Developed Countries

Overweight We have been bearish this niche S&P sector and delivered alpha to our portfolio both via the cyclical and high-conviction underweights this year. Nevertheless, we do not want to overstay our welcome and the time is ripe for a bullish commercial real estate (CRE) stance. The bearish story is well known, but some bullish undertones are widely neglected. The rebound in relative share prices is substantially trailing the 2009 episode, when REITs outshined the SPX by 65% one year following the March 2009 trough. Currently, on a similar SPX advance from the March 2020 lows, REITs are lagging the S&P 500 by 22% (top panel). As large parts of CRE have been at the epicenter of the pandemic, any return to even semi-normalcy in 2021 should see these beaten down stocks sling shot passed the SPX. CRE prices will likely recover in the New Year as vulture funds and opportunistic investors are already bargain hunting. Tack on the likely refinancing lifeline bankers will extend to CRE debt originators (middle & bottom panels) and such a backdrop will loosen the noose around distressed property landlords. Bottom Line: Boost the S&P real estate sector to an above benchmark allocation and add it to the high-conviction overweight call list.

Highlights Brexit no-deal vs. deal = 1.28 vs. 1.37 on GBP/USD. Any break-out into the high 1.30s is a tactical sell – because the bigger driver of GBP/USD is the global stock market, which is due a breather. The medium-term direction of EUR/USD is gently higher… …yet the best expression of this is not through EUR/USD per se, but through a 50:50 combination of the defensive CHF/USD and the cyclical SEK/USD. Underweight technology versus healthcare. Fractal trade: Long RUB/ZAR. Feature Chart of the WeekWhat's Driving Pound/Dollar? Hint: It's Not Brexit Brexit is the story that refuses to go away. In the four and a half years since Britons voted to leave the EU, Americans have managed to elect and then reject a president. But as we write, four and a half years of negotiation have still not managed to deliver a UK/EU trade deal. Perhaps, in true European style, a deal will materialise at the eleventh hour, fifty-ninth minute, and fifty-ninth second. The Big Brexit Decisions Have Already Been Made Yet the recent haggling over a free trade deal is a sideshow, a choice between the most minimalist of deals, or no deal. The much bigger decisions on the UK/EU economic and political relationship have already been made. The recent haggling over a UK/EU free trade deal is a sideshow. The UK will end the free movement of people, leave the customs union and single market, and will have the scope to set its own rules, regulations, and standards. In response to these much bigger decisions, foreign direct investment (FDI) into the UK has fully adjusted, which is to say, slumped. Hence, the pound has largely absorbed Brexit and reverted to its traditional dependence on the direction of global equities (Chart of the Week and Chart I-2). This traditional dependence exists because the value of the UK stock market and other risk-assets is outsized relative to the UK economy. Additionally, the UK stock market is over-weighted to economically sensitive sectors. This makes the pound ultra-sensitive to equity and other risk-asset portfolio inflows and outflows (Chart I-3).   Chart I-2Brexit Has Become Less Important For The Pound Chart I-3FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound Having said that, Brexit developments can still cause deviations from the pound’s established relationship with global equities. For example, the escalation and resolution of tensions over the Withdrawal Agreement last year resulted in a 4 cent (3.5 percent) discount and then a 4 cent premium in pound/dollar within a 1.22-1.30 range. Applying the same framework to the current Brexit tensions, the equivalent range would be 1.28-1.37. But to repeat, the bigger driver of pound/dollar is the direction of global equities, and as we explain later, equities may be due a breather. If, for example, stocks corrected by 10 percent, cable could easily retest 1.25. Hence, any break-out of cable into the high 1.30s is a tactical selling opportunity. The ECB Is Exhausted This week, the ECB will once again dip into its alphabet soup of policy weapons: PEPP, TLTRO, APP, NIRP. Not forgetting the potent, and yet unused, OMT. The unfortunate thing is that these instruments have done all they can. They are exhausted. Weapons that provide liquidity to solvent but illiquid banks are exhausted. The ECB’s weapons can tighten the gap between the EONIA (interbank) lending rate and the ECB deposit facility rate. If the EONIA rate is elevated, it means that the interbank lending market is dysfunctional. But right now, EONIA is deeply negative and little different to the ECB deposit facility. Meaning that there is no liquidity shortage in the banking system, and there is little more that the ECB weapons can do on this front (Chart I-4). Weapons that provide liquidity to solvent but illiquid sovereign borrowers are exhausted. The ECB’s weapons can tighten the gap between a periphery bond yield, say Italy, and a core bond yield, say France. If periphery yields are elevated, it means that periphery sovereigns might be struggling for market funding. But right now, 2-year yields in Italy are deeply negative and little different to those in France. Meaning that there is no liquidity shortage among euro area sovereign borrowers, and there is little more that the ECB weapons can do on this front (Chart I-5). Weapons that depress interest rates along the entire term-structure are exhausted. The ECB’s weapons can depress the level of short-term and long-term euro area interest rates. But right now, both the deposit facility rate and the euro area 7-10 year bond yield are deeply negative. Meaning that euro area interest rates are within touching distance of the lower bound along the entire term-structure, and there is little more that the ECB weapons can do on this front (Chart I-6). Chart I-4Ample Liquidity For Euro Area Banks Chart I-5Ample Liquidity For Euro Area Sovereigns Chart I-6Euro Area Interest Rates Cannot Go Much Lower Some people counter that the ECB is not out of ammunition. It could just buy government debt in the primary market – meaning, print money for government spending. In theory, yes, but this would constitute fiscal easing, and it would require a major rewriting of the central bank mandate including a likely loss of independence. To repeat, in terms of pure monetary easing, the ECB is exhausted, and this carries important implications for the euro, and the euro’s inverse – the dollar. The broad level of the dollar index (DXY) depends on the US versus euro area long-duration bond yield spread. The broad level of the dollar index (DXY) depends on the US versus euro area long-duration bond yield spread (Chart I-7). Given that the ECB’s monetary easing is exhausted, the spread cannot widen from the euro area side, it can only narrow. Chart I-7In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread From the US side, the spread could move symmetrically, at least in theory. But as we explain in the next section, the ability of risk-assets to tolerate higher bond yields is very limited. This imposes a de facto asymmetry on US yield direction to the downside – a fact reinforced by the Federal Reserve’s recent strategic review which explicitly made its reaction function asymmetric. The central bank will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. And the biggest risk of a deflationary shock comes from the elevated valuations in financial markets. The upshot is that the medium-term direction of the euro versus the dollar is gently higher. But the caveat is that this will be punctuated by sharp countertrend euro sell-offs during periods of market stress, as occurred in March. During such dislocations, equity portfolio flows flee to haven assets and markets, which boosts the dollar, yen, and Swiss franc. The compelling proof is that in 2020 the broad dollar index has traded as the perfect mirror-image of the stock market (Chart I-8). Chart I-8In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market Hence, the best expression of medium-term euro appreciation version the dollar is not through the euro per se, but through a 50:50 combination of the defensive Swiss franc and the cyclical Swedish krona. Tech Stocks Are Exhausted Three weeks ago, in Sell Stocks If the Bond Yield Rises By 0.3 Percent, we pointed out that the (earnings) yield premium on tech stocks versus the 10-year T-bond yield was just 0.3 percent above a 2.5 percent lower threshold that had signalled four previous ‘tipping points.’ In the intervening three weeks, a 5 percent rally in tech stocks combined with a 0.1 percent rise in the bond yield has taken tech stocks to this tipping point (Chart I-9). Chart I-9Tech Stock Valuations Are At A Tipping Point Previous flirtations with this tipping point in February 2018, October 2018, April 2019, and January 2019 resulted in an exhaustion or, worse, a correction, in tech stocks – and by extension in the overall market. In this regard, note that the stock market had already peaked in mid-January this year well before the pandemic devastated it in mid-February. Independently signalling an exhaustion of the tech rally, at least in relative terms, the 130-day fractal structure of technology versus healthcare is also at its tipping point of fragility. Again, previous flirtations with this tipping point have resulted in an exhaustion, or reversal, in relative performance. This is because a fragile fractal structure implies excessive trending and a potential liquidity shortage, requiring a price reversal to match sell and buy orders (Chart I-10). Chart I-10Tech Versus Healthcare Performance Is At A Tipping Point Investment does not present certainties. It only presents probabilities which you must play to your advantage. The combination of two independent indicators that suggest that the tech rally is fragile implies a higher than even chance of an exhaustion or correction in the sector in the coming months. Which would then spread to the aggregate market. One thing that might mitigate this is if bond yields backed down again. Therefore, for the time being, we are not making an absolute recommendation, just a relative recommendation between two growth sectors. Underweight technology versus healthcare. On a 6-month horizon, underweight technology versus healthcare. Fractal Trading System* This week’s recommended trade is long RUB/ZAR, whose long downtrend is now at a 130-day fractal reversal point. The profit-target and symmetrical stop-loss is set at 5 percent. The rolling 12-month win ratio now stands at 59 percent. 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 II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations    

In the latest Strategy Report we published our high-conviction calls for the year 2021 comprising four overweights and three underweights. We want to hedge our high-conviction calls with a long VIX futures position for the June 16, 2021 expiry. We are spending $25.3 to go long and are comfortable paying up for insurance when the SPX is at all-time highs and there is a risk of some growth disappointment in the next six months. The chart below draws a parallel with the March 2009 SPX lows and plots the VIX in 2009 and 2010. While the path of least resistance is lower for volatility, sporadic surges are typical in the year following recessions. The S&P 500 also troughed in March 2020 and if history is an accurate guide, the path to SPX 4,000 will be rocky next year. As a reminder, the S&P 500 suffered a 16% correction in May 2010 and the VIX spiked higher Bottom Line: We went long the VIX June 2021 futures as a small hedge to overweight equity positions.

2020 will soon be history and on the eve of the New Year, it is instructive to update our presidential cycle and SPX returns research. Encouragingly, still elevated policy uncertainty will likely continue to recede next year and act as a tonic to equity returns. The chart shows the S&P 500’s performance in the first year of a presidential cycle. The market rallies 8% and 6% on a median and average basis, respectively. With regard to the range of outcomes, since 1952 the healthiest rally can net more than 30% in gains, while bear markets have also pushed SPX returns down 30%. Our sense is that 2021 will turn out to resemble 2013 or 2017 rather than 2001 or 2009. Currently, our end-2021 SPX 4,000 target (first introduced in our November 9 Special Report) represents a 17% gain from the Election Day and falls within the historical return norm. Bottom Line: Our cyclically sanguine broad equity market view remains intact.