Developed Countries

In the September 8thStrategy Report we first created the “Back To Work” basket and recommended investors to gain exposure to the reopening trade by initiating a long “Back To Work”/short “COVID-19 Winners” pair trade. More recently, and in light of the handsome gains that this trade has produced, we instituted a 5% rolling stop in order to protect profits. Yesterday, our stop was triggered compelling us to crystallize 21.5% in gains since inception. Not only did this long/short trade serve its purpose by capturing the economic reopening and vaccine related rollout euphoria, but it also outperformed the market by 700bps as the SPX rose only by 14.5% since September 8th. Bottom Line: Lock in 21.5% gains in the long “Back-To Work”/short “COVID-19 Winners” pair trade since the early-September inception.  

While everyone was preoccupied with the effect TSLA’s SPX inclusion would have on the index’s 12-month forward P/E, the real change crept up in the long-term EPS growth expectations. This story stock caused the S&P 500’s five-year profit growth expectation to skyrocket from 12% to 21% overnight (top panel) and push down the S&P 500 forward P/E/G to near par (not shown). Back in late-1999, YHOO’s SPX inclusion also caused a bump in this metric, but it paled in comparison to TSLA’s current dominance. In other words, nine percentage points of growth are attributed to a single stock or 43% of the SPX EPS growth is tied to the fortunes of TSLA. We highly doubt this will occur as analysts have been upgrading profit estimates and price targets for TSLA hand over fist, with some using DCFs out to 2040 in order to back up their forecasts. Drilling deeper beneath the surface into the consumer discretionary sector is revealing. TSLA’s inclusion pushed the sector’s 5-year forward profit growth estimates to 83% (bottom panel). To put this in perspective it translates into consumer discretionary profits increasing 20 fold in the next 5 years; no, this is not a typo. Assuming that stock prices follow profits as it typically transpires, then prices will have to rise by a similar amount. Again, our sense is that this is highly unlikely. In comparison, AMZN’s graduation to the SPX in late-2005 barely budged this profit growth metric for the GICS1 sector as tech stocks were still licking their wounds from the dotcom bubble burst. Bottom Line: Frothiness is prevalent in certain parts of the equity market and some near-term caution is warranted. We reiterate our recent recommendation that investors deploy fresh capital via going long the $390/$410 SPY call spread and financing it via a $340 put either for March or June expiries. For additional analysis please look forward to this coming Monday’s Strategy Report.

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation Chart 17The Case For US Inflation Chart 18The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China Chart 27No Inflation In China Chart 28No Inflation In China Chart 29No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are ElevatedChart 36Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force Chart 38A Mania In Full Force Chart 39A Mania In Full Force Chart 40A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese StocksChart 45Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks Chart 62The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

Overweight The S&P movies & entertainment index has been on a tear recently likely due to receding fiscal uncertainty and the normalization process in the economy (third panel). This niche communication services sub-industry is dominated by the two key players DIS and NFLX, and while they are fierce competitors, our view remains that there is plenty demand for the pair of them to remain successful. We first showed the relative P/E/G ratio for this index in mid-December, and highlighted how the ratio was below the historical mean and offered compelling value. True, today it has spiked, but it is nowhere near previous extreme readings (bottom panel). Keep in mind that analysts still remain relatively neutral to slightly pessimistic on the industry’s growth prospects and earnings power (second panel). The fact that relative net earnings revisions are negative, underscores that investors should buy the breakout in relative share prices. Bottom Line: We remain overweight the S&P movies & entertainment index. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, LYV. ​​​​​​​

Special Report

Highlights Higher corporate taxes mean that the structural profit margin will drift lower. Combined with only modestly rising sales, aggregate stock market profits will continue to go nowhere, as they have since 2008. Hence, the continuation of the structural bull market will depend on multiple expansion and a declining global bond yield, as it has since 2008. The good news is that the relationship between a declining bond yield and stock market valuation is exponential. This means that the equity bull market will end when the yield on the US 10-year T-bond and the yield on the Italian 10-year BTP reach zero. Until then, long-term investors should stay in equities. But avoid the three sectors whose profits are in terminal decline: oil and gas, basic resources, and banks (other than for brief countertrend trades). Fractal trade: underweight European basic resources. Feature Feature ChartThe Post-2008 Bull Market Is Due To Higher Valuations, Not Profits A core tenet of investment is under threat. The core tenet is that the stock market goes up because profits go up. This tenet is under threat because, since 2008, the global stock market has nearly doubled while profits have gone nowhere. Granted, the pandemic took its toll on profits in 2020. But we are looking at forward earnings per share, the profits anticipated over the next 12 months. Forward earnings per share are discounting a V-shaped recovery in 2021, and have recovered almost all their pandemic losses. Yet the remarkable thing is that even after this snapback, profits are no higher today than they were in August 2008! This remarkable observation leads to a salutary conclusion. The global stock market has nearly doubled since 2008 because the multiple paid for unchanged profits has nearly doubled (Feature Chart). Furthermore, the reason that the multiple has nearly doubled is that the global bond yield has collapsed. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The salutary conclusion is that the raging bull market since 2008 is entirely due to the collapse in bond yields (Chart I-2). Chart I-2The Post-2008 Bull Market Is Due To The Collapse In Bond Yields Flat Profits Hide Big Winners And Big Losers The preceding analysis applies to the global stock market, and its profits, taken as a sum of the parts. But among the parts are some big winners and some big losers. Although overall profits have gone nowhere since 2008, some sector profits have been in major structural uptrends while other sector profits have been in terminal decline. The major profit uptrends are in technology +170 percent, and healthcare +110 percent (Chart I-3). And the terminal declines are in oil and gas -80 percent, basic resources -40 percent, and banks -35 percent (Chart I-4). Chart I-3The Sector Profits In Structural Uptrends Chart I-4The Sector Profits In Structural Downtrends It follows that among stock markets, the major profit uptrends are in those markets with a high weighting to the sector profits in uptrends: specifically, tech-heavy US +55 percent, healthcare-heavy Denmark +40 percent, and tech-heavy Korea +25 percent (Chart I-5). And the major profit downtrends are in those markets with a high weighting to the sector profits in terminal decline: specifically, bank-heavy Spain -55 percent, Italy -45 percent, and Austria -45 percent (Chart I-6). Chart I-5The Stock Market Profits In Structural Uptrends Chart I-6The Stock Market Profits In Structural Downtrends When profits are in terminal decline, the valuation boost from lower bond yields is not enough to take the stock market higher. Hence, ask an investor in Spain or Italy when the equity bull market will end, and he will look at you quizzically. In Spain and Italy, the bull market ended thirteen years ago! In Spain and Italy, the bull market ended thirteen years ago. One important message for long-term investors is that when a sector’s profits go into structural decline, it is terminal. It is almost unheard of for these sectors to return to structural growth. Furthermore, the support to the sector price from falling bond yields is not enough to offset the weight of collapsing profits. In any case, bond yields cannot fall forever. Hence, long-term investors should stick with the growth sectors. And avoid the three sectors whose profits are in terminal decline: oil and gas, basic resources, and banks. Profit Margins Peaked In 2008 It seems counterintuitive that aggregate stock market profits have gone nowhere since 2008. After all, the world economy has experienced a long expansion during which the revenues of globally listed companies have grown by over 40 percent (Chart I-7). Chart I-7Post-2008, Sales Have Expanded But Profits Have Gone Nowhere If sales are up while profits have gone nowhere, then, as an accounting identity, it means that the profit margin has eroded (Chart I-8). In turn, if profits are taking a smaller share of sales, then, as another accounting identity, some other component must be taking a larger share. That other component has been wages. Wages, as a share of income, reached their low-point just after the 2008 financial crisis, since when they have been trending higher, eroding the profit margin (Chart I-9). Chart I-8The Profit Margin Peaked ##br##In 2008 Chart I-9The Wage Share Of Income Bottomed After The 2008 Crisis Interestingly, this demonstrates that if wages are rising faster than income, it does not necessarily lead to consumer price inflation. Instead, as we have seen since 2008, it can just erode the profit margin. Hence, looking ahead, a key question is what will happen to the wage share of income? What will happen to the profit margin? Another component of income that can erode the profit margin is corporate taxes. So, a further question is what will happen to the corporate tax rate? Predicting The End Of The Bull Market The longevity of the bull market depends on four things: sales, wages, taxes, and the bond yield. Let’s address all four in turn. Sales tend to grow most strongly immediately after a severe recession. Unlike the severe sales recessions of 2008 and 2015, the pandemic recession only made a short-lived dent to the revenues of listed companies. From this starting point, we can expect only modest growth in sales through the next few years. Wages will be subject to opposing forces. High structural unemployment in the post-pandemic world will constrain wage growth. Against this, the wage share of income should benefit from a coordinated global agenda of ‘levelling up’ through, for example, higher minimum wages and increased rights and benefits for workers. Taken together, the wage share of income is likely to go sideways. The much bigger threat to profits is higher corporate taxes. Indeed, after reaching a low after the 2008 financial crisis, the US corporate tax rate did start to rise for a while, before the Trump tax cuts took the corporate tax rate back to a low. However, the newly installed Biden administration, supported by a Democratic House and Senate, is highly likely to reverse the Trump tax cuts, with corporate taxes bearing the brunt (Chart I-10). Chart I-10Corporate Taxes Will Go Up Elsewhere in the world too, governments are desperately seeking ways to mitigate – or at least, contain – ballooning deficits that have paid for the pandemic. Raising corporate taxes is an easy and politically expedient answer. The UK finance minister, Rishi Sunak, is strongly hinting that corporate taxes are going up. The big threat to profits is higher corporate taxes. Higher corporate taxes with a flat wage share of income means that the structural profit margin will continue to drift lower. Combined with gently rising sales, the likely outcome is that aggregate stock market profits will continue to go nowhere, just as they have since 2008. Hence, the continuation of the structural bull market will depend on multiple expansion and a declining global bond yield, just as it has since 2008. Here we can present some good news. The relationship between the declining bond yield and stock market valuation is exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but more downside. This extra riskiness of bonds means that investors demand a reduced (and ultimately no) risk premium on equities versus bonds. In effect, as bond yields decline, the required return on equities collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-11 demonstrates this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market earnings yield is on the linear right scale. The logarithmic versus linear scales visually demonstrate that at a lower bond yield, a given change in the bond yield has a much greater impact on the earnings yield. Chart I-11The Relationship Between Bond Yields And Stock Market Valuations Is Exponential We conclude that the equity bull market will end when the global bond yield can go no lower. In practical terms, this means when the yield on the US 10-year T-bond and the yield on the Italian 10-year BTP reach zero. Until then, long-term investors should stay in equities. Fractal Trading System* The recent outperformance of European basic materials is vulnerable to reversal, given that its fragile 65-day fractal structure has reliably indicated previous reversals. Accordingly, underweight European basic resources versus the market, setting a profit target and symmetrical stop-loss at 4 percent. The rolling 12-month win ratio now stands at 59 percent. Chart I-12Europe: Basic Resources Vs. Market When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields   Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations