022 Is Monetary Tightening A Death Knell For US Equities? Historically, equities wobbled two-to-three months prior to the first rate hike, and then took a breather for another couple of months for the dust to settle (Chart 3B). January and now February volatility and pullbacks are textbook behavior of equities at the cusp of a new monetary regime. However, in three of the four tightening cycles since 1990, the stock market was higher a year later. The same is true for long-term rates: In all but one of the episodes of a sharp rise in the 10-year Treasury yield since 1990, the stock market rose (Table 1). Chart 3BEquities Wobble Around The First Rate Hike Table 1Equity Performance Around Periods Of Rising Treasury Yields Economic Growth: Supply (Finally) Meets Demand Of course, the best antidote to higher rates is strong economic growth. So far, everything is in order on that front, with economists projecting solid 2022 nominal GDP growth of around 7.6%. Economic growth is slowing but off high levels. At last, global supply chains are gradually unclogging, and shipping bottlenecks are starting to clear. Even automakers are now saying that auto chips are becoming more readily available. However, part of the reason that supply and demand are getting closer to each other is that demand for goods is waning, dampened by both saturation and higher costs. The latest ISM PMI reading shows that both new orders and the backlog of orders are falling (Chart 4, top panel). Prices paid have also turned, heralding that the worst of price increases may be behind us (Chart 4, bottom panel). Will this contain inflation enough to appease the Fed? Possible, but not highly likely. Chart 4Demand Is Weakening Earnings: Good But Not Good Enough With economic growth slowing, earnings and sales growth are also rolling over (Chart 5A). As investors are trying to decipher the state of the American economy, they are increasingly focused on corporate guidance. So far 12 companies offered positive guidance vs 28 with negative guidance. The Negative/Positive ratio for Q4-2021 currently stands at 2.3, compared to 0.8 in the prior four quarters. Price action in response to projected lower growth has been brutal. And while 78% of companies have beaten earnings expectations, this is a smaller share than during the other pandemic recovery quarters. The magnitude of the earnings surprise has also fallen (Chart 5B). Chart 5AEarnings And Sales Growth Are Slowing Chart 5BThe Magnitude Of Earnings Surprises Has Fallen This earnings season has also seen some of the largest moves on the back of companies’ reports. Positive surprises by Google, Microsoft, and Amazon have soothed investors' fears and led to broad-based next-day rallies, while skimpy results from PayPal and Meta, not only have sent these companies down more than 20%, erasing billions in market capitalization, but also have dragged down their nearest competitors (Square, Snap, etc.). Also, many companies are complaining about rising input and labor costs cutting into their profitability. This is hardly a surprise. According to our analysis of the NIPA accounts, in the US labor costs constitute 55% of sales. With wages rising at the fastest pace in years, their effect on corporate profitability can be meaningful (Chart 6A). To make things worse, input costs are also soaring – the latest PPI reading is 9.7%. Chart 6AMargins Are Contracting As... However, companies are more and more constrained in their ability to pass on their cost increases to customers, although the elasticity of demand varies across industries. Many companies can no longer afford to raise prices without suppressing demand for their products. Corporate pricing power has turned decisively lower (Chart 6B). As a result, profit margins have contracted across all sectors, except Energy. Bottom-line – earnings are good so far, but they have failed to allay investor fears of waning profitability. Chart 6B...Corporate Pricing Power Is Declining Sector Positioning Revenge Of The Nerds – Be Granular While we believe that equities are poised for another leg up, as economic growth remains strong and corporate earnings are decent, we recommend that investors be granular in their sector selection: Avoid areas most adversely affected by a tighter monetary regime and slowing growth. Per our previous analysis, we recommend underweighting the Technology sector on a tactical basis, but within Tech, stay overweight more defensive Software and IT Services. We also like Banks and Insurers that benefit from rising rates and prefer Value and Small over Growth. We are also constructive on Industrials, which are the primary beneficiaries of the new Capex cycle and the US industrial renaissance. Consumer Services Are Finally Rebounding In the meantime, with Omicron finally receding, consumer spending is shifting from consumer goods to services (Chart 7A). Consumers are flush with cash, and still have $2.2 trillion in their coffers. We have been overweight the Travel complex (Hotels, Restaurants, Cruises) since October. However, performance was derailed in the late fall as many consumers chose to stay at home and wait for the variant to pass. Also, many of the industries in the Travel complex have been challenged by the sheer number of staff quarantining or on sick leave. We upgraded Airlines at the beginning of January and remain optimistic about the outperformance of the Consumer Services sector. Upgrading Consumer Staples We are also upgrading Consumer Staples, which is a “deep” defensive that offers downside protection in an environment of heightened volatility and slowing economic growth (Chart 7B). Moreover, consumer confidence is down as Americans are disheartened by prices in the supermarket and at the gas station. However, demand for consumer staples is inelastic and should be inflation-proof. The sector is trading at 21x forward multiples and is expected to grow earnings at 6% over the next 12 months, bettering the S&P 500. Chart 7AWaning Demand For Goods Is Replaced By Demand For Services Chart 7BMacroeconomic Backdrop Favors Defensive Consumer Staples Investment Implications The market correction is still running its course, and while it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. Rising rates are a temporary headwind. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart 8Macroeconomic Backdrop Chart 9Profitability Chart 10Valuations And Technicals Chart 11Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuations And Technicals Chart 19Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals Chart 23Uses Of Cash Energy Chart 24Macroeconomic Backdrop Chart 25Profitability Chart 26Valuations And Technicals Chart 27Uses Of Cash Financials Chart 28Macroeconomic Backdrop Chart 29Profitability Chart 30Valuations And Technicals Chart 31Uses Of Cash Health Care Chart 32Sector vs Industry Groups Chart 33Profitability Chart 34Valuations And Technicals Chart 35Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Chart 37Profitability Chart 38Valuations And Technicals Chart 39Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Chart 41Profitability Chart 42Valuations And Technicals Chart 43Uses Of Cash Materials Chart 44Macroeconomic Backdrop Chart 45Profitability Chart 46Valuations And Technicals Chart 47Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Chart 49Profitability Chart 50Valuations And Technicals Chart 51Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Chart 53Profitability Chart 54Valuations And Technicals Chart 55Uses Of Cash Recommended Allocation Footnotes
Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent. Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver 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