Semiconductors
An analysis on Turkey is available below. Highlights Due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions between the US and China will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. The RMB is set to depreciate dragging down emerging Asian currencies. There is evidence that the equity rally from late-March lows has been driven or supercharged by retail investors worldwide. Such retail-driven manias never end well, though they can last for a while. Feature Emerging market equities are facing a critical technical resistance. Chart I-1 shows that over the past decade, EM share prices often found support at the horizontal line during selloffs. The latter could now become a resistance point. In turn, the Australian dollar and the S&P 500 have climbed to their 200-day moving averages (Chart I-2). Chart I-1EM Stocks Are Facing A Technical Resistance Chart I-2S&P 500 And AUD Are At Critical Technical Juncture Having rallied strongly in the past two months, it is reasonable to expect that global risk assets will take a breather as investors assess the economic and geopolitical outlooks. China: Aggressive Stimulus… China has embarked on another round of aggressive stimulus. The government program approved by the National People’s Congress (NPC) last week laid out the following macro policy objectives: Stabilize employment. The NPC has pledged to create more than 9 million new jobs in urban areas. Although this is lower than last year’s target of more than 11 million new jobs, it is very ambitious given the number of layoffs that have occurred year-to-date. Chart I-3China: Money/Credit Is Set To Re-Accelerate Significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth accelerated in April and will continue to move higher (Chart I-3). Lending to enterprises and households as well as overall bank asset growth have all accelerated (Chart I-3, bottom two panels). Boost aggregate government spending (budgetary and quasi-fiscal) growth to 13.2% in 2020 versus 9.5% last year. Local government’s special bond quotas have been set at RMB 3.75 trillion yuan, compared with RMB 2.15 trillion last year. The central government will issue special bonds in the order of 1 trillion yuan. The proceeds will be transferred to local governments to support tax and fee reductions, as well as to boost consumption and investment. Support SMEs. The government will extend its beneficial loan-repayment policy for SMEs until March 2021. It will extend exemptions for SMEs on social security contributions, VAT and other fees and taxes through to the end of this year. The government estimates a total of RMB 2.5 trillion in tax and fee reductions for companies in 2020. Table I-1 details potential scenarios for the credit and fiscal spending impulse (CFI). In our baseline scenario, the CFI will rise to 15.5% of GDP by year-end (Chart I-4). In short, in 2020 the CFI will likely be larger than it was in 2015-’16 and closer to its 2012 level. However, it will still fall short of the 2009-2010 surge. Table I-1Simulation On Credit And Fiscal Spending Impulse For 2020 Chart I-4Our Projections For The Credit And Fiscal Spending Impulse In summary, it is fair to say that for now, the authorities have abandoned their deleveraging objective and are encouraging a substantial acceleration of both debt and credit. However, it will take time before the stimulus filters through the economy and boosts growth. This will be the case because of the following persistent headwinds: First, the reduced willingness of households and enterprises to spend. The top panel of Chart I-5 reveals that consumers’ marginal propensity to spend is falling. Enterprises’ willingness to invest continues to trend lower. Historically, companies’ willingness to invest has been a good indicator for industrial metals prices. So far it has not validated the advance in base metals (Chart I-5, bottom panel). The rationale for this correlation is that Chinese companies account for 50-55% of global industrial metals demand. Second, the COVID-19 economic downturn in China was much worse than previous downturns, and the financial health of companies and households is considerably poorer than before. This is why it will take very large amounts of stimulus to produce even a moderate recovery. In particular, a portion of the credit expansion will go toward plugging operating cash flow deficits at companies rather than to augment investment. For example, in the US, commercial and industrial loan growth surged in 2007/08 and this year (Chart I-6). In all of those cases, the underlying cause for credit acceleration was companies drawing on their credit lines to close their negative operating cashflow gaps. Chart I-5China: Households And Enterprises Are Less Willing To Spend Chart I-6US Loan Growth Spikes In Recessions The same phenomenon is presently occurring in China. This entails more credit origination will be required in China in this cycle before we witness a revival in capital spending. Third, geopolitical tensions between the US and China will escalate further in the months ahead. We elaborate on this in more detail below. As far as China’s growth outlook is concerned, rising geopolitical tensions with the US will weigh on both consumer and business confidence. On the whole, due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. Chart I-7Chinese Economy: Still Very Weak In addition, the mainland economy is still undergoing post-lockdown normalization – not recovery. Both capital spending and household consumption are still in recession (Chart I-7). Bottom Line: China is yet again resorting to aggressive fiscal and credit stimulus. Mainland growth is bound to improve over the remainder of the year. However, financial markets have run a bit ahead of themselves, and we will wait for a pullback before recommending China-related plays. …But Geopolitics Is A Major Risk Despite an improving growth outlook, Asian and China-related risk assets could struggle in the months ahead due to escalating geopolitical tensions between the US and China. On the surface, the COVID-19 crisis seems to be the culprit behind rising tensions between the two nations. However, the pandemic has only accelerated an otherwise unavoidable confrontation between the existing superpower and the rising one. BCA’s Geopolitical Strategy team has been writing about cumulating tensions and the potential for them to boil over in the months before the US election. The contours of the rise in geopolitical tensions will be as follows: President Trump’s chances of re-election have declined, with the recession gripping the US economy and unemployment surging. There is little doubt that he will use external foes to rally the nation behind the flag. Blaming China for the pandemic and acting tough is probably the only way for Trump to switch his campaign’s nucleus from the economy to foreign policy, which will raise the odds of his election victory. The US administration will not resort to import tariffs this time around. Going forward, the administration’s goal will be cutting China’s access to foreign technology. Technology in general and semiconductors in particular will be the key battleground in this new cold war. The US will also step up its pressure on multinationals to move production out of China. The broader idea is to impede China’s technological advance. Even though the US rhetoric on China’s policies toward Hong Kong will be tough, there is little the US can do or will do regarding Hong Kong. Rather, the more important battleground will be Taiwan and its semiconductor industry. Finally, China’s political leadership cannot tolerate being perceived as weak domestically in the face of US pressures. They will retaliate against the US. One form of retaliation against Trump could be pushing North Korea to test its strategic military weapons that could undermine Trump’s foreign policy credibility in the US. Another form of retaliation could be tolerating moderate currency depreciation. The latter will challenge Trump’s claims that he has been victorious in dealing with China. The latest decision to ban US and foreign companies from accepting orders from Huawei and the slide in the value of the RMB are consistent with these narratives. To our surprise, however, financial markets in general and Asian markets in particular have not sold off meaningfully in response to the US ban on Huawei and renewed RMB depreciation. Critically, China is the world’s largest consumer of semiconductors, accounting for 35% of global semiconductor demand. Restricting Chinese purchases would be negative for global semiconductor producers. China has been aware of the risk of US restrictions on its imports of semiconductors and has been ramping up its semi imports since 2018. Semi imports have been booming even though smartphone sales had been shrinking (Chart I-8). This is a sign of large semiconductor restocking in China which has helped global semi sales in general and TSMC sales in particular in the past 18 months. In brief, major semi restocking by China in the past 18 months along with the ban on sales to Huawei all but ensure that global semiconductor sales will be weak this year. It does not seem that global semi stocks in general and Asian ones in particular are pricing in this outcome. Global semiconductor stocks are a hair below their all-time highs, and their trailing P/E ratio is at 21. Specifically, given Huawei is the second-largest customer of TSMC, the latter’s sales will be negatively affected (Chart I-9). Chart I-8Has China Been Stockpiling Semiconductors? Chart I-9TSMC Has Benefited From China Stockpiling Semiconductors Finally, both DRAM and NAND prices are falling anew (Chart I-10). Further, DRAM revenue proxy correlates with Korean tech stocks and points to lower share prices (Chart I-11). Chart I-10Semiconductor Prices Have Begun Falling Chart I-11Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Crucially, Chinese, Korean and Taiwanese stocks account for 60% of the MSCI EM equity market cap. Hence, a selloff in these bourses will weigh on the EM equity index. Chart I-12 shows that the latest drawdown in these North Asian equity markets was relatively small compared to the drop in the rest of the EM equity universe. Hence, Chinese, Korean and Taiwanese share prices are not discounting a lot of bad news making them vulnerable to the geopolitical risks that lie ahead. Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. Chart I-12North Asian Stocks Versus The Rest Of EM Bottom Line: Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. The large share of Chinese, Korean and Taiwanese stocks in the MSCI EM equity index implies significant downside risks to the EM equity benchmark. The Global Economic Outlook As economies around the world open, the level of economic activity will certainly begin to rise. The opening of shops, offices and various other facilities will result in a partial normalization and an increase in economic activities. However, we cannot call this a recovery. Rather it is just a snapback from the lockdowns which both equity and credit markets have already fully priced in. The outlook for global share prices and credit markets depends on what happens to the global economy following this post-lockdown snapback. Will the snapback be followed by an actual recovery or will the level of activity stagnate at low levels? For now, our sense is that following the initial snapback a U-shaped recovery is the most likely global scenario. This does not exclude the possibility that activity in some sectors/countries will follow a square root trajectory. From a global macro perspective, we have the following observations to share: Certain industries will likely experience stagflation. Due to social distancing measures, they will be forced to limit their output/capacity and compensate for their increased costs by charging higher prices. In this group, we would include airlines, restaurants, and other service sector businesses. The short-term outlook for consumer spending is contingent on fiscal stimulus. A material reduction in fiscal support for households will weigh on their spending capacity. Capital spending will remain subdued outside China’s stimulus-driven local government and SOE investment outlays, and outside the technology sector, generally. Critically, economic activity in many countries and industries will remain below pre-pandemic levels until late this year. This implies that despite the snapback, some businesses will still be operating below or close to their breakeven points. This will have ramifications on their ability to service debt and on their willingness to invest and hire. Any rise in government bond yields worldwide will be limited as central banks in both DM and EM will cap yields by augmenting their purchase of government and in some cases corporate bonds. We discussed EM QE programs in detail in last week’s report. Bottom Line: It is tempting to interpret the post-lockdown snapback in economic activity as a recovery. However, the nature and depth of this recession is unique. Investors should consider both the direction of economic indicators and the level of economic activity in relation to a company’s breakeven point. This is an extremely difficult task. And that is in addition to gauging the odds of a second wave of COVID-19 infections later this year. In the context of such complexities facing investors, there is astonishing evidence that the recent equity rally has been driven by unsophisticated retail investors. A Retail-Driven Equity Rally There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. Such retail-driven manias never end well, though they can last for a while. The following articles corroborate the worldwide phenomenon that retail investors have been opening broker accounts en masse and investing in stocks: Bored Day Traders Locked at Home Are Now Obsessed With Options Frustrated sports punters turn to US stock market Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing It is fair to assume that retail investors do very little fundamental analysis. Not surprisingly, since March global share prices have decoupled from profit expectations. Although some professional investors have no doubt also played the rally, surveys of asset managers and traders suggest that generally they have stayed lukewarm on stocks. Specifically, the net long position of asset managers and leveraged funds in various US equity index futures remains very low (Chart I-13). Chart I-14 shows that US traders’ and professional individual investors’ sentiment on US stocks are at multi-year lows. Only US investment advisors have become fairly bullish again (Chart I-14, bottom panel). Chart I-13Fund Managers Have Stayed Lukewarm On Stocks Chart I-14Professional Investors’ Sentiment On Stocks Have Been Subdued Who will capitulate first: retail or professional investors? It is hard to predict the behavior of investors but, if we had to guess, our take could be summed up as follows: If geopolitical tensions escalate much more or the number of COVID-19 inflections in some large countries rises anew, retail investors will likely sell before professional investors step in. In this scenario, share prices will drop considerably. In the case of an absence of geopolitical tensions or a new wave of infections, it is hard to see how economic data that is improving could lead to a substantial drawdown in equities even if the level of activity remains very depressed. In this case, corrections will be small and short-lived. Investment Strategy Chart I-15Beware Of Breakdowns For global equity portfolios, we continue recommending underweighting EM stocks. Regardless of the direction of global share prices, EM will continue underperforming DM (Chart I-15, top panel). The basis for this is rising geopolitical tensions in China and weakness in the RMB will spill over into other emerging Asian currencies (Chart I-15, bottom panel). We continue recommending short positions in the RMB and KRW versus the US dollar. In terms of the absolute performance of EM equities and credit markets, as well as EM currencies versus the greenback, we recommend being patient. Global and EM financial markets are presently at a critical juncture, as illustrated in Charts 1 and 2 on pages 1 and 2. If these and some other markets meaningfully break above current levels of resistance, we will upgrade our stance on EM stocks and credit markets and close our short positions in EM currencies versus the US dollar. If they fail to do so, a considerable selloff is likely to follow. As to EM local currency bonds, we are long duration but cautious on EM currencies. For the full list of our recommendations for EM equity, credit, local fixed-income and currency markets, please refer to pages 18 and 19. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, CFA Research Analyst linx@bcaresearch.com Turkish Lira: Facing A Litmus Test The Turkish lira has rolled over at its resistance level on a total return (including carry) basis (Chart II-1). The spot rate versus the US dollar is at its 2018 low. In short, the exchange rate is facing a litmus test. The culprit of a potential downleg in the lira is an enormous monetary deluge. Chart II-2 reveals that broad money supply growth has accelerated to 35% from a year ago. Local currency money supply is skyrocketing because the central bank and commercial banks are engaged in rampant money creation and public debt monetization. Chart II-1Turkish Lira (Including Carry): A Good Point To Short Chart II-2Turkey’s Broad Money: The Sky Is The Limit While such macro policies could benefit economic growth in the short term, they also herald growing inflationary pressures and currency devaluation. First, Turkish commercial banks have been on a government bonds buying binge since 2018 (Chart II-3, top panel). They presently own 62% of total local currency government bonds, up from 45% in early 2018. In addition, the central bank is de-facto engaging in government debt monetization. The Central Bank of Turkey (CBT) has bought TRY 40 billion of government bonds in the secondary market since March (Chart II-3, bottom panel). When a central bank or commercial bank buys a local currency asset from a non-bank, a new local currency deposit is created in the banking system and the money supply expands. Chart II-3Turkey: Public Debt Monetization In Full Force Chart II-4Turkey: Loan Growth Exceeds 30% Second, the commercial banks’ local currency loan growth has surged to 32% (Chart II-4). Government lending schemes and newly introduced regulations are incentivizing commercial banks to continue lending in order to boost domestic demand. In particular, state owned banks are providing loans at interest rates well below both the policy and inflation rates. The most likely outcome from such policies is rampant capital misallocation and an increase in non-performing loans. The former will weigh on productivity in the long turn. Third, the central bank has been providing enormous amounts of liquidity to commercial banks (Chart II-5, top panel). The latter’s local currency excess reserves – which are exclusively created out of thin air by the central bank - have surged (Chart II-5, bottom panel). In fact, the effective policy rate has been hovering below the actual policy rate, suggesting that there is an excess liquidity overflow in the banking system. In a nutshell, the central bank has been providing fuel to commercial banks to expand money supply via the purchases of local currency government bonds and loan origination. Fourth, an overly loose monetary stance will lead to higher inflation and currency devaluation. Moreover, wages continue to expand at an annual rate of 15-20%, confirming the fact that inflationary pressures are genuine and broad within this economy (Chart II-6). Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Chart II-5Central Banks' Liquidity Provision To Banks Chart II-6Turkey: A Sign Of Genuine Inflation Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Finally, Turkey’s current account deficit is set to widen, and the central bank’s net foreign currency reserves are non-existent at best. Booming credit growth will keep domestic demand and imports stronger than they otherwise would be. In the meantime, the complete collapse in tourism revenues and Turkey’s large foreign debt obligations, estimated at $160 billion over the next six months, entail negative balance of payment dynamics. Barring capital controls, Turkey will not be able to preclude further currency depreciation. Investment Implications Short the Turkish lira versus the US dollar. We recommend dedicated equity investors underweight Turkish equities and credit relative to their respective EM benchmarks. Also, we are reiterating our short Turkish banks / long Russian banks position. Local currency yields will offer little protection against currency depreciation. As such, investors should underweight domestic bonds. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively. In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage. The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5). Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic? Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Neutral (Downgrade Alert) Tech stocks have been on a tear with the sector besting the SPX by over 40% since 2015. While such a breakneck pace is unsustainable, what is missing from this outperformance is relative forward earnings participation. Specifically, on a sub sector level, our newly created S&P semiconductors earnings model is flashing a red light as it forecasts the steepest contraction in semi earnings since the GFC. Meanwhile, relative share prices have rallied ~15% since the mid-2019 lows highlighting the prevalent euphoria in semi equities. Bottom Line: We remain on the sidelines in the S&P semiconductors index, but we have entered into a tactical S&P semi equipment underweight position. Please see the recent Weekly Report for more details.
In terms of end usage, except smartphones, the top five end uses for semiconductors are personal computers (PCs) (12%), servers (11%), diverse consumer products (12%), automotive (10%), and industrial electronics (9%). Structural PC demand is down, but…
Highlights Portfolio Strategy Lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the time is ripe for an underweight stance in the S&P semi equipment index. The chip down cycle is far from over, leading global semi sales indicators remain downbeat and our semi profit growth model is waving a yellow flag, compelling us to put the S&P semiconductors index on downgrade alert. Recent Changes Downgrade the S&P semiconductor equipment index to underweight, today. Table 1 Feature The S&P 500 made fresh all-time highs last week, despite the ongoing profit contraction and a well telegraphed hawkish Fed interest rate cut. The “hope rally” continues and the longer it lasts defying sagging profit fundamentals, the larger the snapback will be in the ensuing months. We remain cautious awaiting a turn in our proprietary four-factor macro SPX earnings growth model and in the meantime our strategy is to sell this strength and raise dry powder. Worrisomely, Chart 1 shows that analysts have thrown in the towel and are downgrading SPX long-term profit growth expectations at a faster pace than in the aftermath of the dotcom bubble. Historically, the S&P 500 and its five-year forward EPS growth estimates are joined at the hip, and the current message is bearish for the broad equity market. Chart 1Will Sinking Profit Growth Expectations Pull Stocks Lower? Importantly, on the valuation front, in May of 2018 we first showed the SPX P/E/G ratio and at the time we accurately argued that “on this valuation measure the SPX appears cheap”.1 How times have changed since then. Following that trough, the P/E/G ratio has nearly doubled and is now sitting right at 1.5 or one standard deviation above the historical mean (we divide the 12-month forward price-to-earnings ratio by the long-term EPS growth rate using I/B/E/S data, second panel, Chart 2). We are clearly in overshoot territory and this valuation metric represents another yellow flag. Chart 2SPX P/E/G Ratio Is In Overshoot Territory Moving on to the bond market, what caught our attention was a recent WSJ article detailing how investors are no longer paying up to own the lowest quality paper and while overall junk spreads were coming in, at the bottom of the pit investors were shunning CCC rated junk bonds.2 What is interesting is that this lowest quality corner of the junk market has some excellent forward looking properties and tends to lead not only the overall junk market, but also equities. Chart 3 shows the CCC rated option adjusted spread (OAS) versus the overall high yield OAS on a year-over-year change basis on inverted scale. This measure of bond market stress is moving in the opposite direction of S&P 500 momentum and we expect stocks to converge lower to this junk bond market stress indicator (JBMSI). Chart 3Bond Market Not Buying Stock Market Euphoria This week we are downgrading a niche tech subgroup that has gone parabolic and updating another early-cyclical tech subindex. The overall corporate bond ratings migration data (defined as downgrades minus upgrades as a percent of total) corroborates the JBMSI message and warns that the steep divergence with stocks is unsustainable (corporate bond ratings migration data shown inverted, middle panel, Chart 4). Chart 4Unsustainable Divergences Similarly, the S&P 500’s net earnings revision ratio is also negative and before long it will exert downward pull on SPX momentum (bottom panel, Chart 4). Under such a backdrop, we continue to recommend investors avoid chasing the broad equity market higher and instead build up their cash coffers, at least until we get a definitive signal that the path of least resistance is higher for profits. This week we are downgrading a niche tech subgroup that has gone parabolic and updating another early-cyclical tech subindex. Sell The Semi Equipment Exuberance Tech stocks have been on a tear with the sector besting the SPX by over 40% since 2015. While such a breakneck pace is unsustainable, what is missing from this outperformance is relative forward earnings participation. In fact, tech profit expectations stalled versus the overall market in late-2018 and have not been able to keep up with relative share prices. In other words, the forward multiple has skyrocketed and is now trading at a 15% premium to the SPX, at a time when relative margins are sinking like a stone (Chart 5). Importantly, given that stock performance should follow profit performance we are perplexed by this dynamic with investors religiously bidding up the sector’s forward multiple. Tack on the recent news of a plunge in overall tech capex growth – especially excluding software – and the tech sector’s bleak profit outlook dims further (Chart 6). Worryingly, within the tech sector the semiconductor equipment space is even more puzzling. Chart 7 shows that relative forward profits are trailing relative share prices as investors have extrapolated the recent positive trade news far into the future. As a reminder this index has a 90% foreign sales exposure with roughly 30% of sales originating from China. As a result, the S&P semiconductor equipment forward P/E is just below the broad market, nearly doubling on a year-over-year basis (middle panel, Chart 7). Chart 5Mind The Gap Chart 6Even Tech Investment Is Cracking The last time we tried to lean against semi equipment exuberance on the back of deteriorating profit fundamentals was on July 8 when we downgraded this index to underweight. But, we were offside and thankfully our risk management metric (stop loss at -7%) limited our downside a mere ten days later. Chart 7Sell Semi Equipment Stocks Since then, relative share prices have skyrocketed by 40% and we now have more confidence to re-enter our position. Today we recommend a downgrade in the S&P semi equipment index to a below benchmark allocation. This is a speculative/tactical downgrade and thus we also set a trailing stop loss near the -10% relative return mark. While bulls would buy this breakout, we are sticking our heads out and recommend selling the strength and warn that the S&P semi equipment all-time highs look more like a mania, eerily similar to the dotcom bubble era (Chart 8). Chart 8Chip Equipment Mania The contracting ISM manufacturing survey signals that relative share price momentum running at a 60%/annum clip is unwarranted and bound to return to earth (second panel, Chart 9). The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (third & bottom panels, Chart 9). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (Chart 10). Chart 9To The Moon… Chart 10…And Back? Not only is the relative share price momentum running at the fastest clip in 19 years, but our proprietary Technical Indicator is also signaling that it is a good time to shun away from these hyper-cyclical tech stocks. The last three times our TI spiked to over one standard deviation above the historical mean, relative share prices corrected on average by 36% in the ensuing 12-18 months (Chart 11). While we are confident to downgrade this index to underweight, there is a risk to our bearish view. Were the U.S. dollar to depreciate definitively from current levels, then it would reflate the global economy and put this position offside. In fact, there are some green shoots in the emerging markets that are appearing, but in order for them to blossom further and not get nipped in the bud the trade-weighted U.S. dollar has to fall (Chart 12). Chart 11Time To Be Contrarian In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the time is ripe for an underweight stance in the S&P chip equipment index. Chart 12Risk To View: U.S. Dollar The Global Reflator Bottom Line: Downgrade the S&P semi equipment index to underweight, today with a stop loss at the -10% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Is Semi Euphoria Warranted? Similar to the broad tech space and the S&P semiconductor equipment subgroup, semi producers are also showing signs of excess. Chart 13 shows that relative forward EPS are in a clear and steep downtrend with no end in sight, whereas relative share prices are near post GFC highs, pushing the semi forward P/E on a par with the SPX. While the relative margin squeeze in chip stocks has been a whopping 5%, semi forward margins are still projected to outpace overall market by an impressive 15% (bottom panel, Chart 13). Trailing semiconductor earnings are contracting and our newly created top-down chip profit growth model is sputtering, warning that more earnings pain lies ahead (semi pricing power, global exports and the greenback comprise our proprietary S&P semiconductors earnings model, Chart 14). While chip earnings season has been a mixed bag with INTC on the bullish side and TXN on the bearish camp, TXN’s CFO commentary really grabbed our attention musing that: “When there are tensions in trade and obstacles to trade, what do businesses do? They become more cautious. And they pull back. And we are at the very end of a long supply chain. And when the ones at the very front pull back, it becomes a traffic jam” (emphasis ours). Chart 13Falling Profits Should Exert Downward Pull On Stocks Chart 14BCA Chip Profit Growth Model Is Bearish Our global semi sales-to-inventories ratio is still contracting also warning that the path of least resistance is lower for chip profits (Chart 15). In other words, the inventory liquidation phase has just began and steep price concessions to rebalance the markets will continue to weigh on the sector’s profit prospects. With regard to chip final-demand, while 5G euphoria has gripped the sector, our proprietary global auto sales proxy and global capex indicator (using the IFO’s World Economic Survey dataset) underscore that the global chip down cycle is far from over (Chart 16). Chart 15Semi Down Cycle … Chart 16… Is Far… Netting it all out, the chip down cycle is ongoing and leading global semi sales indicators remain downbeat. Other macro variables confirm that semi end-demand remains feeble. The global manufacturing PMI is waning and our diffusion index is probing multi-year lows. Our in-house calculated Global ZEW survey is also heralding additional global semi sales weakness in the coming months as it is hovering near levels last hit during the Great Recession (middle panel, Chart 17). Chinese electronics imports remain in contractionary territory (bottom panel, Chart 17) and U.S. new orders for computers & electronic products are on the verge of contraction (not shown). Despite this souring backdrop, investors have given the semi industry the benefit of the doubt and are anticipating a swift final-demand recovery. Our indicators suggest otherwise, and we expect relative share prices to converge lower to still contracting relative profit and revenue estimates (Chart 18). Chart 17…From Over… Chart 18…But Investors Are Mesmerized Netting it all out, the chip down cycle is ongoing and leading global semi sales indicators remain downbeat. Moreover, our semi profit growth model is waving a yellow flag, compelling us to put the S&P semiconductors index on downgrade alert. Bottom Line: Stay on the sidelines in the S&P semiconductors index for now, remove the upgrade alert and put it on downgrade watch. Stay tuned. The ticker symbols for the stocks in this index are: BLBG – S5SECO – INTC, TXN, ADI, AMD, MXIM, XLNX, MCHP, NVDA, AVGO, QCOM, MU, SWKS, QRVO. Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1. Please see BCA U.S. Equity Strategy Report, “Resilient” dated May 14, 2018, available at uses.bcaresearch.com. 2. https://www.wsj.com/articles/wave-of-financial-stress-hits-low-rated-companies-11571736606 Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
A more speculative and higher octane vehicle to explore the trade war-related mispricing from Part I of this Insight is via a long S&P machinery/short S&P semiconductors pair trade. Most of the drivers mentioned in Part I also hold true in this subsector market-neutral trade, but we have to introduce another key driver: China. Encouragingly, China’s fiscal and credit impulse signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can spike 20%, near the late-2018 highs (top panel). Moreover, Chinese money supply growth is showing some signs of life and capital committed to infrastructure spending is coming out of hibernation (second & bottom panels). Goldman Sachs’ China current activity indicator is on a similar upward trajectory, underscoring that the path of least resistance is higher for relative share prices (third panel). Bottom Line: We have initiated a long S&P industrials/short S&P tech pair trade and a long S&P machinery/short S&P semiconductors pair trade in yesterday’s Weekly Report.
Highlights Portfolio Strategy The trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. A tentative tick up in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Recent Changes Initiate a long S&P Industrials/short S&P Tech pair trade on a tactical three-to-six month time horizon, today. Initiate a long S&P Machinery/short S&P Semiconductors pair trade on a tactical three-to-six month time horizon, today. Feature The S&P 500 oscillated violently again last week, as the barrage of declining economic data, heightened trade war-related volatility and political upheaval dominated the news flow. While the Fed remains the backstop of last resort, we doubt additional interest rate cuts, which are already aggressively priced in the bond market, will boost lending and entice CEOs to invest in capital expenditure projects. Investors have to stay patient and disciplined, let this economic slowdown play out and allow for the natural healing of the economy. As a reminder, the ISM manufacturing index has been decelerating for twelve months and only been below the boom bust line for two. If history is an accurate guide, an additional three-to-six months of manufacturing pain are in store before a definitive bottom is in place (bottom panel, Chart 1). Such a macro backdrop, still warrants caution on the prospects of the broad equity market. Chart 1Allow Time For Economic Healing Beginning in August, a number of BCA publications became a tad more cautious on risk assets. Following our October editorial view meeting last week, this cautiousness was cemented with a tactical downgrade of global equities to neutral from previously overweight in the BCA House View matrix. While this marks a clear shift toward this publication’s less sanguine view of the U.S. equity market adopted during the summer, BCA's cyclical 12-month House View remains overweight global equities. Worryingly, the majority of the indicators we track continue to emit distress signals and warn that the SPX has further downside (Chart 2), especially absent profit growth. Importantly, we first correctly posited last May that the back half of the year global growth reacceleration was in jeopardy and would go on hiatus courtesy of rising policy uncertainty.1 Such a backdrop would boost the U.S. dollar and simultaneously take a bite out of SPX EPS.2 Chart 2Soft Data Red Flag Last week we highlighted that the U.S. dollar is the most important indicator to monitor given its global deflationary/reflationary properties. Were the greenback to maintain its year-to-date gains, it will continue to dent SPX profitability via P&L translation loss effects and likely sustain the profit recession into early 2020 (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 3). Chart 3Greenback Weighing On Profits U.S. Equity Strategy’s S&P 500 four-factor macro EPS growth model remains downbeat (middle panel, Chart 4). Were we to isolate the U.S. dollar as a single variable and re-run the regression it is clear that additional greenback appreciation will further weigh on SPX profit growth (bottom panel, Chart 4). Meanwhile, the easing in financial conditions and drubbing of the 10-year Treasury yield since the Christmas Eve lows is already reflected in the 23% jump in the forward PE multiple, which explains over 90% of the SPX’s rise since the Dec 24, 2018 trough (top & middle panels, Chart 5). In other words, for multiples to expand anew, financial conditions would have to further ease, which in our view is a tall order (bottom panel, Chart 5). Chart 4EPS Model Warrants Caution Chart 5Financial Conditions Are The Forward P/E This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe. Thus, we would lean against the narrative that easy financial conditions are not fully reflected into stocks. In contrast, our worry is that junk spreads are on the verge of a breakout and such a backdrop would tighten financial conditions and aggravate an SPX drawdown (junk OAS shown inverted, Chart 6). Adding it all up, the trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe. Chart 6Watch Junk Spreads Initiate A Long Industrials/Short Tech Pair Trade… Ever since the Sino-American trade war started in March 2018, the market has punished industrials, but tech has escaped unscathed. While the global growth soft patch preceded the U.S./China trade spat, courtesy of the Fed’s tightening cycle and Chinese policymakers’ slamming on the brakes, the trade war has served as a catalyst to aggressively shed deep cyclical equities except for tech stocks (Chart 7). We think this misalignment presents a playable opportunity to generate alpha by going long industrials/short tech, irrespective of the trade war’s outcome. In other words, this market neutral trade will be in the black either because the trade spat gets resolved or because there will effectively be no “real” deal including intellectual property and the tech sector. If the two sides manage to iron out their differences and strike a deal, industrials stocks should benefit from a greater catch-up phase because they have been depressed over the past two years, while tech stocks are near relative all-time highs. In contrast, a “no deal” scenario, should also re-concentrate investors’ minds and lead to a relative selling in tech stocks versus their already beaten-down deep cyclical peers: industrials. Chart 7Bifurcated Deep Cyclicals Market Chart 8Lots Of Bad Trade War News Reflected In Prices Chart 8 shows the drubbing in relative share prices as three key macro drivers have felt the trade war’s wrath. In more detail, were a deal to get struck, growth expectations will reverse course and a bond market sell-off will almost immediately reflect such an improvement in the global macro backdrop. Rising interest rates on the back of a reflationary/inflationary impulse are a boon for industrials and a bane for high growth tech stocks (top panel, Chart 8). Similarly, the middle panel of Chart 8 highlights that the ISM manufacturing survey should climb above the boom/bust line and outshine the San Francisco Fed’s Tech Pulse Index (that comprises “coincident indicators of activity in the U.S. information technology sector”3) on news of a successful deal. Finally, relative capital expenditure outlays should also veer in favor of industrials as previously mothballed infrastructure projects will come out of hibernation (bottom panel, Chart 8). In contrast, tech capex has been resilient of late with analytics, security and cloud computing being the most defensive capex corner, leaving little room for additional relative capex gains. Taking the opposite side i.e. a “no deal”, we doubt the metrics we depict in Chart 8 would sink that much further. If anything we believe that there is an element of exhaustion and relative share prices would jump on news of a breakdown in trade talks as tech sector fire sales would trump the sell-off in already depressed industrials. Meanwhile, the U.S. dollar and relative share prices have been steeply diverging recently and this gap will likely narrow via a catch-up phase in the latter (top & middle panels, Chart 9). According to Factset’s latest data the S&P industrials sector garners 37% of its sales from abroad, whereas the S&P information technology sector’s foreign exposure stands at 57% of total revenues.4 Therefore, given this 20% delta, a rising greenback should be beneficial to the more domestically geared industrials stocks (bottom panel, Chart 9). On the operating front, industrials also have the upper hand. The relative wage bill is sinking like a stone (shown inverted, middle panel, Chart 10) at a time when relative selling price inflation is holding its own (top panel, Chart 10). The upshot is that a relative profit margin jump is in store in the coming months which should boost the relative share price ratio (bottom panel, Chart 10). Chart 9Unsustainable Divergence Chart 10Industrials Have The Upper Hand U.S. Equity Strategy’s proprietary relative Cyclical Macro Indicators and relative profit growth models capture all these drivers and both signal that an industrials versus tech earnings-led outperformance phase looms into year end (Chart 11). Chart 12 shows that the relative earnings breadth and relative net earnings revisions are both deep in negative territory. In terms of technicals, the relative percentage of groups trading with a positive 52-week rate of change has hit the lowest level in the past two decades (second panel, Chart 12) and our composite relative technical indicator is roughly one standard deviation below the historical mean (bottom panel, Chart 11). Chart 11Profit Models And... Chart 12...Washed Out Breadth Say Buy Industrials At The Expense Of Tech Finally, relative valuations are also bombed out. Our relative valuation indicator has been in a six-year uninterrupted drop, falling from two standard deviations above the mean to one standard deviation below the mean (fourth panel, Chart 11). Such entrenched bearishness in relative value is unwarranted. Bottom Line: Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. …And A Long Machinery/Short Semis Pair Trade A more speculative and higher octane vehicle to explore this trade war-related mispricing is via a long S&P machinery/short S&P semiconductors pair trade. Most of the drivers mentioned above also hold true in this subsector market-neutral trade. However, in this section we will drill deeper in the China/EM drivers. The Emerging Asia leading economic indicator (EALEI) has plummeted to levels last hit around the 1998 LTCM bailout (top panel, Chart 13). While more pain is likely in the coming months as global trade has ground to a halt, we doubt the carnage in the EALEI can continue indefinitely. In fact, a tentative trough in the Emerging Markets (EM) manufacturing PMI heralds a brighter outlook for relative share prices (bottom panel, Chart 13). Chart 13Same Trade War Theme, Different Vehicles To Play It Chart 14China... Encouragingly, China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can spike 20% near the late-2018 highs (Chart 14). Chinese money supply growth is showing some signs of life and capital committed to infrastructure spending is coming out of hibernation. Goldman Sachs’ China current activity indicator is on a similar upward trajectory, underscoring that the path of least resistance is higher for relative share prices (Chart 15). Chart 15...Holds The Key Chart 16Firming Final Demand... On the operating front, relative new orders and relative shipment growth have both ticked higher (top & middle panels, Chart 16). Importantly, our relative demand proxy suggests that the relative end-demand backdrop is also firming. Using Caterpillar’s global sales to dealers data compared with global chip sales reveals that a wide gap has formed between relative share prices and our relative demand gauge (bottom panel, Chart 16). If our thesis pans out in the upcoming three-to-six months then machinery will trounce semis. Finally, relative pricing power corroborates that machinery demand has the upper hand versus semiconductor final demand. The Commodity Research Bureau’s raw industrials index is climbing relative to Asian DRAM prices. The upshot is that the compellingly valued relative share price ratio will gain steam in the months ahead (Chart 17). In sum, a tentative up-tick in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Bottom Line: Initiate a long S&P machinery/short S&P semiconductors pair trade today. The ticker symbols for the stocks in the S&P machinery and S&P semis indexes are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS, and BLBG – S5SECO – INTC, TXN, NVDA, AVGO, QCOM, MU, ADI, AMD, XLNX, QRVO, MCHP, MXIM, SWKS, respectively. Chart 17...Is A Boon To Relative Pricing Power Key Risk To Monitor One important risk to both of our newly recommended market-neutral trades is China. We recently touched base with our ex-Chief Geopolitical Strategist and currently Chief Strategist at the Clocktower Group, Marko Papic. He warned us that all bets would be off because: “I think we will look back at the recession of 2020 and it will be known as the “China recession”. Basically, China just decided to stop playing, pick up its toys, and go home”. If Marko’s wise words were to ring true, then such a Chinese policy shift will truly be a game changer with negative global economic growth implications. With regard to our pair trades, they would both be offside. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Consolidation” dated May 21, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “On Edge” dated May 13, 2019, available at uses.bcaresearch.com. 3 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 4 https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_100419A.pdf Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights Portfolio Strategy Rising lumber prices, melting interest rates and profit-augmenting industry productivity gains all signal that it no longer pays to be bearish the S&P home improvement retail (HIR) index. Poor revenue growth prospects, the ongoing global manufacturing contraction and downbeat financial variables all indicate that high-beta semi equipment stocks have ample downside. Recent Changes Downgrade the S&P semi equipment index to underweight on a tactical three-to-six month time horizon, today. Upgrade the S&P home improvement retail index to neutral and remove from the high-conviction underweight list, today. Put the S&P consumer discretionary sector on upgrade alert and remove from the high-conviction underweight list, today. Table 1 Feature July 10 marks the two year anniversary of our seminal “SPX 3,000?” report.1 We were very early both compared with the sell and buy side (to our knowledge the great Byron Wien is the only other strategist that had such a target) and as a reminder, at the time, the S&P 500 was trading near 2,400. A number of BCA peers and BCA clients alike confronted our über bullishness with disbelief, but our 3,000 target – based on our dividend discount model, an EPS and multiple sensitivity analysis and an equilibrium equity risk premium analysis – proved a prescient call. Throughout this period (we had actually been bullish since Brexit, when our profit growth models hooked up) we maintained our cyclical bullishness and never wavered (top panel, Chart 1). Now that SPX futures hit our 2019 target, we want to remain ahead of the curve, as Stan Druckenmiller once mused: “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today”. Chart 1Rally Running On Fumes In early June we shaved our 2021 EPS to $140 and our end-2020 SPX target fell to a range of 1,890-2,310. We posited that the easy gains in equities were behind us and we are not willing to play 100-200 points to the upside for a potential 1,000 point drawdown, owing to a souring macro backdrop (five key reasons underpin our cautious broad equity market stance that we outline in our recent webcast). On the eve of earnings season, investors have been obsessing with the “Fed put”, but neglecting the looming profit recession (bottom panel, Chart 1). Moreover, while markets cheered the trade truce following the recent G20 meeting, odds are high that manufacturing will remain in the doldrums as the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, and no tariff rollback was agreed. As a result, highly-cyclical global trade and manufacturing will likely continue to weigh on the economy for the remainder of the year. A simple liquidity indicator points to profit growth trouble into early-2020, which stands in marked contract with sell-side analysts who anticipate 10% EPS growth. Chart 2 shows the gulf gap between industrial production and broad money growth. Since 1960, this liquidity indicator has been an excellent leading indicator of SPX profit momentum and the current message is to expect a sustained deceleration in the latter. Chart 2Earnings… BCA U.S. Equity Strategy’s four-factor macro S&P 500 profit growth model corroborates this signal and warns that a profit contraction is nearing (Chart 3). Chart 3…Trouble… Following up from last week, Goldman Sachs’ U.S. Current Activity Indicator is also flashing red for SPX profit growth. Similarly, our corporate pricing power gauge is sinking steadily and underscores that a profit recession is a high probability outcome (Chart 4). Meanwhile, a longtime friend that I call “the smartest man in California” brought a slight variation of Chart 5 to my attention recently and highlighted that: “Historically, periods of falling manufacturing PMI result in larger negative earnings growth surprises as market forecasters rarely anticipate the breadth and depth of slowdowns. Profit growth trends are set to weaken further in the coming six months. Without profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally, and until there is an upturn in growth momentum, rallies should be faded.” Chart 4…Proliferating Chart 5Expect Downward… Even net EPS revisions have taken a turn for the worse and are probing recent lows (Chart 6). Drilling beneath the surface is revealing. Trade-exposed sectors bear the brunt of the EPS downgrades. Tech (60% foreign sales exposure), materials, industrials, and energy are deeply in negative territory (Chart 7). On the flip side, defensive sectors are offsetting some of the cyclical sectors' weakness with health care, real estate, utilities and consumer staples hovering close to zero (Chart 8). Chart 6…Profit Surprises Chart 7Net Earnings Revisions… Chart 8…Sectorial Breakdown With regard to the contribution to profit growth for calendar 2019, the divergences have widened significantly since our last update in early-April, with the financials sector solely holding the broad market’s profit fate in its hands. In more detail, Chart 9 shows that financials are responsible for 79% of the overall anticipated profit growth, up from 45% in early-April, whereas technology, energy and materials each have a negative profit growth contribution north of 30%. Table 2 puts all these figures in perspective, and also updates the sector market capitalization and profit weights. Table 2S&P 500 Earnings Analysis In sum, the SPX profit growth backdrop remains anemic and absent a pickup in growth momentum the risk/reward tradeoff is skewed to the down side. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are making a subsurface change in an early-cyclical subgroup, and trimming a highly cyclical tech subindex. Put Consumer Discretionary Stocks On Upgrade Alert, And… Consumer discretionary stocks have marked time over the past year. But, now that the Fed is ready to ease monetary policy it will no longer pay to be bearish (Chart 10). This early-cyclical sector benefits the most from lower interest rates, and vice versa. Thus, we are putting this sector on our upgrade watch list and removing it from our high-conviction underweight list. We anticipate to execute this upgrade in coming weeks via boosting the S&P internet retail index to overweight. This subgroup is already on upgrade alert. Before triggering these upgrades, however, today we recommend a subsurface consumer discretionary move. Chart 10Lower Interest Rate Beneficiary …Lift The Home Improvement Retailers To Neutral We are compelled to upgrade the S&P HIR index to a benchmark allocation and remove it from our high-conviction underweight list for a small relative loss. Similar to the parent GICS1 sector, HIR stocks are inversely correlated with interest rates (fed funds rate discounter shown inverted, middle panel, Chart 11), given the close residential real estate market links they enjoy (top panel, Chart 12). Now that the bond market forecasts that the Fed will cut rates four times by next July, home improvement retailers should be cheering this news. Chart 11Two Profit Boosters Chart 12Resilient Pricing Power Jumping lumber prices should be a boon to HIR same-store sales. Recent steep production curtailments in lumber yards have been a tonic to prices that have rebounded $100/tbf in a little over a month. Keep in mind, that building materials & construction supplies stores make a set margin on lumber sales and thus higher selling prices translate straight into higher profits; the opposite is also true (bottom panel, Chart 11). Home improvement retailers have been flexing their pricing power muscles recently and this represents another boost to their top line growth prospects (middle panel, Chart 12). While the recent tariff rate increase related input cost inflation has yet to hit the industry’s bottom line, it remains to be seen if HIR margins will take a hit or retailers will pass it on through further price hikes. Importantly, industry labor restraint is a welcome offset and has been a profit booster as measured by our expanding productivity gauge (bottom panel, Chart 12). Our HIR model captures all these positive forces and has likely put in a durable trough recently, signaling that a brightening backdrop looms for the S&P HIR index (Chart 13). Chart 13Model Says It No Longer Pays To Be Bearish But prior to getting carried away up the bullish lane, these Big Box retailers have to contend with some key headwinds, and prevent us from boosting exposure to an above benchmark allocation. Residential fixed investment has been contracting for five consecutive quarters and remains a far cry from the 2006 peak as a share of output (Chart 14). Similarly, existing home sales, a key HIR demand driver, have softened recently at a time when home inventories have jumped (inventories shown inverted, top panel, Chart 15). Chart 14But, Some Headwinds… Chart 15…Persist As a result, remodeling activity has taken a backseat, at the margin, weighing on industry same-store sales growth (bottom panel, Chart 15). Home owners have avoided dipping into their currently rebuilt home equity to undertake renovation projects. Until the reflationary wave of lower mortgage rates rekindles single family home sales and thus remodeling activity, only a neutral weighting is warranted in the S&P HIR index. All of this has led to a sustained deterioration in HIR operating metrics with the sales-to-inventories ratio contracting at an accelerating pace. The implication is that before long, home improvement retailers may have to resort to margin-denting price concessions to clear the inventory overhang (middle panel, Chart 15). Netting it all out, rising lumber prices, melting interest rates and profit-augmenting industry productivity gains all signal that it no longer pays to be bearish the S&P HIR index. Bottom Line: Lift the S&P HIR index to neutral and remove from the high-conviction underweight list for a relative loss of 5.9% since inception. The ticker symbols for the stocks in this index are: BLBG – S5HOMI – HD, LOW. Downgrade Semi Equipment To Underweight While the post G-20 trade related entente should have boosted semi equipment stocks that garner a large slice of their revenues in China, relative share prices are below Friday’s June 28 close. A tactical trading opportunity has re-emerged, and today we recommend trimming the S&P semi equipment index to underweight on a three-to-six month time horizon, but with a tight stop at the -7% relative return mark. But before proceeding with our analysis, a brief recap of the recent history of our moves in this hyper-cyclical tech sub-index is in order. In late-November 2017 we recommended a high-conviction underweight position in the S&P semi equipment index at the height of the bitcoin fever.2 In mid-December 2018 we swung for the fences and upgraded this niche semi index to overweight as the street had finally capitulated and became extremely bearish on semi equipment stocks.3 Finally in early-March 2019 we booked handsome profits in this trade and moved to the sidelines (vertical lines denote recommendation changes, Chart 16).4 Semi equipment stocks are capital intensive, require precision manufacturing and their sales cycle is a carbon copy of the broad manufacturing cycle. The middle panel of Chart 17 shows this tight positive correlation with the ISM manufacturing index and sends a grim message for semi equipment manufacturers. Chart 16Time To Fade Semi Equipment Stocks Chart 17Chip Equipment Equities Follow The Manufacturing Cycle Global trade and manufacturing continue to contract and, specifically, the EM manufacturing PMI is below the 50 boom/bust line (second panel, Chart 18). Tack on elevated policy uncertainty, and the implication is that investors should sell semi equipment stock strength (top panel, Chart 18). Growth-sensitive financial variables also signal a challenging backdrop for relative share prices. Not only are emerging market stocks trailing their global peers year-to-date, but EM Asian currencies are also exerting downward pull on the relative share price ratio (third & bottom panels, Chart 18). Finally, with regard to industry operating metrics, the news is equally glum. Global semi cycles typically last four-to-five quarters and we only just passed the half way mark. Thus, there is more downside to industry sales momentum and we would lean against recent analyst relative revenue euphoria (middle panel, Chart 19). Asian DRAM prices are deflating, and this semi equipment industry pricing power proxy emits a similarly weak signal for top line growth (bottom panel, Chart 19). Chart 18Financial Variables Say Sell Chart 19Lean Against Recovering Top Line Growth Estimates Summing it all up, poor revenue growth prospects, the ongoing global manufacturing contraction and downbeat financial variables all indicate that semi equipment stocks have ample downside. Bottom Line: Downgrade the S&P semiconductor equipment index to underweight on a tactical basis (three-to-six month horizon), but set a tight stop at the -7% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ– AMAT, LRCX, KLAC. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes: 1 Please see BCA U.S. Equity Strategy Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls” dated November 27, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps